This was more of a “cash follows tax” approach, in which the operating agreement provided a calculation for the allocation of taxable income/loss and distributions were then made based on the balance of the each partner’s capital account.
The Regulation provides a safe harbor for economic effect if:1.
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hen a partner withdraws from a partnership, it usually does not matter to the principals whether the withdrawing partner receives compensation for his partnership interest from third parties, from the partnership, or from the remaining partners themselves.
After all, there is generally little, if any, actual economic difference between the liquidation of a partner’s interest and a sale of that interest.
Consider the taxation of payments for unrealized receivables.
In a liquidation, these payments will be taxed as ordinary income to the distributee (departing partner) under Section 736(a) of the Code, and the remaining partners will receive ordinary deductions.
Taxable income/loss is allocated so that, after the income/loss allocation has been made, the balance in each partner’s capital account shall, to the extent that is possible, be equal to an amount that would be distributed to the partner based on a hypothetical liquidation of the partnership.
Distributions are made based on the waterfall calculation.However, the differences in tax consequences between a sale and liquidation can be quite significant.In many cases, structuring a partner’s withdrawal as a liquidation will provide more favorable tax treatment than if it is structured as a sale to the remaining partners.However, if the transaction is instead structured as a sale, the departing partner will still have ordinary income under Section 751(a), but the remaining partners will receive no deduction.(If a Section 754 election is in effect, the remaining partners will of course obtain a basis step-up, which will reduce their ultimate taxes.) If any of the payments to the departing partner are attributable to inventory, it would also generally be preferable to structure the transaction as a liquidation rather than as a sale.Also, they are not required to recognize their share of any unrecaptured Section 1250 gain on assets held by the partnership, which shifts instead to the remaining partners.