Buyout of a business partner demands serious study of the facts. What concerns us is not motives but results, which are crucial to the transaction’s ultimate tax impact. Fundamental to the process is understanding of what’s being acquired. Is it a partnership interest or shares of a corporation? The business partner of an incorporated operation is not really a partner for tax purposes. Instead, he’s one of the company stockholders. His stock is an asset – like furniture – that’s being exchanged for cash.
Most important is the source of money for acquisition of the departing shareholder’s business interest. Are funds provided by the remaining shareholder or from the company coffers? If you personally buy the shares of your departing business partner, it has no impact on company accounting. It’s merely a private transaction between two individuals. If, however, the corporation repurchases the departing person’s stock, a special bookkeeping rule is triggered. This is not an expense and therefore doesn’t affect the company’s profit. The acquisition is also not the same as purchasing other types of assets.
Stock repurchased by the corporation that was previously issued to a shareholder is “treasury stock.” The shares are not retired. The cost to reacquire them remains in a negative equity account on the company Balance Sheet. Shares of treasury stock can be sold to new shareholders in the future or continue being held in the treasury stock account forever. Owners of small corporations must remember that buying out a fellow owner with company money cannot result in a business expense. The procedure simply causes recording of treasury stock, which is more shares “issued” than “outstanding.”
When a part owner of your partnership business departs, acquiring his or her ownership interest triggers distinctly complex tax accounting rules. The predicament in a buyout is deciding whether you are purchasing the departing partner’s interest or whether the partnership is redeeming the interest. With either path, the departing partner receives the same amount of money and you end up owning the entire business. But detours along the way will impact the tax results.
A common misperception is that using company cash to buy out a partner is an expense. A partnership interest is generally considered an asset – although an intangible one. Purchasing your partner’s business share is therefore simply trading one asset for another – money for a partnership interest. Exceptions arise if the buyout entails tangible assets. When the business buys a partner’s share of business assets, a bookkeeping adjustment may be required to the company’s cost basis in those assets. Comprehending the full range of possibilities for various asset types is a challenge best given to knowledgeable accountants.
Another dilemma is allocation of the partnership’s taxable income in the buyout year. The partnership ends when your partner conveys his entire business interest. Bookkeeping is closed for the year-to-date and profit or loss up to the buyout is split between you and the departing partner. Subsequent income is taxable to you alone as sole proprietor. Further complications exist of course if you have multiple partners and only one departs. In those cases, following the money trail and determining all tax consequences is no match for the inexperienced.
The Finance Writer 