The tax treatment of redemptions of partnership interests is extremely complex and uncertain. The uncertainty in this area of Subchapter K provides considerable flexibility to taxpayers but comes with increased risk that a position taken with respect to a redemption could be challenged. Differences in treatment of redemptions of partnership interests and sales of partnership interests create planning opportunities, even though sales and redemptions often have the same economic results. To address perceived abuses arising in connection with the planning flexibility, courts and the Service have at times sought to recharacterize redemptions as sales. This Article discusses the circumstances in which a transaction will be treated as a redemption rather than a sale of a partnership interest to the other partners or a new partner.
After discussing the tax treatment of redemptions of partnership interests under section 736, which contains rules regarding the characterization of the payments made in redemption of a partnership interest, this Article discusses several ways in which sale and redemption treatments differ with respect to the timing of income recognition for the partnership and the remaining partners and the character of income recognized by the partner whose interest is liquidated. Such differences include the application of the “hot asset” rules of section 751(b), the treatment of goodwill, the application of installment sale treatment where payments are made in more than one taxable year, and the mechanics of basis adjustments.
This Article then discusses other areas of uncertainty in the treatment of redemptions of partnership interests including distributions of partnership property, tiered partnership and corporate blocker structures, so-called stuffing allocations, and redemptions of a foreign partner’s interest if the partnership is engaged in a U.S. trade or business. Taxpayers appear to have considerable flexibility in structuring redemption transactions to minimize tax liability in these situations but, in many cases, may prefer having a clear answer rather than navigating the complexity and uncertainty inherent in the partnership redemption rules.