Key Takeaways

  • A change in partnership ownership can occur through a partner buyout, capital investment, or partner withdrawal.
  • The transaction type affects partnership tax status, capital accounts, and possible partnership termination under IRS rules.
  • Form 8308 may be required for reporting certain sales or exchanges of partnership interests involving unrealized receivables or inventory.
  • Selling or transferring partnership ownership requires proper valuation and legal documentation to protect all parties.
  • Partnership continuation rules under IRS regulations may impact whether the partnership maintains its tax identity after ownership changes.

Having a partnership change in ownership can mean adding or withdrawing partners. Partners can agree to add new partners in two different ways. The partner who's new could buy out part or all of the interest of the current partner or partners. The new partner could also invest in the partnership, which would cause an increase in how many partners there are. The partnership will account for these partner changes differently.

Buying Out Existing Partners

Say there are two current partnerships - MJM, which has a capital balance of $70,000, and EAM, which has a capital balance of $50,000. If MJM wants to retire and the partners will have TLM buy out the partnership interest held by MJM, the accounting records for the partnership need to reflect this ownership change. Since TLM is buying all of MJM's interest directly from the company, any cash that MJM gets from TLM will not be recorded on the books.

This is because it's an exchange of an investment by people who have no assets that are being taken or given to the partnership. This means it doesn't matter if TLM pays $50,000 or $100,000 for the new partnership interest that MJM. The partnership simply needs to record the capital accounts change by using MJM's current balance of their capital account.

Tax Implications and Reporting Requirements

When there's a change in partnership ownership due to a buyout, it’s important to consider tax implications under IRC Section 751(a). If the selling partner’s interest includes unrealized receivables or inventory, the transaction may trigger ordinary income rather than capital gain treatment for the selling partner. In such cases, the partnership must file IRS Form 8308, Report of a Sale or Exchange of Certain Partnership Interests, to disclose the transaction to the IRS.

Additionally, a partner’s buyout may or may not trigger a technical termination of the partnership under pre-2018 tax laws (no longer applicable under current law post-TCJA), but it could still impact allocations and tax filings depending on ownership shifts. Ensure that both the buyer and seller document the transaction with an updated partnership agreement and properly adjusted capital accounts.

Investment in the Partnership

If TLM decides to become a third partner and join the current partnership by investing $30,000 cash in it, the partnership needs to record this extra cash and define the new capital account for the partner. The following rules apply:

  • How much capital that's recorded for TLM depends on their ownership interest in this partnership.
  • Any difference between the cash that's contributed by TLM to the partnership and the ownership interest must be given to the current partners.
  • The difference can increase what the current capital account balances are and can be a bonus to current partners to be taken out from the current capital account balances so it will be a bonus to the upcoming partner.

If a 20 percent ownership interest for the partnership is received by TLM for their investment of $30,000, the initial capital account balance needs to be determined by adding this $30,000 to the total capital of the partnership before the investment, and then multiply by 20 percent. This will calculate the ownership interest of TLM. In this case, TLM's capital account will be credited $30,000 and, if they receive a 30 percent interest for their investment of $30,000, the capital account will be credited $45,000.

This $15,000 difference between the original balance of $45,000 and the $30,000 cash investment needs to be deducted from the current partners' capital account balances as defined by their sharing of losses and gains. If there is a 15 percent interest received by TLM in the partnership for an investment of $30,000, the cash account for the partnership will be debited by $30,000 and the capital account for TLM will be credited by $22,500.

The leftover $7,500 will be credited to the other two capital account balances for the remaining partners based off the 60 percent/40 percent ratio for sharing their gains and losses. The capital account balance for MJM will increase by $4,500, and EAM's will increase by $3,000.

Transfer of Ownership Percentages

Transferring ownership percentages can involve partial transfers of partnership interest rather than a full buy-in or buyout. A partner may wish to transfer a portion of their interest to a new or existing partner. In these cases, ownership percentages must be recalculated to reflect the updated distribution of profits, losses, and voting rights.

Key considerations when transferring ownership percentages include:

  • Establishing a fair market value for the transferred interest.
  • Updating the partnership agreement to reflect new ownership shares.
  • Addressing any buy-sell agreements or right of first refusal clauses that may govern internal transfers.
  • Revising profit and loss allocation formulas in compliance with IRS partnership tax rules.

A valuation professional or legal advisor is often involved to ensure compliance and fairness for all partners.

Retirement or Withdrawal of a Partner

If a current partner wants to withdraw or retire from a partnership, the partner can choose to be bought out by a current partner or can get assets from the partnership. If the partner decides to purchase a retiring partner's interest, the partnership needs to record an entry, so the capital account balance is closed out and the capital account balance amount is added to the partner who has newly purchased the interest.

If the partnership decides to give their assets to the partner who's retiring in the amount that is the partner's capital account balance, there must be an entry made to decrease the assets and have the capital account balance of the retiring partner be zeroed out. If the retiring partner gets fewer or more assets than the capital account balance of the partner, the difference will be added to or taken from the capital accounts of the partners who are remaining.

Partnership Continuation Rules and Termination Triggers

Under IRS regulations, a change in partnership ownership caused by a partner’s withdrawal may raise questions about whether the partnership continues or terminates for tax purposes. Generally, a partnership continues if at least two partners remain and the business does not cease.

However, ownership changes can necessitate:

  • Revising the partnership’s employer identification number (EIN) if considered a termination.
  • Filing a final partnership return if the partnership ends.
  • Notifying the IRS and state tax authorities of structural changes.

A technical termination (as defined before 2018) occurred if 50% or more of the partnership interest was sold or exchanged within a 12-month period, but this rule was repealed by the Tax Cuts and Jobs Act. Nonetheless, state rules or other legal provisions may still create similar effects.

Additionally, retiring partners receiving payments over time may be subject to Section 736 rules, distinguishing between distributive share payments and guaranteed payments, with different tax treatments.

Frequently Asked Questions

  1. Do I need to file IRS Form 8308 when a partner sells their interest?
    Yes, if the sale involves unrealized receivables or inventory, the partnership must file Form 8308 to report the transaction.
  2. What happens to the partnership if a partner leaves?
    The partnership generally continues as long as at least two partners remain and business operations continue.
  3. Does buying out a partner trigger a partnership termination?
    Not under current federal tax law (post-2018), but it may affect capital accounts and reporting requirements.
  4. How is ownership percentage recalculated after a transfer?
    Ownership percentages are adjusted based on the value of the interest transferred and updated in the partnership agreement.
  5. Is a formal valuation required when transferring partnership ownership?
    While not always legally required, a formal valuation ensures fairness and protects against disputes or tax challenges.

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