Deductibility of Payment Made in Redemption of a Recalcitrant Partner's Interest Arising in Connection with a Dispute

QUERY: Can any part of a payment, or payments, made to settle a partners’ dispute, including the redemption of a recalcitrant partner’s interest, provide an ordinary current deduction for the remaining partners?

Yes, if the transaction is structured, and respected, as a redemption. Distributions made by a partnership in liquidation/redemption of a partner’s interest in a partnership are categorized either as “payments for partnership property”; as a distributive share to the recipient of partnership taxable income, if the amount, thereof, is determined with regard to the income of the partnership; or as a guaranteed payment, if the amount is determined without regard to partnership income.Absent an agreement between the parties as to how much of the payments are “payments for partnership property,” the entire amount of such payments will be so characterized. Generally, as long as adverse parties agree on how much of the payments are “payments for partnership property” which are not deductible by the partnership, the balance will be characterized either as the redeemed partner’s “distributive share,” or as guaranteed payments. A redeemed partner’s “distributive share” reduces the amount of partnership income that would otherwise be allocated to the remaining partners, while guaranteed payments are deductible by the partnership.

However, while this rule applies to distributions made in redemption of a partner’s interest, it does not apply to a purchase and sale of a partner’s interest. In a transaction characterized as a purchase and sale of a partner’s interest, 100% of the consideration paid would be considered to be paid with respect to the acquisition of the selling partner’s interest. Therefore, none of the payments would be currently deductible. If the partnership makes a Section 754 election, then the purchasing partner, or partners, would be able to avail themselves of a basis “step-up,” generally equal to the amount by which the total consideration paid exceeds the selling partner’s share of the partnership’s basis in the “property.” However, such a basis “step-up,” to the extent properly allocable to depreciable property, would be depreciated over a newly assigned useful life of the “property.” To the extent such basis “step-up” is allocable to land, there would be no deduction until the “property” is sold.

As a result of the “disguised sale” rules, the source of the cash used to redeem the partner’s interest can make a difference as to whether the transaction is characterized as a redemption or as a purchase and sale. The safest and best approach would be to use cash available and on hand in the partnership. In such case, characterization of the payment as a redemption would be pretty much a “slam dunk.”. Any other likely source of the cash would carry some degree of uncertainty in connection with the extent to which the “disguised sale” rules might apply. If the cash comes from third party debt, subject to a mortgage on the partnership’s property, while there is some risk, it would be very likely that the payment to the redeemed partner would be respected as a redemption. If the cash comes from a partner loan, it will be more closely scrutinized. If the terms are not commercially reasonable and found to have equity characteristics, then the likelihood that the transaction is characterized as a purchase and sale is increased significantly. If the cash comes from capital contributions of all the remaining partners, a reasonable argument may be made that the distribution should be respected as a redemption. In contrast, if the cash comes from capital contributions of fewer than all the remaining partners, the transaction is pretty certain to be characterized as a purchase and sale.

Lastly, to “book-up” or not to “book-up”! Whenever a partner is admitted or redeemed, the partnership may “revalue” its “property” and “book-up” all partners’ capital accounts immediately before the contemplated transaction, to reflect their “economic value.” If this is done, the redeemed partner’s capital account will equal that portion of the amount being paid which is considered to be with respect to such partner’s interest in the property. As a result, the redeemed partner’s capital account will be reduced to zero by the payment. The remaining partners’ capital accounts will reflect their share of the “booked-up” value of the net equity, and any resulting loss caused by that portion of the amount being paid which is considered to be a guaranteed payment deductible by the partnership will be appropriately allocable to the remaining partners, whose capital accounts are positive as a result of the “book-up.”

If the partnership elects not to “revalue” its “property” and “book-up” the capital accounts, and the source of the cash is a partner loan, there could be “partner minimum gain” (i.e., the amount by which the “partner debt” exceeds the basis of the partnership’s “property”), in which case the entire loss would be required to be allocated to the lending partner. If the other remaining partners guarantee their portion of the loan, however, then they would be entitled to their proportionate share. If the partnership elects not to “revalue” and the source of the cash is a third party mortgage, then there could be “partnership minimum gain” ( i.e., the amount by which the mortgage exceeds the basis of the property securing it), in which case, in the absence of the redemption transaction, the loss would be allocable “pro-rata” to all partners to the extent of any increase in such “partnership minimum gain.” However, since the redemption transaction would be both anticipated and imminent, it must be taken into account for purposes of determining income or loss allocations. Therefore, the entire loss would be still be allocated to the remaining partners.