Key Elements
- Purchase price. The agreement should also indicate whether the seller is selling their entire interest or only part of it.
- Valuation method. Options include a fixed price, an independent appraisal, and a formula. Often, the valuation will include discounts for lack of control or marketability for the shares.
- Payment terms. An agreement should indicate whether the payment will be made as a lump sum, in installments, or in some other way.
- Approvals. Typically, a partnership buyout agreement will indicate the minimum partnership interest required to approve the sale.
- Capital account balance. An agreement will state whether the purchase price includes the balance of the seller’s capital account.
- IRC § 736 allocation. For tax purposes, the agreement should be clear about how the buyout payment is split between income and capital gains.[1]
- IRC § 754 election. The agreement should address whether the partnership will make a tax basis adjustment following the buyout.[2]
Calculating a Partnership Buyout
In drafting a partnership buyout agreement, both partners have to agree on the value of the interest being purchased in the buyout. There are a few ways to value the interest, most commonly:
- Book value. This is the value that appears in the books, or in the company record. To calculate, subtract liabilities from assets.
- Appraisal value. To find a business appraiser, you can consult the databases at the National Association of Certified Valuators and Analysts, American Society of Appraisers, and the American Institute of CPAs (AICPA).
- Multiple of earnings. To calculate, multiply the company’s EBITDA (earnings before interest, tax, depreciation, and amortization) by some number, typically between 2 and 6.
Financing Options
Common methods of financing a partnership buyout include:
- Cash
- Bank loan
- Seller financing. Often, the selling partner puts the buying partner on a payment plan. A promissory note can be used to legally enforce payment.
- Small Business Administration (SBA) loan. SBA offers 7(a) loans and 504 loans that can help finance a partnership buyout.
Reporting a Buyout
Usually, the buyout payment is reported as proceeds from the sale of a partnership interest on Schedule D. Some parts of the payment, such as those related to inventory, are taxed as ordinary income rather than capital gains.[3]
If the selling partner gets real estate as part of the buyout, a 1031 exchange can allow them to reinvest in property, therefore deferring capital gains.[4] Also, if after the buyout there’s only one remaining partner, the partnership is dissolved for tax purposes. The partnership should file a final Form 1065 and a Schedule K-1 for each partner.
50/50 Partnership Buyout
The buyout process works the same way it would in any other partnership buyout. The nuance of a 50/50 ownership structure is that no one has a majority interest to swing the vote if the partners disagree on the value of the interest. In this case, a third-party appraisal is strongly recommended.
Buyout Alternatives
Sometimes, partners who can’t agree on the direction of the business going forward think of a buyout as their only means of resolution. Dissolving the business and dividing its assets could be a simpler route. The partners could also agree to bring a new partner on board. Mediation is another alternative.