The number one most important thing you need for a successful partnership is a great partner. Number two is a solid exit strategy.
All great things must come to an end, and when that day comes for your partnership you’ll want to have a plan. You’ll want to know exactly what your and your partner’s obligations are, what you’ll do with all the assets… and, of course, what you'll do about all the taxes.
When One Partner Buys Out the Other
One common scenario is when you buy out your partner’s interest and continue the business on your own. This usually happens in a 2-person partnership and is often called a “partnership divorce”.
Whether you’re building new bridges or burning them to the ground behind you, we won’t judge. Today we’re here to show you what tax implications might come up so you're not caught by surprise.
How a Partnership Buyout Works
A partner buyout happens in a few stages:
First, the partnership liquidates all its assets to the 2 partners. Next, you buy the selling partner's assets. Your new basis is the purchase price, and your new holding period (to calculate long-term vs short-term capital transactions) starts the day after purchase.
Then you receive your share in the partnership’s distributions. If part of that includes cash, you might have to report a taxable gain. It depends on your former partner’s taxable basis in the partnership before the buyout.
Since you have ended the partnership you must file a Final Partnership Return at the end of the year.
The Tax Implications
When you buy out your partner’s interest in the business, they usually face a taxable gain or loss. If they’ve held the partnership interest for over a year, this gain is treated as a capital gain, benefiting from lower long-term capital gains tax rates. However, if you have “hot assets” like zero-basis receivables, appreciated inventory, or depreciable assets that have increased in value, some of this gain could be taxed as ordinary income.
You also want to pay close attention to any local and State taxes. If your partner was a passive investor they might also get hit with a 3.8% Net Investment Income Tax (NIIT).
Deducting Suspended Losses
Now here’s a really cool possibility:
Say your partner has suspended losses from this year or previous years in the partnership. Guess what? You will most likely be able to deduct them all this year!
Takeaway
Partnerships don’t need to end badly, and they don’t need to come with nasty tax surprises. Make sure to have a solid exit strategy and work closely with your tax advisor to plan proactively ahead of time. Most tax strategies need time and foresight to be implemented effectively.
If you're considering buying out your partner's share, consult your CPA about capital gains, "hot assets", passive losses, basis, and—one topic we did not cover today— goodwill.
As the saying goes, a failure to plan, is a plan to fail.
