Buying Out a Partner: How Section 736 Taxes the Payments
Why payments to a departing partner split into two kinds with different tax results, the hot-asset rule, and the difference between a partnership buyout and a sale to the other partners.
Reviewed by the Fairlight Accounting cross-border tax team — U.S. & Canadian Tax Desks
When a partnership pays a departing partner for their interest, Section 736 splits the payments into two kinds. Payments for the partner's share of partnership property are distributions — capital gain to the partner above basis, no deduction to the partnership. Payments for anything else are ordinary income to the partner and reduce the remaining partners' taxable income.
On this page
What are the two kinds of payment?
| Payment | Tax to the departing partner | Tax to the partnership |
|---|---|---|
| Section 736(b): for the partner's share of partnership property, including goodwill when the agreement provides for it | Capital gain or loss (after basis), except for the share of hot assets | No deduction; the partnership's remaining assets get a basis step-up (Section 734(b)) only with a Section 754 election in effect (a basis reduction is mandatory if it would exceed $250,000) |
| Section 736(a): everything else — amounts above the value of the partner's share of property (a fixed sum or a share of future profits) and, for a general partner in a service partnership, payments for unrealized receivables and for goodwill the agreement does not provide for | Ordinary income | Deductible as a guaranteed payment or allocated as a distributive share |
Why does the agreement's goodwill clause matter?
For a general partner in a partnership where capital is not a material income-producing factor (law, consulting, medical practices), payments for goodwill are capital gain only if the partnership agreement provides for goodwill payments. Without that clause, goodwill payments are ordinary income to the partner and deductible to the firm. Partners negotiate this: the departing partner wants capital treatment; the remaining partners want the deduction. For any other partner — a limited partner, or any partner in a firm where capital is a material income-producing factor — goodwill is partnership property and payments for it are Section 736(b) payments regardless of the agreement.
What are hot assets?
Unrealized receivables (including depreciation recapture) and inventory. The departing partner's share of these is taxed as ordinary income whether the deal is a sale or a redemption, under Section 751 — in a redemption, inventory counts only if it has appreciated substantially (value above 120 percent of basis), and service-firm receivables are often covered by Section 736(a) instead. In a cash-method service firm, accounts receivable are the usual hot asset.
Buyout by the partnership or sale to the partners?
A sale of the interest to the remaining partners (Section 741) is capital gain to the seller, subject to the hot-asset rule, and gives the buyers a cost basis in the interest they bought — plus a step-up in their share of the partnership's assets (Section 743(b)) if a Section 754 election is in effect. A redemption by the partnership follows Section 736. The economic result can be the same while the tax differs — in particular, a redemption lets the partnership deduct Section 736(a) payments, and a sale cannot.
How are installment payouts handled?
Payments over several years are taxed as received. The Section 736(b) portion is a series of distributions, not an installment sale: the partner recovers basis first and reports gain only after basis is used up, unless the payments are a fixed sum and the partner elects to spread basis over them. The Section 736(a) portion is ordinary income as paid. The agreement should state how each payment is allocated between the two kinds; absent that, the regulations allocate fixed payments proportionally and treat payments tied to future income as Section 736(b) payments first.
Frequently asked questions
Can a partner receive a buyout as a loan repayment?
If the partner had a loan to the partnership, repayment is a separate, tax-free return of principal; it must be documented as a loan from the start.
What if a partner dies?
The estate's basis in the interest is stepped up to date-of-death value, so a buyout at that value produces little capital gain — but Section 736(a) payments are income in respect of a decedent (Section 753), taxed to the estate or heirs as received with no step-up, and hot-asset treatment still applies to the estate's share.
Does the departing partner owe self-employment tax?
Section 736(a) payments generally are self-employment income, except qualifying lifetime retirement payments under a written partnership plan to a partner who no longer performs services (Section 1402(a)(10)); Section 736(b) payments are not.
Do these rules apply to an LLC?
Yes, for an LLC taxed as a partnership.
Official sources
The IRS explains: “Payments made in liquidation of the interest of a retiring or deceased partner in exchange for their interest in partnership property are considered a distribution, not a distributive share or guaranteed payment that could give rise to a deduction (or its equivalent) for the partnership.” — Internal Revenue Service, Publication 541 (12/2025), Partnerships, https://www.irs.gov/publications/p541
The statute provides: “For purposes of this subsection, payments in exchange for an interest in partnership property shall not include amounts paid for— (A) unrealized receivables of the partnership (as defined in section 751(c)), or (B) good will of the partnership, except to the extent that the partnership agreement provides for a payment with respect to good will.” — Legal Information Institute, Cornell Law School, 26 U.S. Code § 736 - Payments to a retiring partner or a deceased partner’s successor in interest, https://www.law.cornell.edu/uscode/text/26/736
Next step
Fairlight Accounting handles U.S. domestic, cross-border (U.S.–Canada), and international tax returns, plus bookkeeping, payroll, and CFO advisory. Our U.S. Tax Desk models the buyout both ways — redemption and sale — before the term sheet is drafted. See pricing or book a free fit call.
Cross-border taxes, handled in one place
U.S. and Canadian filings prepared together by our U.S. and Canadian Tax Desks.
Book a free fit call