311 / What are the income tax consequences when a deceased partner’s interest is liquidated under a business purchase agreement?

The term “liquidation” refers to termination of a partner’s entire interest by means of a distribution or series of distributions by a partnership. This is an entity redemption plan.¹ The term sale refers to purchase of a deceased’s partnership interest by a surviving partner or partners individually; this is a cross-purchase plan.² Sale of a deceased partner’s interest under a business purchase agreement is discussed in Q 313.

The portion of a partnership’s payment that is allocable to a deceased partner’s interest in partnership property is treated as a distribution, or payment for the purchase of a capital asset.³ If capital is not a material income-producing factor for a partnership and a deceased partner was a general partner, then payments for an interest in partnership property will not include unrealized receivables or goodwill unless the partnership agreement provides for payments for goodwill.⁴

The estate or other successor in interest should realize no gain or loss if a partnership has elected to adjust the basis of partnership property to reflect the new basis of the deceased’s partnership interest since that basis will be determined under stepped-up basis rules. Generally, the valuation placed by partners on a partner’s interest in partnership property in an arm’s length agreement will be regarded as correct.

The amount of any money or the fair market value of any property received by a partner in exchange for all or a part of the partner’s interest in the partnership attributable to unrealized receivables of the partnership or inventory items of the partnership is considered an amount realized from a sale or exchange of property other than a capital asset. Amounts realized from a sale of property other than a capital asset generally are treated as ordinary income to the extent of gain.

The basis of these items also may be adjusted if a partnership elects. Payments for a deceased’s interest in partnership property are not deductible by a partnership, but they increase, pro rata, the basis for each remaining partner’s partnership interest.

The portion of a partnership payment that is allocable to a deceased’s interest in unrealized receivables or inventory items of a partnership is ordinary income to the estate or other recipient.⁵ Unrealized receivables include accounts receivable that were not previously includable in taxable income of partners and depreciation that is treated as ordinary income under IRC Sections 1245 and 1250 on the sale of depreciable property.⁶ In determining the value of unrealized receivables, full account will be taken of the estimated cost of completing performance of the contract and of the time between the sale and time of payment.⁷ Payments for unrealized receivables are deductible by a partnership.⁸

Any additional amounts paid by a partnership are treated as ordinary income ( Q 314).

Ordinary income payments in a liquidation of a deceased partner’s interest are income in respect of a decedent.⁹ Consequently, a recipient of the income is entitled to an income tax deduction for any portion of the federal death taxes, including the generation-skipping transfer tax imposed on a taxable termination or a direct skip occurring as a result of a decedent’s death, paid by the decedent’s estate that is attributable to the value of that income.¹⁰

A partnership, even a two-person partnership, will not be considered to have terminated so long as liquidation payments under IRC Section 736 are being made.¹¹ Note that the 2017 tax reform legislation repealed the technical termination rule that previously applied to partnerships.

See Q 312 for a discussion of how goodwill is treated in this context.