Key Takeaways:
- Liquidating distributions are generally tax-free up to partner’s basis
- Gain recognized only when cash/marketable securities exceed basis
- Loss recognized only on liquidating distributions of money, receivables, or inventory
- “Hot assets” (unrealized receivables, inventory) create ordinary income
- IRC 736 provides special rules for retiring/deceased partners
- In-kind distributions can defer gain recognition
- Plan liquidations carefully. Tax consequences vary significantly.
The partnership is ending. Maybe you’re retiring. Maybe the business is dissolving. Maybe you’re cashing out your interest.
However it happens, liquidating a partnership triggers tax rules different from normal operations. What you receive, how you receive it, and whether “hot assets” are involved all affect whether you recognize gain, loss, ordinary income, or capital gain.
Some partners discover unexpected tax bills. Others miss planning opportunities that could have saved thousands.
This guide covers partnership liquidation tax consequences, IRC 736 payments for retiring partners, hot asset rules, and strategies to minimize tax on the way out.
Table of Contents
Types of Partnership Liquidations
Not every partnership exit works the same way.
Complete Liquidation
The entire partnership dissolves. All assets are distributed. All partners exit. The entity ceases to exist.
Tax consequences apply to everyone. Each partner receives their share based on the partnership agreement.
Partial Liquidation (Partner Redemption)
One partner’s interest is completely redeemed. The partnership continues with remaining partners.
Only the exiting partner faces immediate tax consequences. Remaining partners may see indirect effects through changed allocations and basis adjustments.
Winding Up Period
After dissolution, partnerships often have a “winding up” period. Business continues until affairs are settled. The partnership remains a tax entity during this time.
Income earned during winding up is still partnership income, allocated to partners per the agreement.
Liquidating Distribution vs. Sale of Partnership Interest
Partners exit partnerships two ways: distributions from the partnership or sales to third parties.
| Feature | Liquidating Distribution | Sale of Interest |
|---|---|---|
| Who pays partner | Partnership distributes assets | Buyer pays cash |
| Tax character | Generally capital, with hot asset exceptions | Generally capital, with Section 751(a) exceptions |
| Timing control | Partnership controls distribution timing | Parties negotiate terms |
| Installment treatment | IRC 736(a) may apply | IRC 453 installment rules may apply |
| Remaining partners affected | Indirectly through reduced partnership assets | May trigger Section 754 adjustments |
The distinction matters because different Code sections apply.
For distributions: Sections 731, 732, 736, 751(b) For sales: Sections 741, 751(a), 743(b)
General Tax Rules for Liquidating Distributions
IRC Section 731 provides the framework.
When Gain Is Recognized
Cash exceeds basis: If cash distributed exceeds your outside basis immediately before distribution, you recognize gain on the excess.
Example:
- Partner’s basis: $50,000
- Cash received in liquidation: $75,000
- Gain recognized: $25,000 (capital gain)
Marketable securities: Marketable securities are treated as cash for this purpose. Securities received in liquidation count at fair market value.
When Loss Is Recognized
Loss recognition on liquidation is more limited.
Requirements for loss:
- Must be a complete liquidation of your interest
- You receive ONLY: cash + unrealized receivables + inventory
- Your basis exceeds what you received
If you receive other property (equipment, real estate, etc.), no loss is recognized. Your basis in the distributed property simply equals your remaining basis.
Example where loss recognized:
- Partner’s basis: $100,000
- Receives: $60,000 cash + $15,000 inventory (basis)
- Nothing else
- Loss recognized: $25,000 (capital loss)
Example where loss NOT recognized:
- Partner’s basis: $100,000
- Receives: $60,000 cash + equipment worth $40,000
- Partner takes basis in equipment, no loss allowed
Character of Gain/Loss
Gain or loss under Section 731 is capital gain/loss, treated as from sale of partnership interest.
But: Hot asset rules can recharacterize part of the gain as ordinary income.
“Hot Assets” and Ordinary Income (IRC 751)
Here’s where liquidating distributions get complicated.
What Are Hot Assets?
IRC Section 751 identifies two categories:
1. Unrealized receivables
- Accounts receivable (for cash-basis partnerships)
- Depreciation recapture amounts
- Items that would produce ordinary income if the partnership sold them
2. Substantially appreciated inventory
- Inventory items
- Substantially appreciated = FMV exceeds 120% of basis
These are called “hot” because they produce ordinary income when sold, not capital gain.
Why Hot Assets Matter
When a partner receives a distribution that changes their share of hot assets, ordinary income may result.
The concept: If you’re entitled to 25% of partnership assets but receive liquidation that effectively shifts your share of hot assets, that shift is treated like a sale. You’re deemed to “sell” your hot asset interest.
Example:
- Partnership has $400,000 in receivables (zero basis), $400,000 in cash
- Partner owns 50%: $200,000 receivables interest, $200,000 cash interest
- Partner receives $300,000 cash in liquidation (no receivables)
- Partner effectively exchanged $100,000 of receivables for $100,000 cash
- $100,000 ordinary income (as if partner collected those receivables)
Calculation Under Section 751(b)
The hot asset calculation is mechanical:
- Determine partner’s share of hot assets before distribution
- Determine partner’s share of hot assets after distribution
- If share decreases, partner is deemed to “sell” the reduction
- Ordinary income equals the difference
This applies even if the partner only receives cash.
IRC 736 Payments: Retiring and Deceased Partners
IRC Section 736 provides special rules when a partner retires or dies and the partnership makes payments for their interest.
Two Categories of Payments
Section 736(a) Payments:
- Distributive share of partnership income
- Guaranteed payments for services or capital use
- Tax treatment: Ordinary income to recipient
- Partnership effect: Deductible (for guaranteed payment portion)
Section 736(b) Payments:
- For partner’s share of partnership property
- Tax treatment: Capital gain/loss under normal distribution rules
- Partnership effect: Not deductible
Why the Distinction Matters
736(a) payments are ordinary income but potentially deductible by the partnership. This shifts income character and can benefit both sides if structured properly.
736(b) payments follow normal liquidating distribution rules. Capital gain treatment for the partner, no deduction for the partnership.
Special Rule for Service Partnerships
For partnerships where capital is not a material income-producing factor (law firms, accounting firms, consulting firms):
Unrealized receivables and goodwill can be classified as 736(a) payments if the partnership agreement so provides.
This means:
- Retiring partner receives ordinary income
- Partnership can deduct the payment
- Remaining partners’ taxes decrease
Without proper agreement language, these payments default to 736(b) (capital treatment, no deduction).
Example: Structuring 736 Payments
Scenario: Retiring partner from law firm receives $500,000 for their interest:
- $200,000 for share of tangible assets
- $150,000 for share of receivables
- $150,000 for goodwill
With proper agreement:
- $200,000: 736(b) payment (capital gain)
- $150,000 receivables: 736(a) payment (ordinary income, deductible)
- $150,000 goodwill: 736(a) payment (ordinary income, deductible)
Without proper agreement:
- All $500,000: 736(b) payment (capital gain, not deductible)
The retiring partner’s total income is the same, but character differs. The partnership’s deduction opportunity exists only with proper planning.
In-Kind Distribution Benefits
Distributing appreciated property in-kind (rather than selling and distributing cash) offers significant tax advantages.
No Gain at Partnership Level
When a partnership distributes appreciated property to a partner, no gain is recognized by the partnership or remaining partners.
Compare to corporations: If a C-Corp distributes appreciated property, the corporation recognizes gain as if it sold the property. Double taxation follows.
Partnerships avoid this. Appreciated property distributes without immediate tax.
Partner Takes Carryover Basis (Sort Of)
In a liquidating distribution:
- Partner’s basis in distributed property equals their remaining outside basis
- Allocated among properties received
Example:
- Partner’s basis: $200,000
- Receives real estate (partnership inside basis $300,000, FMV $500,000)
- Partner’s basis in real estate: $200,000 (limited to outside basis)
- Built-in gain: $300,000 ($500,000 FMV – $200,000 basis)
Partner doesn’t recognize gain on receipt. But if they sell the property later, they’ll recognize $300,000 gain.
When to Use In-Kind Distributions
Partner plans to hold property long-term: Deferral is valuable. No current tax, eventual tax when property sells.
Partner has losses to offset: If partner has other capital losses, the eventual gain may be offset.
Avoid immediate recognition: When selling the property would create current cash needs for taxes partners can’t cover.
Basis of Property Received in Liquidation
Understanding basis in distributed property prevents surprises.
The General Rule
In a liquidating distribution, your basis in distributed property equals your remaining outside basis after reduction for cash received.
Example:
- Outside basis: $150,000
- Cash received: $50,000
- Property received: Equipment + Real estate
- Basis to allocate to property: $100,000 ($150,000 – $50,000)
Allocation Among Multiple Properties
If you receive multiple properties:
Step 1: Allocate first to unrealized receivables and inventory, up to partnership’s inside basis in those items
Step 2: Allocate remaining basis to other property
Step 3: If multiple “other” properties, allocate based on relative FMV
Example:
- Remaining basis to allocate: $100,000
- Receive: Inventory (inside basis $20,000), Equipment (inside basis $40,000, FMV $60,000), Real estate (inside basis $80,000, FMV $90,000)
- Step 1: $20,000 to inventory
- Step 2: $80,000 to equipment and real estate
- Step 3: Allocate $80,000 based on relative FMV
- Equipment: $80,000 × ($60,000 / $150,000) = $32,000
- Real estate: $80,000 × ($90,000 / $150,000) = $48,000
Partner’s basis may be higher or lower than partnership’s inside basis depending on these calculations.
State Tax Considerations
Federal rules are complex enough. States add another layer.
Different State Treatments
- Some states don’t recognize IRC 736 distinctions
- State withholding requirements may apply
- Multi-state partners face apportionment issues
- State filing requirements continue during winding up
For multi-state partnership filing requirements, see our separate guide.
California and New York Specifics
California and New York both have unique rules that can create state-level tax even when federal tax is minimal. Partners in these states should pay particular attention during liquidation.
Planning to Minimize Tax on Liquidation
Strategy 1: Distribute Appreciated Property In-Kind
If the partnership has appreciated assets, consider distributing them rather than selling:
- No current partnership-level gain
- Partners defer gain until they sell
- Especially valuable for real estate
Strategy 2: Time Distributions Strategically
Spread liquidating payments over multiple years:
- Installment treatment under IRC 736
- Manage tax brackets year-over-year
- Allow time for partner to use capital losses
Strategy 3: Structure 736(b) vs. 736(a) Payments
For retiring partners from service partnerships:
- Consider whether 736(a) treatment benefits both sides
- Partnership gets deduction
- Partner receives ordinary income (but may have lower overall tax if partnership is high-bracket)
Strategy 4: Address Hot Assets Proactively
Hot assets create ordinary income whether you want them to or not. Planning options:
- Distribute hot assets proportionally to avoid 751(b) issues
- Consider whether receiving hot assets directly (with basis) is better than cash
Strategy 5: Verify Partner Basis Before Liquidation
Many partners don’t accurately track outside basis. Basis errors discovered during liquidation are expensive:
- Understated basis = unexpected gain
- Overstated basis = underreported gain and potential penalties
Calculate and verify basis before finalizing liquidation.
Strategy 6: Document Distribution Treatment
The IRS can challenge whether something is a distribution or disguised sale. Documentation matters:
- Written distribution agreement
- Board/partner resolutions
- Clear allocation of assets
- Proper Form 1065 and K-1 reporting
Frequently Asked Questions
Is a partnership liquidation taxable?
Generally, liquidating distributions are tax-free up to your basis. Gain is recognized only when cash or marketable securities exceed your basis. Loss is recognized only in limited circumstances (complete liquidation, receiving only cash, receivables, and inventory).
What are “hot assets” in partnership taxation?
Unrealized receivables and substantially appreciated inventory. When distributions change a partner’s share of hot assets, ordinary income can result even if the partner only receives cash.
What’s the difference between IRC 736(a) and 736(b) payments?
736(a) payments are for services or capital use (ordinary income to partner, potentially deductible by partnership). 736(b) payments are for partnership property (capital gain/loss to partner, not deductible by partnership).
Should we distribute property or sell it first?
Distributing appreciated property in-kind typically defers tax. The partnership doesn’t recognize gain on distribution. Selling first triggers partnership-level gain allocated to all partners.
How is basis determined for distributed property?
In a liquidating distribution, your basis in distributed property equals your remaining outside basis after cash reduction. This may be more or less than the partnership’s inside basis, depending on your specific situation.
Do I need to file anything special for partnership liquidation?
The partnership files a final Form 1065 marked “final return.” Each partner receives a final Schedule K-1. State filings vary. Dissolving the legal entity may require separate state filings.
Exit With a Plan
Partnership liquidations offer planning opportunities that disappear once distributions happen. The difference between thoughtful structuring and default treatment can be tens of thousands in taxes.
Hot asset rules create ordinary income. 736 distinctions affect both character and deductibility. In-kind distributions defer gain that cash distributions don’t.
These rules reward planning. They punish rushing.
If you’re approaching partnership liquidation, whether through retirement, dissolution, or buyout, SDO CPA can help you structure the exit to minimize tax consequences. We analyze your specific assets, partner basis, and available elections to recommend the best approach. Contact us before finalizing any liquidation.