When a partnership admits a new partner or a current partner disposes his/her interest in the partnership during the partnership’s tax year, federal income tax regulations allow the partners to select a method that will be used to allocate tax items between a departing partner and the remaining partners. Generally, the partnership operating agreement provides a specific method of allocation. However, in the absence of such allocation method, it will be determined on a case-by-case basis by agreement between the partners. Here are some of the acceptable allocation methods:
1. Proration Method
Under the proration method, the departing partner's share of the firm's tax items for the entire year are determined based on the portion of the year. For example, A partner with a 10% share of profits and losses leaves on June 30 of the current year. Since the departing partner was present for half the tax year (six months out of 12), he is allocated 5% (10% times 1/2) of all partnership tax items for the year.
However, applying the proration method may not be suitable for the case of uneven income distribution. For example, if the firm created a considerable capital gain with 80% total income in the second half of the tax year, it would not be fair for the departing partner, as the partner is over-allocating the taxable income.
2. Interim Closing of the Books Method
The partnership can conduct an interim closing of the books at the time the partner departs. In other words, the partnership's books are closed on the exit date, and the taxable items are aggregated until the departing date of the tax year. The departing partner is allocated his or her normal percentage share of those amounts. The partner is allocated 0% of the tax items for the period after her/his departing.
For instance, let’s assume that the firm made 80% of total income in the second half of the taxable year with a large capital gain at the end of the year. By applying the interim closing of the books method, the departing partner, who has 10% share of profits and losses, will be allocated only 2% (10% times 20%) of the income and 0% of the capital. Although this interim closing of the books method relatively better reflects the economic reality, fees for conducting the interim closing of the books method may be costly.
3. Alternative “Reasonable Method”
Federal tax regulations also allow partnerships to use alternative "Reasonable Method" to allocate tax items to departing partners. For example, a partnership could allocate both recurring and non-recurring (e.g. crucial litigation settlements or gain and loss from the sale of major assets) taxable items rather than simply applying the proration method. To be specific, let’s assume that the firm's income was earned relatively evenly throughout the year, but there was a major capital gain at the end of the year. This complementary alternative “Reasonable Method” takes account for the departing date of the partner when it comes to allocate non-recurring taxable items; the departing partner will be allocated 5% (10% times ½) of the income and 0% of the capital gain.
Additionally, the S corporation income must be typically allocated amongst stakeholders on a per-share and per-day basis. However, the S corporation can also elect a “closing of the books” method under certain circumstances; for example, if a shareholder disposes her/his entire interests during a year or more than 20% of her/his ownership interests, the shareholder may elect to close the books as of the date of that disposition.
It is important to be aware of potential significant positive or negative tax consequences of an elected income allocation method for the departing and remaining partners. It is recommended to consult with a tax advisor to find the best option for your company's situation.