the Uniform Partnership Act; in addition, the Uniform Limited Partnership Act has been adopted to govern limited partnerships. These state laws govern the formation of partnerships and their internal management. Depending upon the state, these laws usually limit the ability of a partner to transfer his or her partnership interests. While these laws are important in the operations of a partnership, their effects on buy-sell agreements are felt chiefly through the partnership agreements in individual situations. Therefore, this paper will concentrate upon the Federal tax law, both income and estate.
Taxation of Partnership Interest Transactions:
Before delving into the specific characteristics of buy-sell agreements, it is necessary to have some understanding of the taxation of partnership interest transactions. Because the partners, and not the partnership entity itself, are taxed, all of the partners have a vital interest in the drafting of buy-sell agreements. Among the issues which need to be considered are whether the buyout should be structured as a sale or liquidation of the interest and the possible consequences of a sale (whether the sale would trigger a termination of the partnership under the tax code).
The most important issue when considering a partnership buy-sell agreement is whether the buyout should be structured as a sale of the interest under Section 741 or as a liquidation of that interest under Section 736. Although both a sale and a liquidation of a partner's interest are the same in result, with the partner disposing of his interest for value, the tax consequences can be greatly different. Because an interest in a partnership is considered a capital asset, realization of gain upon the disposition of that asset is taxable as a capital gain. Thus, gain in the complete liquidation of a partner's interest is only recognized to the extent that the distribution exceeds the partner's adjusted basis in his...