Payments to a retiring or deceased partner for their share of partnership goodwill can be taxed either as long-term capital gain, topping out at 20 percent in 2026, or as ordinary income at rates up to 37 percent. Which rate applies turns on three things: whether capital is a material income-producing factor in the business, whether the departing partner was a general partner, and whether the partnership agreement specifically provides for a goodwill payment. Partnership goodwill tax treatment under Section 736 of the Internal Revenue Code is one of the few areas of partnership tax where a single sentence in a written agreement can shift hundreds of thousands of dollars between the departing partner and the IRS.
The Two Tax Paths Under Section 736
Section 736 sorts every payment made to a retiring partner, or to a deceased partner’s estate or successor, into one of two categories.
Section 736(b) covers payments made in exchange for the partner’s interest in partnership property. These are treated as distributions. For the departing partner, they typically produce capital gain or loss, taxed at long-term capital gains rates. The partnership gets no deduction, because it is paying for a property interest.
Section 736(a) covers everything else. These payments are ordinary income to the recipient. If the amount varies with partnership earnings, it is treated as the partner’s distributive share of income. If it is a fixed dollar amount that does not depend on firm performance, it is a guaranteed payment under Section 707(c).1Office of the Law Revision Counsel. 26 USC 736 – Payments to a Retiring Partner or a Deceased Partners Successor in Interest The top federal rate is 37 percent in 2026.2Internal Revenue Service. IRS Releases Tax Inflation Adjustments for Tax Year 2026 The offsetting effect for the remaining partners is that Section 736(a) payments either reduce the partnership’s taxable income or generate deductible guaranteed payments. The tax burden shifts from the firm to the departing partner.
Why the Partnership Agreement Controls Goodwill
Goodwill does not follow the ordinary property rule. The statute carves goodwill out of Section 736(b) treatment unless the partnership agreement specifically provides for a payment with respect to goodwill.1Office of the Law Revision Counsel. 26 USC 736 – Payments to a Retiring Partner or a Deceased Partners Successor in Interest If the agreement says nothing about goodwill, the payment defaults to Section 736(a) and is taxed as ordinary income.
To lock in capital gains treatment, the agreement must explicitly reference goodwill or describe the payment in terms that clearly identify it as compensation for the firm’s intangible value. Vague language about “settlement amounts” or “intangible interests” may not satisfy the IRS. The IRS and the courts look for language that was in place before the liquidation event, so amending the agreement after a partner announces retirement invites scrutiny.
Valuation matters too. Treasury regulations state that the IRS will generally accept the value the partners set at arm’s length, whether that is a fixed dollar figure or a formula.3eCFR. 26 CFR 1.736-1 – Payments to a Retiring Partner or a Deceased Partners Successor in Interest A reasonable valuation reflects historical earnings, market position, and industry benchmarks. Many partnerships use independent appraisals or agreement-defined formulas. An inflated figure invites challenge; a number negotiated between partners with opposing economic interests is hard to second-guess.
Which Partnerships the Goodwill Rule Actually Applies To
The goodwill carve-out only reaches certain partnerships. Section 736(b)(3) limits it to firms where capital is not a material income-producing factor and where the departing partner was a general partner.1Office of the Law Revision Counsel. 26 USC 736 – Payments to a Retiring Partner or a Deceased Partners Successor in Interest In practice, that means service partnerships: law firms, medical practices, accounting groups, consulting firms, and similar organizations whose revenue comes from the partners’ skills and relationships.
For service partnerships, both the goodwill carve-out and the unrealized-receivables carve-out apply. Payments for goodwill default to ordinary income unless the agreement addresses goodwill. Payments for unrealized receivables are always ordinary income; the agreement cannot override that.1Office of the Law Revision Counsel. 26 USC 736 – Payments to a Retiring Partner or a Deceased Partners Successor in Interest Limited partners in a service partnership are not caught by the carve-out, because Section 736(b)(3) reaches only general partners.
Capital-intensive partnerships operate under different rules. In manufacturing firms, retailers, and real estate ventures, capital is a material income-producing factor, so Section 736(b)(2) does not apply. Goodwill is automatically treated as partnership property under Section 736(b) regardless of the agreement’s language, and retiring partners receive capital gains treatment on their share without any special drafting.
Self-Employment Tax on Ordinary-Income Payments
The 37 percent ordinary rate is not the full cost of Section 736(a) classification. Guaranteed payments under Section 736(a) are generally subject to self-employment tax at 15.3 percent (12.4 percent Social Security up to the wage base, plus 2.9 percent Medicare on all earnings).4Internal Revenue Service. Self-Employment Tax (Social Security and Medicare Taxes) On a large goodwill buyout, that additional layer adds tens of thousands of dollars.
Section 1402(a)(10) provides an exception for retirement payments made under a written partnership plan, but the requirements are demanding. The retired partner must have performed no services for the partnership during the year the payments were received, the other partners must owe nothing to the retired partner except the plan payments, the retired partner’s capital interest must have been fully paid out, and the payments must continue at least until death.5Office of the Law Revision Counsel. 26 USC 1402 – Definitions Any consulting work for the old firm, even informally, blows the exemption for the year.
Section 736(b) payments are not subject to self-employment tax at all, because they are property distributions rather than earned income.
When a Deceased Partner’s Estate Receives the Payments
The cost of silence in the agreement climbs sharply when the departing partner has died. Section 736(a) payments made to a deceased partner’s estate or successor are treated as income in respect of a decedent under Section 691.6eCFR. 26 CFR 1.753-1 – Partner Receiving Income in Respect of Decedent The payments are included in the estate’s gross income and receive no stepped-up basis at death. The estate pays ordinary tax on the full amount, and if payments are spread over years, the estate or beneficiary continues reporting ordinary income each year. A single sentence in the agreement designating goodwill payments could have converted most of that income to capital gain.
Installment Buyouts Over Multiple Years
Buyouts often play out in installments. The regulations set specific allocation rules.
If the total amount is fixed and paid over a set number of years, each installment is split proportionally. The Section 736(b) share of each payment equals the ratio of total 736(b) amounts to total payments under both categories. The rest is Section 736(a). If a given year’s payment falls short of the 736(b) amount allocated to that year, the shortfall carries forward.3eCFR. 26 CFR 1.736-1 – Payments to a Retiring Partner or a Deceased Partners Successor in Interest
If the payments are not fixed (say, they track a percentage of future revenue), the ordering flips. Every payment is treated as a Section 736(b) distribution first, up to the full value of the partner’s interest in partnership property. Only after that value is exhausted do subsequent payments become Section 736(a) ordinary income.3eCFR. 26 CFR 1.736-1 – Payments to a Retiring Partner or a Deceased Partners Successor in Interest The practical result: capital gains treatment in the early years, ordinary income later.
The partners can also agree on a custom year-by-year allocation, so long as the total allocated to Section 736(b) over the life of the buyout does not exceed the fair market value of the departing partner’s interest in partnership property at the retirement or death date.
Basis Step-Up for the Remaining Partners
When the departing partner recognizes gain on Section 736(b) payments and the partnership has a Section 754 election in effect, the remaining partners capture an offsetting benefit. Section 734(b) increases the adjusted basis of the partnership’s remaining assets by the amount of gain the departing partner recognized on the distribution.7Office of the Law Revision Counsel. 26 USC 734 – Adjustment to Basis of Undistributed Partnership Property Where Section 754 Election or Substantial Basis Reduction The step-up reduces future taxable gain when the partnership eventually sells those assets.
Section 755 governs how the increase is spread across assets, using a residual method that pushes remaining value onto Section 197 intangibles and, ultimately, goodwill.8eCFR. 26 CFR 1.755-1 – Rules for Allocation of Basis In a service partnership where goodwill dominates the intangible value, most of the step-up lands on goodwill. Goodwill that receives a basis increase this way qualifies as a Section 197 intangible amortizable over 15 years, giving the remaining partners a stream of annual deductions.9Office of the Law Revision Counsel. 26 USC 197 – Amortization of Goodwill and Certain Other Intangibles Without a Section 754 election in place, no basis adjustment occurs and this benefit is lost.
Section 736(a) payments do not generate a basis adjustment. The remaining partners already receive a current-year tax benefit from the deduction or income reduction, so no step-up sits on top.
Reporting and Documentation
The partnership reports liquidation payments on Form 1065, due the fifteenth day of the third month after the partnership’s tax year ends. For calendar-year partnerships, that is March 15, and Schedule K-1 to each partner is due the same day.10Internal Revenue Service. Publication 509 (2026), Tax Calendars
The retiring partner’s K-1 must separate Section 736(a) amounts from Section 736(b) amounts. Guaranteed payments under 736(a) generally appear on line 4, and 736(b) distributions show up in the capital account analysis and distributions section. The retiring partner then reports 736(b) capital gains on Schedule D of Form 1040 and 736(a) ordinary income on the appropriate income schedules.
Before any of that, the partnership needs to calculate the retiring partner’s adjusted basis in the partnership interest immediately before liquidation. That number starts with the partner’s original capital contribution, adds subsequent contributions and the partner’s share of accumulated income, and subtracts prior distributions and the partner’s share of losses. A wrong basis figure distorts gain or loss on every Section 736(b) payment.
Section 751 Statements for Hot Assets
If the distribution involves “hot assets” (unrealized receivables or substantially appreciated inventory under Section 751), both the partnership and the retiring partner must attach a statement to their returns. The partnership’s statement shows the Section 751(b) computation. The retiring partner’s statement shows the same computation from their side, along with the transaction date and the amount of gain or loss attributable to Section 751 property versus capital gain or loss on the rest of the interest.11GovInfo. 26 CFR 1.751-1 – Unrealized Receivables and Inventory Items Omitting the statements does not change the tax treatment, but it invites scrutiny and penalties for incomplete returns.
Keep the partnership agreement with its goodwill clause, the basis calculations, and any independent valuations in the permanent records. If the IRS questions the allocation between Section 736(a) and 736(b), the agreement and supporting valuations are the first documents an examiner will ask for. Mismatches between the partnership’s Form 1065 and the retiring partner’s Form 1040 are one of the most common triggers for correspondence audits on these transactions.