IRC 736, 731, 732, and 737: Partnership Liquidating Distributions and the Retiring Partner Guide

Last reviewed: July 2026

A deep practitioner guide for enrolled agents, CPAs, and tax attorneys handling partnership liquidating distributions, retiring partner buyouts, and related basis mechanics

Section 1: Current Distributions vs. Liquidating Distributions -- The Foundational Distinction

Every partnership distribution analysis begins with the same threshold question: is this a current distribution or a liquidating distribution? The answer controls which version of IRC 732 applies, whether loss recognition is possible under IRC 731(a)(2), and whether IRC 736 governs the payment at all.

Current distributions: the partner continues

A current distribution (also called a non-liquidating distribution) is any distribution that does not liquidate the partner's entire interest. After a current distribution, the partner still holds an interest in the partnership and continues to be a partner. The distribution may be cash, property, or a combination, but it does not terminate the partner's participation in the entity.

Under the current distribution rules:

• Gain recognition: A partner recognizes gain under IRC 731(a)(1) only if money received (including deemed money from the reduction of the partner's share of partnership liabilities under IRC 752(b)) exceeds the partner's outside basis. The gain is treated as if the partner sold their partnership interest; the character is capital gain unless hot assets under IRC 751 apply.
• No loss recognition, ever: In a current distribution, a partner NEVER recognizes a loss. If the distributed property's basis would exceed the partner's outside basis, the partner's outside basis simply goes to zero. The unrecovered outside basis disappears; it does not become a loss.
• Basis of distributed property: Under IRC 732(a), the distributed property takes a basis equal to the lesser of (a) the partnership's adjusted inside basis in the property or (b) the partner's outside basis remaining after reduction for money received. The partner can never take a basis in distributed property that exceeds their remaining outside basis.
• Reduction of outside basis: Under IRC 733, the partner's outside basis is reduced (not below zero) by the amount of money received and by the basis allocated to distributed property under IRC 732(a). The remaining outside basis tracks future transactions.

Liquidating distributions: the partner exits

A liquidating distribution terminates the partner's entire interest in the partnership. After a liquidating distribution, the partner has no further interest; they are no longer a partner. This is the triggering event for IRC 736 when the exiting partner is a retiring or deceased partner.

Under the liquidating distribution rules:

• Gain recognition: Same as a current distribution; money received (including deemed money under IRC 752(b)) in excess of outside basis triggers gain under IRC 731(a)(1).
• Loss recognition (limited): Under IRC 731(a)(2), a partner may recognize a loss in a liquidating distribution, but ONLY if the partner receives solely money, unrealized receivables, or inventory. If any other property is received, no loss is recognized; the outside basis is allocated to that other property under IRC 732(b). The loss, when available, is treated as if the partner sold their partnership interest.
• Basis of distributed property: Under IRC 732(b), the distributed property takes a basis equal to the partner's remaining outside basis after reduction for money received and for basis allocated to IRC 751 property. That remaining outside basis is then allocated among the distributed properties under IRC 732(c). Hedge all allocation mechanics among multiple distributed properties to IRC 732(c) and the applicable regulations.
• IRC 736 overlay: When the liquidating distribution is made to a RETIRING partner (or a deceased partner's successor), IRC 736 applies and splits the total payment into two buckets with different tax treatment, as described in Section 4 below.

Why the distinction is the starting point

Practitioners handling partnership buyouts and retirement agreements frequently encounter structures that blur the line between current and liquidating distributions -- installment payments made over several years, for example, or payments tied to future income. The classification question must be resolved before any other analysis can proceed. A payment that terminates the partner's entire interest on the date of the first installment is a liquidating distribution even if the cash is paid out over time. A series of annual distributions that each leave the partner with a continuing interest is a series of current distributions. The legal effect of each payment on the partner's interest, not the payout schedule, controls the classification.

Section 2: The IRC 732 Basis Rules -- Current vs. Liquidating

IRC 732 determines the basis of property distributed by a partnership to a partner. The rule differs significantly depending on whether the distribution is current or liquidating, and the mechanics interact with the partner's outside basis in ways that can produce counterintuitive results.

Current distribution basis: IRC 732(a)

In a current distribution, the distributed property takes a basis determined under IRC 732(a). The starting point is the partnership's adjusted inside basis in the property. That starting-point basis is then capped by the partner's outside basis remaining after reduction for any money received in the same distribution. The basis of the distributed property is the LESSER of:

• (a) The partnership's adjusted inside basis in the property (IRC 732(a)(1)); or
• (b) The partner's outside basis, reduced by money received in the distribution (IRC 732(a)(2)).

This "substituted basis" concept means the partner cannot step up the property's basis beyond what the partnership held, and also cannot take a basis that would drive the partner's outside basis below zero. When a partner's outside basis is low (common when the partner acquired their interest at a low price or when substantial cash distributions have previously eroded outside basis), the distributed property may take a basis significantly lower than the partnership's inside basis in the same property.

Liquidating distribution basis: IRC 732(b)

In a liquidating distribution, the distributed property takes a basis determined under IRC 732(b). The mechanic is fundamentally different: rather than starting with the partnership's inside basis and capping it by outside basis, IRC 732(b) starts with the partner's remaining outside basis and assigns it to the distributed property.

The sequence is:

1. Reduce the partner's outside basis by money received (including deemed money from liability relief under IRC 752(b)).
2. Reduce the remaining outside basis by the basis allocable to IRC 751 property (unrealized receivables and inventory) distributed in the same transaction, as determined under IRC 732(c) and the applicable regulations.
3. Assign the remaining outside basis to the other distributed properties under IRC 732(c).

The key consequence: if the partner's remaining outside basis exceeds the aggregate fair market value of the distributed property, that excess basis flows into the distributed property (potentially giving the property a basis above its FMV). Conversely, if the outside basis is below the aggregate FMV of the distributed property, the property takes a basis below FMV, and no loss arises at the distribution step (unless the IRC 731(a)(2) conditions are met).

Cite: IRC 732(a) (current distribution basis), IRC 732(b) (liquidating distribution basis). Hedge all allocation mechanics among multiple distributed properties to IRC 732(c) and the applicable regulations.

The basis "squeeze" in a liquidating distribution

One of the most practically significant consequences of IRC 732(b) is what happens when the partnership distributes property with a high inside basis to a partner whose outside basis is lower. In a current distribution, the property would take the inside basis as a starting point (capped by outside basis). In a liquidating distribution, the property takes only the partner's outside basis -- regardless of how much inside basis the partnership held in the same property. The partner may be taking property with significant built-in gain from a basis standpoint, all because their outside basis was insufficient to absorb the partnership's full inside basis.

The reverse situation also occurs: if the partner's outside basis exceeds the partnership's inside basis in the distributed property, the excess basis flows to the distributed property under IRC 732(b). This is the mechanism that can create a "stepped-up" inside basis in the partner's hands on a liquidating distribution when a Section 754 election is in place (via IRC 734(b), discussed in Section 6).

Deemed money and IRC 752(b)

A critical but frequently overlooked input in both current and liquidating distribution analysis is the treatment of partnership liabilities. When a distribution reduces the distributing partner's share of partnership liabilities (for example, when the partner exits a partnership that carries mortgage debt), the liability reduction is treated as a distribution of money to the partner under IRC 752(b). This deemed money distribution is added to any actual cash distributed before comparing to outside basis. The result: a partner can recognize gain under IRC 731(a)(1) in a distribution that involves no actual cash transfer, purely because their share of the partnership's debt has been reduced.

Cite: IRC 752(b) and the applicable regulations for all liability relief mechanics. The correct allocation of partnership liabilities under IRC 752 is a prerequisite to the distribution analysis and should be confirmed in the applicable regulations before any gain recognition computation.

Section 3: IRC 737 -- The Seven-Year Contribution Trap

IRC 737 addresses a specific problem in the interaction between the contribution rules and the distribution rules: what happens when a partner who contributed appreciated property to a partnership receives a distribution of different property?

The problem IRC 737 solves

Under IRC 704(c), built-in gains on property contributed to a partnership must be allocated back to the contributing partner when the partnership ultimately disposes of that property. This prevents contributing partners from shifting pre-contribution gain to other partners through the partnership.

But what if the partnership never sells the contributed property? What if, instead, the contributing partner receives a distribution of OTHER partnership property -- property different from what they contributed -- and the contributed property stays in the partnership? Without a specific rule, the contributing partner could extract value from the partnership in the form of a distribution of appreciated non-contributed property, take a low basis in that property under IRC 732, and the pre-contribution gain on the originally contributed property would remain deferred, potentially indefinitely.

IRC 737 is the answer. It requires the contributing partner to recognize gain when they receive a distribution of "other property" (property that is not the property they contributed) within 7 years of the contribution of appreciated property to the partnership.

The IRC 737 gain: what triggers it and how it is computed

IRC 737 applies when all of the following are present:

• The partner contributed appreciated property (property whose FMV exceeded its adjusted basis at the time of contribution) to the partnership;
• The contribution occurred within the 7-year period ending on the date of the distribution; and
• The partner receives a distribution of property OTHER than the contributed property (or proceeds from the disposition of the contributed property).

When IRC 737 applies, the contributing partner must recognize gain equal to the LESSER of:

• (a) The net precontribution gain: the excess of the FMV of all of the partner's contributed property (that has not been distributed back to the contributing partner) over the aggregate adjusted tax basis of that contributed property at the time of the distribution (IRC 737(b)). This is the remaining unrecognized built-in gain tracking amount; or
• (b) The excess distribution: the excess of the FMV of the OTHER property received in the distribution over the partner's outside basis in the partnership interest immediately before the distribution (IRC 737(a)).

The character of the IRC 737 gain is the same as the character of the gain that would have been recognized had the partnership sold the contributed property at its FMV on the date of the distribution. In most cases this means ordinary income or capital gain tracking the nature of the contributed property, though the specific character analysis should be confirmed in the applicable regulations and IRS guidance.

Cite: IRC 737(a)-(c). Hedge all IRC 737 mechanics (including netting across multiple contributed properties and interaction with IRC 704(c)) to IRC 737(b)-(c) and Treas. Reg. 1.737-1 et seq.

Basis effects of IRC 737 gain recognition

When a partner recognizes IRC 737 gain:

• The partner's outside basis in the partnership interest is increased dollar-for-dollar by the gain recognized (before the distribution occurs for purposes of computing the IRC 732 basis of the distributed property).
• The net precontribution gain tracking amount is reduced by the gain recognized, reflecting that a portion of the pre-contribution gain has now been brought into income.
• The partnership's inside basis in the contributed property is increased (under IRC 737(c)(2)) to reflect the gain recognized by the contributing partner, preventing the same gain from being recognized again when the partnership disposes of the contributed property.

The interaction between the IRC 737 outside basis increase and the IRC 732(b) liquidating distribution basis rules is important: because the outside basis increase occurs before the IRC 732 computation, the contributing partner may take a higher basis in the distributed property than they would have absent the IRC 737 gain recognition.

Interaction with IRC 704(c)(1)(B)

IRC 737 and IRC 704(c)(1)(B) operate in parallel and cover different sides of the same transaction. IRC 704(c)(1)(B) governs what happens when the CONTRIBUTED property is distributed to a NON-contributing partner within 7 years: the contributing partner must recognize the built-in gain as if the partnership had sold the property. IRC 737, by contrast, governs what happens when the CONTRIBUTING partner receives DIFFERENT property within 7 years of the contribution.

The two provisions do not overlap -- they address different facts -- but they interact in complex multi-asset, multi-partner situations. The contributing partner's gain, the non-contributing partner's distribution, and the partnership's basis adjustments must all be coordinated. For the specific coordination rules, see the IRC 704(b) and 704(c) Partnership Allocations Guide. Hedge all coordination mechanics to Treas. Reg. 1.737-1 and Treas. Reg. 1.704-4.

Section 4: IRC 736 -- The Retiring Partner Rules

IRC 736 is the primary provision governing payments made by a partnership in liquidation of the interest of a retiring partner or a deceased partner's successor in interest. It applies only to liquidating distributions -- not to current distributions and not to sales of partnership interests -- and it imposes a specific two-bucket framework on all payments made in connection with the liquidation of the retiring partner's interest.

Who and what IRC 736 covers

IRC 736 applies to payments made by a partnership to a partner in liquidation of their ENTIRE interest, when that partner is:

• A retiring partner (a partner who is withdrawing from the partnership and receiving a buyout of their interest); or
• A deceased partner's estate or successor in interest (payments made to buy out the interest that passed at death).

IRC 736 does not apply to sales of partnership interests to third parties (those are governed by IRC 741 and IRC 751(a)). It applies only to redemptions -- situations where the partnership itself is making the liquidating payments, not a purchasing partner.

The two-bucket framework: IRC 736(b) and IRC 736(a)

Every payment made in connection with the liquidation of a retiring partner's interest is divided into two buckets:

Feature	IRC 736(b) Payments	IRC 736(a) Payments
What it covers	Payments allocable to the retiring partner's share of partnership PROPERTY (assets)	Payments NOT allocable to the partner's share of property; represents going-concern value
Tax treatment to retired partner	Treated as a distribution; IRC 731 and 732 apply; basis recovered first; capital gain or loss on any excess	Ordinary income; either a distributive share of partnership income (if based on income) or a guaranteed payment under IRC 707(c) (if a fixed amount)
Deductibility to partnership	No deduction; no effect on other partners' distributive shares	Deductible by the partnership (if a guaranteed payment) or reduces other partners' distributive shares
Reporting year	Basis recovered first; gain or loss recognized as each payment is received	Ordinary income recognized in the year received, regardless of basis recovery
Typical content	Partner's share of capital assets, real property, equipment, inventory (in capital partnerships); receivables for certain partnerships	Payments for goodwill (in service partnerships without a goodwill provision in the partnership agreement); going-concern premium; income-based payments

IRC 736(b): payments allocable to property

IRC 736(b) payments are those allocable to the retiring partner's share of partnership property. "Property" for this purpose includes the partner's proportionate share of all partnership assets: capital assets, real estate, equipment, inventory, and (for capital-intensive partnerships) goodwill. The 736(b) amount is determined by reference to the FMV of the partnership's property at the time of the liquidation, apportioned to the retiring partner's interest.

Because IRC 736(b) payments are treated as distributions under IRC 731 and 732, the partner recovers their outside basis first, and only the excess is gain. The partnership gets no deduction for these payments, and the remaining partners' shares are not affected. The IRC 751 hot asset analysis must be completed first: the retiring partner's share of IRC 751 property (unrealized receivables and substantially appreciated inventory) is a key input in determining the full IRC 736(b) allocation.

IRC 736(a): payments beyond property value

IRC 736(a) payments are the remainder: all payments that are NOT allocable to the retiring partner's share of property. These payments represent going-concern value, income streams, or contractual amounts beyond the hard asset value of the partnership interest.

IRC 736(a) payments divide into two sub-types:

• Distributive share: If the amount of the IRC 736(a) payment is determined by partnership income (e.g., the retiring partner is entitled to 20% of the firm's income for three years after retirement), the retired partner is treated as still being a partner for purposes of receiving those payments. They are reported as a distributive share of partnership income, subject to ordinary income treatment. Other partners' distributive shares are reduced accordingly.
• Guaranteed payment (IRC 707(c)): If the IRC 736(a) payment is a fixed amount (not determined by reference to partnership income), it is a guaranteed payment under IRC 707(c). The partnership deducts the payment as a business expense; the retired partner reports ordinary income in the year the payment is received.

The service partnership distinction: where goodwill falls

The most consequential variable in an IRC 736 analysis is the type of partnership. The statute draws a sharp distinction based on whether capital is a material income-producing factor.

Service partnerships (capital is NOT a material income-producing factor): Professional services firms -- law firms, accounting firms, medical practices, consulting firms, and similar entities whose income derives primarily from the services of the partners rather than from capital invested -- are the paradigm case. For these partnerships:

• Unrealized receivables for IRC 736 purposes include NOT ONLY the standard IRC 751(c) items but also the retiring partner's allocable share of PARTNERSHIP GOODWILL, UNLESS the partnership agreement specifically provides that a payment is being made for goodwill (IRC 736(b)(3)).
• Payments for goodwill that is not covered by a specific partnership agreement provision fall into the IRC 736(a) bucket: ordinary income to the retiring partner and deductible by the partnership.
• The practical consequence: a law firm partner retiring without a goodwill provision in the partnership agreement will receive what might economically look like a payment for goodwill, but that payment is taxed as ordinary income rather than as a capital gain distribution. The firm gets the deduction; the retiring partner pays ordinary income rates.
• If the partnership agreement does specifically provide for a goodwill payment, that amount is IRC 736(b): treated as a distribution, basis recovered first, and any excess is capital gain. Cite IRC 736(b)(2)(B).

Capital-intensive partnerships (capital IS a material income-producing factor, or limited partnerships): For partnerships where capital plays a significant role in generating income -- real estate partnerships, investment partnerships, manufacturing partnerships, and most limited partnerships -- the rules are different:

• ALL payments for the retiring partner's share of property, INCLUDING goodwill, are IRC 736(b) payments.
• There is no 736(a) bucket simply because the partner was a capital partner; the IRC 736(a) category captures only true going-concern payments that are genuinely beyond the asset value of the interest (e.g., payments for the right to use the partner's name, income-participation rights that are not simply a reflection of asset value).

The "material income-producing factor" test is a facts-and-circumstances analysis that has generated significant case law. Whether a given partnership's capital is material to its income requires a careful review of the partnership's operations. Hedge the application of this test in any specific case to IRC 736, Treas. Reg. 1.736-1, and applicable case law. A detailed partnership agreement analysis is required before the 736(a)/736(b) split can be finalized.

Cite: IRC 736(a), IRC 736(b), IRC 736(b)(2)(B), IRC 736(b)(3), IRC 707(c). Hedge the specific 736(a)/736(b) allocation mechanics to IRC 736 and Treas. Reg. 1.736-1.

Section 5: IRC 751 Hot Assets in Liquidating Distributions

The hot asset rules under IRC 751 are a prerequisite to any liquidating distribution or retiring partner analysis. Before computing the IRC 736(b) allocation, before determining the IRC 732(b) basis of distributed property, and before applying the IRC 737 precontribution gain rules, the practitioner must identify the partnership's IRC 751 property (hot assets) and determine the retiring partner's proportionate share of those assets.

The starting point: identify IRC 751 property

IRC 751 property for distribution purposes consists of two categories:

• Unrealized receivables (IRC 751(c)): For a cash-method partnership, amounts earned for services rendered or goods delivered but not yet received. For any partnership, amounts that would be ordinary income if the partnership sold its property at FMV, including IRC 1245 recapture on depreciable personal property and IRC 1250 gain on real property. The depreciation recapture component is often the largest IRC 751 item for equipment-heavy or real estate partnerships.
• Substantially appreciated inventory (IRC 751(d)): Inventory items whose aggregate FMV exceeds 120% of the aggregate adjusted basis of all inventory items (IRC 751(b)(3)(A)).

For a complete treatment of the IRC 751 definitions, the 120% inventory test, the depreciation recapture component, and the TD 10048 reporting requirements, see the companion IRC 751 Hot Assets Practitioner Guide.

IRC 751(b): disproportionate distributions and the deemed sale rule

IRC 751(b) applies when a liquidating (or current) distribution changes the retiring partner's proportionate exposure to hot assets versus non-hot assets. If the retiring partner receives more than their proportionate share of hot assets relative to the other partners, or relinquishes a portion of their hot asset exposure in exchange for non-hot-asset property, IRC 751(b) recharacterizes part of the transaction as a deemed sale.

Under IRC 751(b), the distribution is split into two components:

• The component that represents the partner's proportionate share of hot assets (which is treated as an ordinary distribution or deemed exchange); and
• The excess component (the disproportionate shift between hot assets and non-hot assets), which is treated as a deemed sale between the partner and the partnership at FMV.

The deemed sale produces ordinary income to the extent the retired partner is treated as selling hot assets. TD 10048 (effective May 20, 2026, applicable to distributions on or after January 1, 2025) revised the IRC 751(b) regulations and introduced a simplified agreed-value method for these computations. The prior layering approach is displaced for transactions within TD 10048's applicability window. Confirm all IRC 751(b) computation mechanics in Treas. Reg. 1.751-1(b), TD 10048, and current IRS.gov guidance.

Cite: IRC 751(b), IRC 751(c), IRC 751(d). Hedge all IRC 751(b) disproportionate distribution mechanics to Treas. Reg. 1.751-1(b) and TD 10048.

The IRC 736 and IRC 751 interaction: goodwill timing differs

One of the most nuanced points in a retiring partner analysis is that the definition of "unrealized receivables" differs between IRC 751 and IRC 736. For IRC 751 purposes, unrealized receivables are defined in IRC 751(c), which does not generally include goodwill. For IRC 736 purposes, unrealized receivables for a service partnership also include the retiring partner's share of goodwill that is not covered by a specific partnership agreement provision (IRC 736(b)(3)).

This definitional gap means a liquidating distribution payment for a retiring service-firm partner may include amounts that are unrealized receivables for IRC 736 purposes (and therefore IRC 736(a) items producing ordinary income) but are NOT unrealized receivables for IRC 751(b) purposes, and vice versa. The practitioner must apply IRC 751(c) for the hot asset disproportionate distribution analysis, and then separately apply IRC 736(b)(3) for the retiring partner 736(a)/736(b) split. Hedge the specific application of both definitions in any particular case to the applicable regulations.

TD 10048 Form 8308 Part IV: reporting for liquidating distributions

TD 10048 introduced new Form 8308 Part IV reporting requirements for IRC 751 transactions, including liquidating distributions that involve hot assets. Partnerships making liquidating distributions on or after January 1, 2025 that involve IRC 751 property must assess their Form 8308 Part IV obligations and confirm the current reporting requirements in TD 10048 and current IRS.gov guidance. Failure to comply may result in penalties under IRC 6721 and IRC 6722.

Section 6: IRC 734(b) Inside Basis Adjustment and the Section 754 Election

When a partnership makes a liquidating distribution, the distributed property's basis in the retiring partner's hands may differ from the partnership's inside basis in the same property. This creates a disparity between the partnership's "inside basis" (its basis in its assets) and the retiring partner's "outside basis" (which has now been converted into the basis of the distributed property). Without a mechanism to close this gap, the remaining partners may face phantom gain or loss on future dispositions of partnership property.

The outside vs. inside basis distinction

Understanding this disparity requires holding two tracks in mind simultaneously:

• Outside basis: The partner's adjusted basis in the partnership interest itself. This is what the departing partner holds when they exit, and it is the starting point for the IRC 732(b) basis computation on a liquidating distribution.
• Inside basis: The partnership's adjusted basis in its own assets. This is what remains after the retiring partner departs and what the remaining partners effectively hold through the partnership.

In a liquidating distribution, the retiring partner takes a basis in the distributed property equal to their remaining outside basis (IRC 732(b)). The partnership's inside basis in the same property may have been higher or lower. If the retiring partner takes property with an outside-basis-derived basis that is higher than the partnership's inside basis (i.e., the partner's outside basis exceeds the asset's inside basis), there is a "positive disparity": the partner got a step-up, but the partnership's remaining inside basis was not correspondingly increased. The remaining partners may face reduced gain (or additional loss) on future sales of the same assets, distorting their economics.

IRC 734(b): the adjustment when a Section 754 election is in place

When a Section 754 election is in effect (or when a mandatory adjustment applies), IRC 734(b) provides a basis adjustment to the partnership's remaining assets to correct this disparity. The adjustment may be upward or downward:

• Upward adjustment under IRC 734(b)(1)(A): When a partner recognizes gain on a distribution (because money distributed exceeds outside basis), the partnership's inside basis in remaining assets is increased by the amount of gain recognized. This prevents the same gain from being recognized again when the partnership eventually disposes of those assets.
• Upward adjustment under IRC 734(b)(1)(B): When the distributed property takes a basis in the partner's hands that is HIGHER than the partnership's inside basis in that property (because the partner's outside basis exceeded the inside basis), the partnership increases its inside basis in remaining assets by the amount of the step-up.
• Downward adjustment under IRC 734(b)(2)(A): When a partner recognizes a loss on a liquidating distribution (under IRC 731(a)(2)), the partnership's inside basis in remaining assets is decreased by the amount of the loss recognized.
• Downward adjustment under IRC 734(b)(2)(B): When the distributed property takes a basis in the partner's hands LOWER than the partnership's inside basis in that property, the partnership decreases its inside basis in remaining assets by the amount of the step-down.

The IRC 734(b) adjustment is allocated among the partnership's remaining assets under the rules of Section 755 (Treas. Reg. 1.755-1). The Section 755 allocation rules are complex and distinguish between capital-gain-type assets and ordinary-income-type assets. Hedge all IRC 734(b) and Section 755 mechanics to the applicable regulations.

For a full treatment of the Section 754 election mechanics, the IRC 743(b) adjustment on sales of partnership interests, and the interaction between IRC 734(b) and IRC 743(b), see the companion IRC 754 Election: Partnership Basis Adjustment Guide.

Cite: IRC 734(b), IRC 754, Section 755. Hedge all IRC 734(b) mechanics and Section 755 allocation rules to Treas. Reg. 1.755-1 and the applicable regulations.

Without a Section 754 election

When no Section 754 election is in place, no IRC 734(b) adjustment occurs. The inside and outside basis tracks diverge. For the remaining partners, this divergence accumulates over time: each subsequent distribution or sale may produce gain or loss that does not reflect the actual economics of the transaction, because the partnership's inside basis was not corrected when the retiring partner's outside basis was absorbed into the distributed property.

In a mature partnership with significant appreciation, the absence of a Section 754 election can result in substantial phantom gain for the remaining partners on future dispositions. Practitioners advising on partnership buyouts should address whether a Section 754 election is in place or should be made as part of the buyout transaction.

Mandatory basis adjustments

Under prior law, a downward IRC 734(b) adjustment was mandatory (without requiring a Section 754 election) if the amount of the adjustment exceeded $250,000. OBBBA may have modified this mandatory adjustment threshold. All mandatory basis adjustment provisions should be confirmed against enacted OBBBA and current IRS.gov guidance before any filing position is taken. Do not rely on the pre-OBBBA $250,000 threshold without confirming it remains in effect.

Death of a partner: IRC 1014, IRC 743(b), and IRD

When a partner dies, the partnership interest passes to the partner's estate or successor and receives an IRC 1014 fair market value step-up in basis. The step-up is to the FMV of the PARTNERSHIP INTEREST as a whole, not to the FMV of the underlying assets, unless a Section 754 election is in place.

With a Section 754 election in place, IRC 743(b) provides a basis adjustment to the partnership's inside basis in its assets, equal to the difference between the FMV of the partnership interest (the stepped-up basis) and the decedent's share of the partnership's inside basis. This IRC 743(b) adjustment allows the successor to step into the partnership with an inside basis that aligns with the FMV of the interest at death.

If the estate subsequently receives a liquidating distribution (a buyout of the inherited interest), both IRC 736 and, if a Section 754 election is in place, IRC 734(b) apply. Additionally, income in respect of a decedent (IRD) issues under IRC 691 can arise for the decedent's allocable share of unrealized receivables: those amounts were ordinary income the decedent had not yet recognized and may not receive the IRC 1014 step-up, depending on the specific facts. Hedge all post-death mechanics to IRC 736, IRC 1014, IRC 743(b), IRC 691, and the applicable regulations. IRD treatment of partnership-level income items is a complex area with significant case law; it should be confirmed with qualified counsel on the specific facts.

Installment payments under IRC 736

IRC 736 liquidating payments may be structured as installment payments made over multiple years. The reporting depends on which bucket each payment falls into:

• IRC 736(b) installments: Each payment is treated as a distribution. The retiring partner applies their remaining outside basis first (as a tax-free return of basis); once outside basis is exhausted, each subsequent payment is gain. The character of the gain (capital or ordinary) is determined under the normal distribution rules, including the IRC 751 interaction.
• IRC 736(a) installments: Each fixed guaranteed payment is ordinary income in the year received, without regard to basis recovery. There is no installment sale deferral for IRC 736(a) guaranteed payments; they are ordinary income as received.

The interaction of IRC 736 installment payments with the installment sale rules under IRC 453 is a nuanced area. Hedge all installment payment mechanics and any IRC 453 interaction to IRC 736 and Treas. Reg. 1.736-1. In particular, confirm whether the installment method is available for the IRC 736(b) component and how basis is recovered across multiple years of installment payments.

Frequently Asked Questions: IRC 736, 731, 732, and 737