A purchase and sale of a partnership interest[1] may look like any other sale of property or stock, but a partnership interest is a different kind of asset. A partner is treated as something of a hybrid. In some respects, a partner is viewed as the owner of an entity (entity approach), in others the owner of a share of the partnership’s underlying assets (aggregate approach). Viewed as an aggregate, what the buyer is really acquiring is a bundle of the partnership’s inside tax attributes: capital accounts; built-in gains; basis adjustments; and liability shares. How those attributes carry over on a sale has significant effect on the tax consequences, and purchase agreements often fail to address them.
The Buyer Inherits the Seller’s Capital Account
A buyer who pays fair market value may assume its capital account will reflect what it paid. It will not.[2] When an interest is transferred, the transferor’s capital account attributable to that interest carries over to the buyer,[3] because a capital account moves only with contributions, distributions, and allocations. Buying an interest from another partner is none of those.[4] The usual fix, a revaluation or “book-up” of the partnership’s property to fair market value, is also unavailable. The regulations permit a book-up only on an exclusive list of events, each a transaction between the partnership and one or more partners such as a contribution or distribution for an interest, a liquidation of an interest, a grant of an interest for services, the issuance of a noncompensatory option, and a few others.[5] A sale of an interest from one partner to another is not on the list. A § 743(b) basis adjustment, discussed below, can adjust the buyer’s inside basis to reflect outside basis but that is never reflected in the capital account.[6]
A capital account is the partnership’s internal scorekeeping of what each partner has put in and taken out of the partnership, and it governs how profits, losses, and distributions are shared. A buyer who pays full value but inherits a low (or high) seller capital account balance is not economically wrong. The buyer simply holds a scorecard that no longer matches what was paid, merely inheriting the seller’s scorecard. The buyer should price for the gap, obtain the capital account and § 704(c) schedules, and consider a purchase price adjustment or indemnity where the inherited balance diverges materially from the economics.
Why does this matters to the buyer? The capital account is not just a bookkeeping entry. Under the economic effect rules, it controls at least two things the buyer should care about. First, on a liquidation of the partnership or of the buyer’s interest, liquidating distributions must in all cases be made in accordance with the partners’ positive capital account balances.[7] A buyer that pays fair value but inherits a seller’s depleted account is therefore entitled, on a capital account based liquidation, only to that inherited balance rather than what was paid unless a later revaluation or special allocation trues up the capital account. Second, most LLCs and limited partnerships do not require a member to restore a deficit, or negative, capital account, i.e. they have no “deficit restoration obligation” (DRO), and instead rely on the “alternate test” for economic effect and a “qualified income offset.”[8] Under that test, a loss or deduction is respected only to the extent it does not drive the partner’s capital account below zero; the excess is reallocated to the other partners.[9] A buyer that inherits a low capital account thus reaches that ceiling early such that tax losses the buyer economically bears are capped at the inherited balance and shifted to other partners, meaning the buyer cannot currently deduct losses attributable to the value it just purchased. Because a secondary purchase is not a revaluation event, nothing about paying fair value lifts that ceiling — only a DRO, additional capital, or a negotiated allocation will.
Built-In Gain and Loss on Property the Seller Contributed
Section 704(c) exists to keep the tax on an asset’s pre-contribution appreciation or loss with the partner who contributed it. When a partner contributes property worth more (or less) than its tax basis, that “built-in” gain or loss is tracked and charged back to the contributing partner.[10] The trap on a sale occurs when the contributing partner sells its interest, that built-in gain (but not loss) carries over to the buyer, who steps into the seller’s shoes.[11] The buyer can therefore be taxed on appreciation that occurred entirely before the sale, potentially with no cash distribution to cover the tax.
How hard that bites depends on the accounting method the partnership chose for the allocation. Under the traditional method, a quirk called the ceiling rule can leave some of the gain unallocated; curative allocations patch the gap with other real tax items; and the remedial method plugs it with notional, offsetting items.[12] Which method governs each layer is a core diligence question because it determines how much built-in gain the buyer will actually be charged. Two related rules compound the exposure. “Reverse § 704(c)” layers, created when the partnership books up its property on a permitted event, follow the same principles,[13] and the seven-year “mixing-bowl” rules can trigger gain to the contributing partner (now the buyer, as successor) if the contributed property is distributed to another partner within seven years of its contribution or other property is distributed to the buyer.[14] A full discussion of mixing bowl rules is beyond the scope of this writing, but understanding the effect of built-in gain property contributed by the seller is critical to a buyer.
A contributed built-in loss works the opposite way in that it does not carry to the buyer. The loss stays with the contributing partner, and every partnership takes the property at its fair market value at contribution.[15] This is an anti-duplication rule, not a buyer benefit. The decline in value happened on the seller’s watch; the seller’s outside basis still reflects the higher figure, so the seller uses that excess basis on the sale. The buyer paid only the depressed current value and bore none of the decline, so it has no economic loss to claim. The same policy drives the mandatory basis reduction for a “substantial built-in loss,” discussed below.
The § 754 Election and the § 743(b) Basis Adjustment
By default, the inside basis of the partnership’s property does not change when an interest is sold, unless the partnership has a § 754 election in place or has a substantial built-in loss.[16] This is perhaps the most valuable item for a buyer to confirm. Without the election, a buyer who pays for appreciated partnership assets gets no matching inside basis. Instead, the buyer will be taxed on the partnership’s pre-existing gain when those assets are sold, and will receive depreciation deductions off an artificially low basis compared to their purchase price. With the election, § 743(b) gives the buyer alone a special basis adjustment, roughly the difference between its outside basis (what it paid, plus its share of liabilities) and its share of the partnership’s existing inside basis.[17] It can be positive (a step-up) or negative (a step-down).
It may seem the election should always be made. Three practical points complicate that. First, the election is effectively permanent. It binds the partnership for the year of transfer and every year after, reaching future sales and distributions, and it can be revoked only with IRS consent.[18] A buyer bargaining for today’s step-up is potentially signing the partnership up for mandatory step-downs on later transfers (although many step-downs would be mandatory in any event). Second, where the adjustment lands is a negotiated outcome, not a formality. It is allocated first between capital gain and ordinary income property, then within each class by reference to a hypothetical sale of all assets at fair value, and for a business the § 1060 residual method pushes whatever the identifiable assets do not absorb into § 197 intangibles and goodwill.[19] Whether the step-up falls on quickly amortizable or non-amortizable assets materially changes the buyer’s after-tax return. Third, the notice mechanism has teeth and a short fuse. To get the adjustment, the buyer must give the partnership a written notice, signed under penalties of perjury, within 30 days of the sale, identifying the parties and property and supplying the data the partnership needs to compute it.[20] There can be negative consequences to a buyer who fails to satisfy these notice requirements. Finally, even with no election, a substantial built-in loss, where the partnership’s basis in its property exceeds that property’s fair value by more than $250,000 (or the buyer would be allocated a loss over $250,000 on a hypothetical sale), forces a downward adjustment, handing the buyer a step-down it may not expect.[21]
Liability Shares Under § 752 and the Bottom-Dollar Guarantee Trap
Partnerships are unusual in that a partner gets outside basis for its share of the partnership’s debt. An increase in that share is treated as a cash contribution (raising basis); a decrease, as a cash distribution (reducing it).[22] The consequence sellers may miss on a sale is that the relief of the seller’s share of partnership liabilities is added to the cash price as amount realized. Thus, a seller focused on the nominal purchase price can understate its gain by the entire assumed debt figure.[23] Which liabilities shift, and to whom, depends on complex allocation rules which differ for recourse and nonrecourse liabilities.[24]
Another trap is the bottom-dollar guarantee. Parties often add a guarantee or indemnity around a sale to hand a partner the liability share (and basis) it wants. But a guarantee is respected for this purpose only if the partner is on the hook for the first dollars of any shortfall, a true “first-dollar” obligation. Therefore, a guarantee that kicks in only after losses pass some floor is a disregarded “bottom-dollar” obligation and shifts no basis at all.[25] The regulations’ own example shows how easily this backfires: a valid first-dollar guarantee was converted into a disregarded bottom-dollar obligation by a small side indemnity from another partner illustrating that an indemnity negotiated as deal protection destroyed the very basis the guarantee was meant to create.[26]
Tax-Year Timing: Whose Return Picks Up the Year’s Income
A sale does not close the partnership’s taxable year, but the year does close as to a partner who sells their entire partnership interest. Such a seller reports their share of the year’s income, gain, or loss through the sale date; a partner who sells only part stays on the normal tax year of the partnership.[27] The practical effect on a full exit can be bunching. The seller should understand their pre-sale share of the year’s income which will be reported to the seller. When any interest changes mid-year, the partnership must split the year’s items under the “varying-interests” rules, using either an interim closing of the books (the default) or a straight proration.[28] The two can produce very different splits when income is earned unevenly, which is why the choice belongs in the contract rather than the later return, and electing anything other than the default requires a defined agreement of the partners. A dated writing kept with the books by the return due date is important, not something assembled after year-end.[29] One guardrail even under proration is that “extraordinary items,” a one-time asset sale, a debt forgiveness, a large settlement, etc., cannot be prorated across the year and instead be allocated to the partners who held the interest at the moment such events occurred.[30]
Hot Assets Under § 751: Ordinary Income Hiding in the Sale
The character of the gain can also change depending on the partnership’s assets. To the extent the price is attributable to the seller’s share of the partnership’s “unrealized receivables” (which includes depreciation recapture) or “inventory items” that portion is ordinary income, not capital gain, and triggers on obligation to file a separate § 751 statement.[31] A sale of a partnership interest is therefore often not entirely a capital asset sale; a meaningful portion of a seller’s gain can be taxed at ordinary rates. Spotting which assets are trigger ordinary income and being sure the seller is aware of this consequence is essential to advising the seller on their true after-tax proceeds.
Other Issues
The items above are non-exclusive in the list of issues relevant for partnership interest sales. Any number of other issues are relevant, including transactions involving foreign partnership which I am not addressing here. Some, but not all, of those other issues include:
- Disguised sales. The disguised-sale rules do not touch a straight cross-purchase, where the buyer pays the seller directly. They matter when the parties instead route the exit through the partnership. For example, the buyer contributes cash and the partnership redeems the seller, or a partner contributes property and takes back a related distribution. Because § 707(a)(2)(B) pairs a transfer to the partnership with a related transfer back to that or another partner, such a structure can be recast as a currently taxable sale rather than tax-free contributions and distributions.[32]
- Suspended losses and at-risk amounts. A seller’s losses suspended for lack of basis, at-risk, or passive activity limits generally stay with the seller and do not pass to the buyer. A fully taxable sale of the seller’s entire interest to an unrelated person can free up suspended passive losses, a benefit the seller should factor into its transaction analysis.[33]
- Transitioning to a single owner. A tax partnership must have at least two partners. Therefore, a purchase that leaves only one owner terminates the partnership for tax purposes.[34] Rul. 99-6 governs, and it treats the two sides of the deal asymmetrically. The departing partner (or partners) is treated as selling a partnership interest, capital gain or loss under § 741, with the § 751 ordinary income for hot assets. The buyer, however, is treated as buying the partnership’s assets. The partnership is deemed to distribute its assets in liquidation, and the buyer is then deemed to purchase those assets directly (i.e. rather than partnership interests). The buyer takes a cost basis in those purchased assets under § 1012, with a new holding period that begins the day after the sale rather than tacking the partnership’s holding period.[35] The upshot cuts both way in that the buyer gets a new cost basis (fresh depreciation, no inside/outside basis mismatch without needing a § 754 election), but the buyer loses the assets’ holding period (relevant to long-term-gain and recapture timing). Then, the entity becomes a disregarded single-member entity with the partnership filing a final short-year return ending on the sale date. The transaction is bifurcated when the buyer was an existing partner as to partnership assets attributable to the buyer’s preexisting partnership interests.
- Non-tax items. Transfer restrictions, consents, rights of first refusal, and state entity level or transfer taxes can materially affect a transaction as significantly as any of the tax issues addressed here, and none of them waits on the tax analysis.
A Practical Diligence-and-Drafting Checklist
Based on the issues raised above, the following two lists are intended to be helpful in analyzing sales of partnership interests. The first list addresses what diligence parties should obtain. The second list addresses what the purchase agreement should potentially address. As with above, these lists are non-exclusive but represent items which sometimes are missed, especially when counsel involved is not knowledgeable about partnership taxation.
Diligence: What the Buyer Should Obtain and Confirm
| Issue | Diligence request | Why it matters |
| Capital accounts (§ 704(b)) | The § 704(b) capital-account ledgers and recent Schedules K-1 (item L). | Shows the balance the buyer inherits versus the price it is paying. |
| Built-in gain/loss (§ 704(c)) | A schedule of all § 704(c) property, the method per asset, remaining built-in gain/loss, contribution dates, and any reverse § 704(c) allocations. | Reveals pre-purchase gain the buyer will be charged and any seven-year mixing bowl exposure. |
| Basis step-up (§§ 754/743) | Whether a valid § 754 election is in effect (with the election statement and return); whether a substantial built-in loss exists; and the asset data to compute and allocate the § 743(b) adjustment. | Determines whether the buyer gets a step-up or a forced step-down. |
| Liabilities (§ 752) | A liability schedule split recourse/nonrecourse; all guarantees, indemnities, and reimbursement agreements; the allocation methodology. | Drives the buyer’s basis and the seller’s amount realized. |
| Tax-year timing (§ 706) | Whether the seller is disposing of its entire interest or part; the historical allocation method and convention; and any extraordinary items expected near closing. | Fixes whose return picks up the year’s income, and how it is split. |
| Hot assets (§ 751) | A schedule of unrealized receivables and inventory items. | Estimates the seller’s ordinary-income and supports the § 751 statement. |
| Carryforward items and status | The seller’s outside basis, at-risk and passive loss carryforwards; confirmation that two partners remain. | § 708 continuation and full tax consequences to the seller. |
| Non-tax gating items | Transfer, consent, and ROFR provisions, and state entity level or transfer taxes. | These can delay or block a closing regardless of the tax result. |
Purchase Agreement: Provisions to Consider Including
|
Provision |
What it should do |
Whose interest |
| § 754 / § 743(b) covenant | Require the partnership to have (or make) a valid § 754 election for the year of transfer and to make and report the § 743(b) adjustment. | Buyer |
| Information cooperation | Obligate the partnership and seller to deliver the asset values, capital account and basis data, and § 704(c) schedules the buyer needs to file within the 30-day notice window. | Buyer |
| Purchase price / § 755 allocation | Fix the allocation of value among asset classes that determines the § 743(b) step-up, and conform the parties’ reporting. | Both (negotiated) |
| § 704(c) method; anti-mixing-bowl | Disclose and, where possible, fix the § 704(c) method; add representations on contribution dates and covenants against distributions that would trigger § 704(c)(1)(B) or § 737. | Buyer |
| Liability and guarantee structuring | Confirm the buyer’s targeted liability share; draft any guarantee or indemnity as a first-dollar (not bottom-dollar) obligation; avoid side indemnities that would convert it. | Buyer (basis); seller (release) |
| § 706 method and convention | Specify interim closing or proration, document the required agreement of the partners, and allocate responsibility for any extraordinary item. | Both |
| Tax representations | Cover the § 754 election, § 704(c) schedules, hot-asset amounts, absence/disclosure of a substantial built-in loss, tax classification, and compliance history. | Buyer |
| Hot-asset allocation (§ 751) | Acknowledge the § 751(a) ordinary-income recharacterization and assign responsibility for the § 751 statement. | Seller (mainly) |
| Tax indemnity; return cooperation | Backstop pre-closing tax positions and require cooperation on the return, Schedules K-1, and the § 743(b)/§ 755 statements. | Buyer |
| Consents; ROFR; transfer compliance | Obtain required partner consents and ROFR waivers as conditions to closing. | Both |
[1] Throughout, “partnership” means any entity taxed as a partnership for federal income tax purposes whether a state law limited partnership, general partnership, limited liability company, or otherwise.
[2] This discussion relates to the IRC § 704(b) book capital account maintained in accordance with Treas. Reg. § 1.704-1(b)(2)(iv) rather than tax basis capital accounts or financial accounting capital accounts.
[3] Treas. Reg. § 1.704-1(b)(2)(iv)(l).
[4] Treas. Reg. § 1.704-1(b)(2)(iv)(b).
[5] Treas. Reg. § 1.704-1(b)(2)(iv)(f)(5).
[6] Treas. Reg. § 1.704-1(b)(2)(iv)(m).
[7] Treas. Reg. § 1.704-1(b)(2)(ii)(b)(2).
[8] Treas. Reg. § 1.704-1(b)(2)(ii)(b)(3) (deficit restoration obligation); id. § 1.704-1(b)(2)(ii)(d) (alternate test for economic effect; qualified income offset).
[9] Treas. Reg. § 1.704-1(b)(2)(ii)(d); id. § 1.704-1(b)(2)(ii)(e) (unsupported portion reallocated).
[10] IRC § 704(c)(1)(A); Treas. Reg. § 1.704-3(a)(1).
[11] Treas. Reg. § 1.704-3(a)(7); IRC § 704(c)(3) (successor treated as the contributing partner).
[12] Treas. Reg. § 1.704-3(b) (traditional method / ceiling rule), (c) (curative allocations), (d) (remedial method).
[13] Treas. Reg. § 1.704-3(a)(6).
[14] IRC § 704(c)(1)(B); IRC § 737(a)–(b).
[15] IRC § 704(c)(1)(C).
[16] IRC § 743(a).
[17] IRC § 743(b); Treas. Reg. § 1.743-1(d) (previously taxed capital), (j) (adjustment runs to the transferee only).
[18] IRC § 754; Treas. Reg. § 1.754-1(a), (c) (revocation only with district-director consent).
[19] IRC § 755(a)–(b); Treas. Reg. § 1.755-1(a) (two-class split; residual method coordinated with IRC § 1060), (b) (within-class allocation by hypothetical sale).
[20] Treas. Reg. § 1.743-1(k)(2).
[21] IRC § 743(d).
[22] IRC § 752(a), (b).
[23] IRC § 752(d); Treas. Reg. § 1.752-1(h).
[24] Treas. Reg. § 1.752-1(a) (recourse/nonrecourse definitions); § 1.752-2(a)–(b) (recourse share; constructive liquidation); § 1.752-3(a) (nonrecourse tiers).
[25] Treas. Reg. § 1.752-2(b)(3)(ii).
[26] Treas. Reg. § 1.752-2(f), Example 11.
[27] IRC § 706(c)(1), (c)(2)(A)–(B); Treas. Reg. § 1.706-1(c)(2)–(3).
[28] IRC § 706(d)(1); Treas. Reg. § 1.706-4(a)(3)(iii) (interim closing is the default method).
[29] Treas. Reg. § 1.706-4(c) (conventions), (f) (agreement of the partners).
[30] Treas. Reg. § 1.706-4(e).
[31] IRC § 751(a), (c) (unrealized receivables, including depreciation recapture), and (d) (inventory items); Treas. Reg. § 1.751-1(a)(3).
[32] IRC § 707(a)(2)(B).
[33] IRC § 704(d) (basis limitation); § 465 (at-risk); § 469(g) (release on full disposition).
[34] IRC § 708(b)(1).
[35] IRC § 1012.
