Partnership Buyout Tax Implications: IRC 736, Installment Sales, and Basis Adjustments

By Yarik Yarosh, CPA ·September 5, 2026 ·4 min read

Written by Yarik Yarosh, CPA (US & Canada) September 5, 2026 · FL CPA license AC61704 · CPA Ontario

Partnership buyouts are among the most complex transactions in the tax code. When a partner departs (by selling their interest to another partner, or having the partnership redeem their interest), the tax consequences are governed by several interacting code sections: IRC 736 (payments to a retiring partner), IRC 731 (distributions), IRC 741 (recognition of gain or loss on sale), IRC 751 (unrealized receivables and inventory), and IRC 754/743(b) (basis adjustments for the remaining partners). Getting the structure right can mean the difference between capital gains treatment and ordinary income treatment for the departing partner, and between a stepped-up basis and a carryover basis for the remaining partners.

✓Key takeaway

Partnership buyout framework:

Two buyout structures:

Liquidating distribution (partnership redeems the interest). The partnership pays the departing partner for their share. Governed by IRC 736:
- IRC 736(b) payments: for the partner’s interest in partnership property (tangible assets, inventory, capital assets). Treated as a distribution, producing capital gain to the extent the payment exceeds the partner’s outside basis.
- IRC 736(a) payments: for the partner’s share of unrealized receivables and goodwill (if goodwill is not described in the partnership agreement). Treated as either a distributive share of partnership income (ordinary income to the departing partner, deductible by the partnership) or as a guaranteed payment (ordinary income to the departing partner, deductible by the partnership).
- The allocation between 736(a) and 736(b) determines how much is capital gain vs ordinary income.
Sale of partnership interest (one partner buys from the other). Governed by IRC 741:
- The departing partner recognizes gain or loss on the sale: amount realized minus outside basis = gain or loss
- Generally capital gain, EXCEPT: the portion attributable to “hot assets” (IRC 751) is recharacterized as ordinary income
- Hot assets: unrealized receivables (including depreciation recapture) and substantially appreciated inventory

Section 754 election (IRC 754/743(b)):

When a partnership interest is sold (not redeemed), the remaining partners can elect under IRC 754 to adjust the basis of partnership assets by the difference between the purchasing partner’s outside basis and their share of inside basis
Without a 754 election: the purchasing partner takes a carryover basis in partnership assets (potentially creating phantom income if assets are later sold)
With a 754 election: the purchasing partner gets a stepped-up (or stepped-down) basis in their share of partnership assets
The election is irrevocable and applies to all future transfers (not just the current one)

How does the buyout structure affect tax?

Hypothetical example

Round numbers. A 50/50 partnership has two partners (A and B). Partner A wants to exit. The partnership’s assets:

Partnership balance sheet (tax basis / FMV):

Cash: $50,000 / $50,000
Equipment: $30,000 / $80,000 (unrealized gain, Section 1245 recapture)
Goodwill: $0 / $200,000
Accounts receivable: $0 / $20,000 (unrealized receivables)
Total: $80,000 / $350,000

Partner A’s outside basis: $40,000 (50% of $80,000) Partner A’s share of FMV: $175,000 (50% of $350,000)

Scenario 1: Partner B buys A’s interest for $175,000

A’s gain: $175,000 - $40,000 = $135,000
Hot assets (A’s share): equipment gain ($25,000 Section 1245 recapture) + receivables ($10,000) = $35,000 ordinary income
Remaining gain: $135,000 - $35,000 = $100,000 capital gain (attributable to goodwill and cash)
A’s tax: $35,000 x 37% + $100,000 x 20% = $12,950 + $20,000 = $32,950
B now owns 100% with $175,000 outside basis
Without 754 election: B’s share of inside basis remains $80,000. If B sells assets for $350,000, B recognizes $270,000 in gain (even though B just paid FMV).
With 754 election: B gets a $135,000 step-up ($175,000 outside basis minus $40,000 former inside basis share), allocated across assets. If B sells for $350,000, B recognizes only $135,000 in gain ($270,000 - $135,000 step-up).

Scenario 2: Partnership redeems A’s interest (liquidating distribution)

IRC 736(b) payments (for interest in property): $75,000 (cash $25,000 + equipment FMV $40,000 + inventory $10,000)
IRC 736(a) payments (goodwill, assuming no agreement provision): $100,000
736(b) treatment: $75,000 - $40,000 basis = $35,000 gain, partially ordinary (hot assets)
736(a) treatment: $100,000 ordinary income OR guaranteed payment (deductible by partnership)
The partnership agreement controls the allocation between 736(a) and 736(b)

Tax planning: if the partnership agreement specifically provides for goodwill payments, those payments shift from 736(a) (ordinary income, deductible) to 736(b) (capital gain, not deductible). The departing partner prefers 736(b) (capital gain). The remaining partner prefers 736(a) (deductible). This is a negotiation point.

Illustrative numbers only, not a real client and not advice for your facts.

Related guides:

Tax Implications of Business Partnerships: K-1, Self-Employment Tax, and Special Allocations

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Cite this page

Yarik Yarosh, CPA. "Partnership Buyout Tax Implications: IRC 736, Installment Sales, and Basis Adjustments." Blue Cloud CPA, September 5, 2026. https://bluecloudcpa.com/guides/small-business-tax-implications-partnership-buyout

This guide is general information, not tax advice for your specific situation. Which points apply, and how, depends on your facts.