A few years ago, Fred, a client of mine, came into my office telling me he decided to open his own business and he intended to withdraw as general manager/part owner from the partnership of his current business.
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“I am burnt out dealing with those three other guys, so we settled on $100,000 payoff. I’m using the money to open a new business and would like you to handle the books and taxes,” he said.
I told him the withdrawal could be a taxable event. But he stated that was how much he put into the business to begin with and that he was just cashing out—so how could that be taxable?
I sure hate to disappoint people, but facts are facts and so are tax code rules.
Here’s how this sort of transaction works: It doesn’t matter if you are simply walking away from a partnership without receiving a payoff, walking away with a cash buyout, or if the entire partnership is dissolving, there could be tax ramifications. Then again, maybe not. But you have to crunch the numbers.
The IRS has specific rules and formulas for determining capital gain or loss on the disposition of a partnership interest. If you have a gain, you will owe taxes.
Hopefully, accurate books and records have been kept over the years. If so, your basis will be easy to calculate. In fact, the correct amount might be stated on your most recent K-1.
Here’s the formula: Add up how much money and property you contributed to the partnership over the years and then subtract the total amount you have taken in distributions. Combine that result with your share of the profit or loss taken over the years. You must count in your share of the partnership liabilities you will be able to walk away from. And if applicable, the value of unrealized receivables and inventory must be factored in. It can get complicated. If you sell your partnership interest, you are required to file IRS Form 8308 available at the IRS website.
Let’s take Fred’s case for example. He walked in with $100,000 cash on day one and over the five-year period that he was a partner, he took $280,000 in draws. His share of the profits during that time period was $400,000. His share of the liabilities on the books is $25,000. By combining these figures, you arrive at a basis of $195,000. In this example, we see that Fred is cashing out for an amount significantly lower than his adjusted basis in the partnership. So Fred is correct, he will not owe any taxes on the amount that he is receiving. In fact, he will report a capital loss of $95,000, which will benefit him tax wise. It was not a break even proposition, after all.
I couldn’t help but wonder if Fred was getting a fair deal. So I advised him to have a broker value the business to determine if he should get more than what he was willing to settle for. “They really can’t afford to cash me out for what I’m worth,” Fred countered. “It would totally mess with the cash flow.”
“Well, maybe not this minute, no. But what if you accepted a promissory note for the remainder of $95,000? They can pay you over time at a decent interest rate. After all, you are planning to open a new business, which probably won’t show a profit for a year or more. A monthly capital infusion from the old partnership might prove extremely valuable.”
That’s just what Fred did. Those monthly payments helped him out. Today he’s still happy with his decision and is enjoying running a business without partners.
If you are making a change in your business, remember to contact your attorney and tax pro to make sure you have considered all aspects of the disposition.
Bonnie Lee is an Enrolled Agent admitted to practice and representing taxpayers in all fifty states at all levels within the Internal Revenue Service. She is the owner of Taxpertise in Sonoma, CA and the author of Entrepreneur Press book, “Taxpertise, The Complete Book of Dirty Little Secrets and Hidden Deductions for Small Business that the IRS Doesn't Want You to Know.” Follow Bonnie Lee on Twitter at BLTaxpertise and at Facebook.