Internal Revenue Service
Revenue Ruling

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 Rev. Rul. 56-5

1956-1 C.B. 630

Sec. 723

Sec. 1221

IRS Headnote

Goodwill units created by a partnership agreement constitute an integral and indivisible part of a partner's capital investment, and annual assessments paid by a partner to replenish the partnership capital based on his share of the firm's earnings are capital contributions which increase the basis of the partnership interest provided that the income tax is paid thereon. Any gain or loss realized upon the partial or complete liquidation of an individual's partnership interest, a capital asset, is capital in nature and is measured by the difference between the amount received for the partnership interest or portion thereof and the basis of such interest or portion thereof.

Full Text

Rev. Rul. 56-5

Advice has been requested with respect to the treatment of a partnership interest when a partner partially or completely retires from the partnership under the circumstances presented below.

The interest of each partner in the instant partnership is expressed in units owned by him. At one time the partnership articles provided for subdivision of partnership units into capital and goodwill units. Accordingly, some of the partners own partnership units consisting of both capital and goodwill units while others own only capital units. The subdivision was used to measure the partnership interest of a withdrawing partner. By later amendments to the articles, the partnership goodwill was recorded on the firm's book at a nominal amount and henceforth was regarded as a partnership asset having no value for purposes of determining the value of the member's partnership interest. In order to replenish the firm's capital after a large amount had been paid to the estate of a deceased partner, the partners agreed to provide additional working capital by annual assessments based on the number of partnership units held by each. The assessments were credited to an `intangible asset' account and represented a proportionate part of each partner's share of the firm's profit.

After having paid the assessment for two years, the taxpayer, who was a partner in the firm, partially retired. One of the above assessments was paid for the year of his partial retirements. Pursuant to the provisions of the articles then in force, he received from the firm cash and cash equivalents constituting his distributive share of the partnership net income for the taxable year of his partial retirement and consideration for the liquidation of two-thirds of the units representing his partnership interest. No part of the amount received by the partner in consideration of the liquidation of a portion of his partnership interest was attributable to firm earnings not yet subjected to tax whether realized or unrealized by the firm prior to such liquidation The remaining one-third of his units continue to be subject to the risks and profits of the business for five years and he is obliged to pay annual assessments computed on the basis of his reduced profits share. Pursuant to the partnership agreement, the partner received nothing with respect to his investment in goodwill units nor with respect to the annual assessments paid by him.

The partner's goodwill units were not separate investments in and of themselves which he could dispose of without affecting his capital units but both constituted an integral and indivisible part of his partnership interest. The cost of such goodwill units to a partner is not separately deductible by him in whole or in part upon partial or complete liquidation of his partnership interest. Such cost, however, is reflected in the cost of his partnership interest and is part of the basis therefor. The annual assessments which he paid are not deductible by him. Since the purpose of those payments was to replenish the firm's working capital, they are capital contributions, that is, capital expenditures for the partnership interest. As such, they are a part of his partnership interest even though they can be reflected in the liquidation value of such interest only upon termination of the firm and not upon his retirement. Since these annual asessments are a part of the member's partnership interest, there can be no depreciation with respect to them.

Upon his partial or complete retirement, the member realizes gain or loss measured by the difference between the amount received for his partnership interest or portion thereof and the basis of such interest or portion thereof. Since the whole of the basis of the member's partnership interest was allocable to his entire interest, two-thirds of his basis was allocable to two-third of his interest.

G.C.M. 26379, C.B. 1950-1, 58, holds that the sale of a partnership interest is a sale of a capital asset which is subject to the provisions of section 117 of the Internal Revenue Code of 1939. The disposition of a partnership interest, even though it be by way of liquidation thereof, is a capital transaction. Any gain or loss realized upon partial or complete liquidation of a partnership interest is capital in nature. The assessment paid by a partner for a year in which he partially or completely retires should be treated in the same manner as assessments paid by him in years prior to his retirement, that is, as an addition to his basis in his partnership interest, provided that the income tax is paid thereon.

Accordingly, it is held that goodwill units created by a partnership agreement constitute an integral and indivisible part of a partner's capital investment, and annual assessments paid by a partner to replenish the partnership capital based on his share of the firm's earnings are capital contributions which increase the basis of the partnership interest provided that the income tax is paid thereon. Any gain or loss realized upon the partial or complete liquidation of his partnership interest, a capital asset, is capital in nature and is measured by the difference between the amount received for the partnership interest or portion thereof and the basis of such interest or portion thereof.