The partial redemption of a partnership interest is taxed as a current, non-liquidating distribution under IRC Section 731: the redeeming partner reduces outside basis dollar for dollar by the cash received, recognizes gain only to the extent total cash exceeds that basis, and cannot recognize a loss. Because the partner keeps some interest, Section 736 (which governs complete liquidations) does not apply, and Section 741 (sales) does not apply either. What complicates the clean picture are two things almost every redemption touches: a deemed cash distribution from the partner’s reduced share of partnership debt, and the hot-asset rules of Section 751(b), which can convert part of the result into ordinary income.
Why It Isn’t a Sale or a Complete Liquidation
Three routes out of a partnership interest look similar and are taxed very differently. A sale to another partner or an outside buyer falls under Section 741 as the sale of a capital asset, with the partnership itself largely on the sidelines. A complete liquidation of the entire interest is governed by Section 736, which splits payments between those for the partner’s share of property (taxed under Sections 731 and 751) and those characterized as guaranteed payments or distributive shares taxed as ordinary income. The regulations state that Section 736 applies “only to payments made to a retiring partner or to a deceased partner’s successor in interest in liquidation of such partner’s entire interest.”1eCFR. 26 CFR 1.736-1 – Payments to a Retiring Partner or a Deceased Partner’s Successor in Interest
A partial redemption is neither of those. Because the partner walks away with a smaller but continuing interest, the payment is a current distribution under Section 731. No gain unless cash exceeds outside basis. No loss recognition at all on a current distribution.2Office of the Law Revision Counsel. 26 U.S. Code 731 – Extent of Recognition of Gain or Loss on Distribution
How the Redeeming Partner Is Taxed
Start with the partner’s adjusted outside basis in the whole interest. Cash distributed in the redemption reduces that basis dollar for dollar. Gain shows up only once the cumulative cash received (including any deemed cash from a liability shift, discussed below) exceeds the entire adjusted outside basis. The excess is treated as gain from the sale or exchange of the partnership interest, generally capital in character.2Office of the Law Revision Counsel. 26 U.S. Code 731 – Extent of Recognition of Gain or Loss on Distribution
The gain is long-term if the redeemed portion was held for more than one year. Where a partner built up the interest through multiple acquisitions at different times, holding periods can be split, with each portion measured separately based on the fair market value of that portion relative to the whole.3eCFR. 26 CFR 1.1223-3 – Rules Relating to the Holding Periods of Partnership Interests
Payment structure changes the timing but not the mechanics. A lump sum reduces basis all at once. Installment payments are treated as separate distributions; each one reduces basis in turn, and gain surfaces only when cumulative distributions finally cross the basis line. This is not installment-sale treatment under Section 453. It is the ordinary Section 731 rule applied payment by payment.
Phantom Gain From Liability Shifts
The most common surprise in a partial redemption is a tax bill on money the partner never received. When ownership percentage drops, so does the partner’s allocable share of partnership debt. Section 752 treats any decrease in a partner’s share of partnership liabilities as a distribution of cash to that partner.4Office of the Law Revision Counsel. 26 U.S. Code 752 – Treatment of Certain Liabilities That deemed cash stacks on top of the actual cash paid in the redemption.
If actual cash plus the deemed distribution together exceed adjusted outside basis, the excess is taxable gain even though no additional dollars change hands. In a partnership carrying meaningful debt, this can be the largest single tax consequence of the transaction. Model the liability shift before agreeing to a price.
Hot Assets and Ordinary Income Under Section 751(b)
The capital-gain result gets rerouted when the partnership owns “hot assets.” Section 751 defines these as unrealized receivables and inventory items.5Office of the Law Revision Counsel. 26 U.S. Code 751 – Unrealized Receivables and Inventory Items Unrealized receivables are rights to payment for goods or services not yet included in income under the partnership’s accounting method. Inventory is “substantially appreciated” if its total fair market value exceeds 120 percent of the partnership’s adjusted basis in those items.6eCFR. 26 CFR 1.751-1 – Unrealized Receivables and Inventory Items
When a distribution changes the partner’s proportionate share of hot assets versus other partnership property, Section 751(b) treats the shift as a deemed sale or exchange between the partner and the partnership. The portion attributable to the partner’s share of hot assets is taxed as ordinary income, not capital gain.5Office of the Law Revision Counsel. 26 U.S. Code 751 – Unrealized Receivables and Inventory Items The mechanics require comparing the partner’s share of hot and cold assets before and after the distribution, then treating any shift as if one type had been exchanged for the other. The IRS has itself called these regulations “extraordinarily complex and burdensome,” but they still apply.7Internal Revenue Service. Notice 2006-14 – Certain Distributions Treated As Sales or Exchanges
Net Investment Income Tax
An additional 3.8 percent Net Investment Income Tax applies to gains from a partial redemption when the partner’s modified adjusted gross income exceeds the filing-status threshold. The tax is imposed on the lesser of net investment income or the amount by which MAGI exceeds the threshold. The thresholds are not indexed for inflation:
- Married filing jointly: $250,000
- Single or head of household: $200,000
- Married filing separately: $125,000
Net investment income includes capital gains and income from passive activities.8Internal Revenue Service. Questions and Answers on the Net Investment Income Tax Whether redemption gain gets hit turns largely on material participation. A passive investor generally owes NIIT on the gain; an active partner who ran the business generally does not, except on the capital gain portion attributable to assets not used in the active trade or business.
What Happens at the Partnership Level
The partnership must adjust its books right after the redemption. Under the capital account maintenance rules, the redeeming partner’s capital account is decreased by the fair market value of property (including cash) distributed.9eCFR. 26 CFR 1.704-1 – Partner’s Distributive Share The reduced profit-and-loss allocation percentage is then reallocated among the continuing partners under the amended partnership agreement.
The Section 754 Election and Inside Basis
Without a Section 754 election, the partnership’s inside basis in its assets stays put after the distribution, even if the redeeming partner recognized gain. The continuing partners effectively inherit built-in gain that has already been taxed once at the departing partner’s level. A Section 754 election addresses this by requiring the partnership to adjust the basis of remaining assets under Section 734(b).10Office of the Law Revision Counsel. 26 U.S. Code 754 – Manner of Electing Optional Adjustment to Basis of Partnership Property
When the election is in effect and the redeeming partner recognizes gain under Section 731(a)(1), the partnership increases the adjusted basis of its remaining assets by that amount.11Office of the Law Revision Counsel. 26 U.S. Code 734 – Adjustment to Basis of Undistributed Partnership Property Where Section 754 Election or Substantial Basis Reduction The increase is allocated among assets under Section 755 based on the difference between each asset’s fair market value and its existing tax basis. The continuing partners then don’t get taxed a second time on appreciation that already generated a tax bill.
The election is sticky. Once made, it applies to every distribution and every transfer of a partnership interest for that year and all future years. Revocation requires permission from the IRS Commissioner, and the partnership must file Form 15254 no later than 30 days after the close of the partnership year for which the revocation is intended to take effect.12Internal Revenue Service. FAQs for Internal Revenue Code (IRC) Sec. 754 Election and Revocation In a partnership with frequent ownership changes, the ongoing basis-tracking burden is real.
To make the election, the partnership attaches a written statement to a timely filed Form 1065 (including extensions) for the year of the distribution. The statement includes the partnership’s name and address and a declaration that it elects under Section 754 to apply Sections 734(b) and 743(b).12Internal Revenue Service. FAQs for Internal Revenue Code (IRC) Sec. 754 Election and Revocation If the partnership misses the deadline, an automatic 12-month extension is available under Treasury Regulation Section 301.9100-2. Beyond 12 months, late relief requires the Commissioner’s approval under Section 301.9100-3.
Even without an election, a downward basis adjustment becomes mandatory when there is a “substantial basis reduction,” which is triggered when the downward adjustment that would have been required under Section 734(b) exceeds $250,000.11Office of the Law Revision Counsel. 26 U.S. Code 734 – Adjustment to Basis of Undistributed Partnership Property Where Section 754 Election or Substantial Basis Reduction For large redemptions, run the numbers even if no election is on file.
Disguised Sale Risk
When a partial redemption occurs alongside a contribution of property by the same partner, the IRS may collapse the two under the disguised sale rules of Section 707 and Treasury Regulation 1.707-3. If a partner transfers property to the partnership and the partnership transfers cash or other consideration back to that partner in a related transaction, the exchange can be treated as a sale of property rather than a contribution followed by a distribution.13eCFR. 26 CFR 1.707-3 – Disguised Sales of Property to Partnership; General Rules When that recharacterization applies, the partner recognizes gain or loss on the property as if it had been sold outright, and the nonrecognition rules of Sections 721 and 731 do not apply.
A disguised sale is treated as a sale “for all purposes of the Internal Revenue Code,” including the installment sale, imputed interest, and original issue discount rules.13eCFR. 26 CFR 1.707-3 – Disguised Sales of Property to Partnership; General Rules The risk is highest when a contribution and a redemption happen close together. Document an independent business purpose for each side of the transaction.
Reporting the Redemption
The partnership reports the transaction on its annual Form 1065. The redeeming partner’s Schedule K-1 for the year must show the reduced capital account balance and the revised profit-and-loss allocation percentage. If payment is spread over years, each year’s K-1 reflects that year’s distributions.
If a Section 754 election is being made for the year of the redemption, the required statement must be attached to that year’s return. Late attachment does not kill the election if relief is sought promptly, but waiting too long forces the partnership into the discretionary relief process under Section 301.9100-3. State-level filings often need attention too: most states require an amendment to the partnership’s registration or articles of organization when ownership percentages change.