Partner's payments on dissolution of law firm were ordinary income.

T and L were the senior partners in the T law firm, from 1971 until 1976; during this time there was no written partnership agreement. In April 1976, L convened all the other partners and they voted to dissolve the T firm, and announced the formation of the L firm. Legal action followed; ultimately an agreement was reached under which T would receive installment payments for his share of the T firm's unrealized receivables and a lump sum for his interest in the T firm's fixed assets and goodwill.

In 1983 and 1984, T reported the installment payments as resulting from the sale of his T interest, giving rise to long-term capital gain and claiming capital gain deductions. The IRS disallowed the deductions, arguing that the payments were in liquidation of his T firm interest and gave rise to ordinary income. In a memorandum decision, the Tax Court (opinion Halpern, J.) agrees with the Service.

Sale vs. liquidation

The tax consequences of the sale of a partnership interest may differ significantly from those of a liquidation of that interest. That is so even though the economic consequences of those alternatives may be indistinguishable under certain circumstances. For example, when a partner retires, it generally makes little or no economic difference either to him or to the continuing partners whether his interest is purchased pro rata by the continuing partners or liquidated in exchange for payments from the partnership. In either case, the continuing partners ultimately bear the cost of acquiring the interest and their interests in the partnership are increased proportionately. When faced with such a situation, it is clear that the partners have complete flexibility to structure the transaction as either a Sec. 741 sale of the withdrawing partner's interest to the other partners or a Sec. 736 liquidation of the retiring partner's interest by the partnership.

It must be kept in mind, however, that the flexibility that is permitted is not a license to determine the tax result simply by checking a box on the tax return. The permitted flexibility is the flexibility to structure the transaction as either a sale or a liquidation. A transaction properly structured as a sale or liquidation will be taxed accordingly.

Continuation of the partnership business following dissolution of the partnership

The dissolution of a partnership no more terminates the partnership for federal income tax purposes than it does for state law purposes. On dissolution the partnership is not terminated, but continues until the winding up of partnership affairs is completed. Although liquidation of the partnership often follows dissolution, it is not required. Indeed, after dissolution of the partnership, the partners may continue the business of the partnership indefinitely, so that winding up occurs, if at all, only in the technical sense of paying off the outgoing partner (or his estate). If the business of the partnership is carried on by any of its partners in partnership form, the partnership is deemed not to terminate at all for federal income tax purposes.

If, following dissolution, the business of the partnership is carried on by any of the partners in partnership form, and if the withdrawing partner is paid off out of the assets of the continued business by way of a liquidating distribution to him, Sec. 736 will apply to such payment. If, on the other hand, his interest is purchased by the continuing partners, Sec. 741 will apply.

The critical distinction between a sale of a partnership interest under Sec. 741 and a liquidation of such an interest under Sec. 736 is that a sale is a transaction between a third party or the continuing partners individually and the withdrawing partner, while a liquidation is a transaction between the partnership as such and the withdrawing partner.

The payments were made by the L firm to T pursuant to its obligation under the agreement to make such payments. Although the agreement is not unambiguous, we think that the terms thereof better indicate a transaction between the L firm as such and T than they do a transaction between the continuing partners individually and T.

Both the T firm and the L firm are parties. The agreement recites that the L firm, "as successor to the [T] firm," was willing to make payments to and to guarantee such payments regardless of the income received by the partnership. The agreement binds not only the L firm but "its successor firm or entity." T's releases shall include releases of both the firm and the L firm.

Finally, the agreement not only is more consistent with a liquidation of T's interest than it is with a sale of that interest, but its references to Sec. 736 expressly describe the intended tax treatment of the payments called for under the agreement as being that of payments in liquidation of a partner's interest.

Based on the provisions of state partnership law and the agreement, the transaction was between the partnership and T rather than a transaction between the continuing partners in their own rights and T. The transaction was in the nature of payments made in liquidation of T's interest in the partnership and thus the tax consequences are determined under Sec. 736 (rather than Sec. 741).