Your Partner Is Leaving. Before You Sign Anything, Read This.

Two partners, one company, and one of them wants out.

You agree on a number. You shake hands. Then you find out that how you structure the deal — and what kind of entity you’re buying out of — determines whether the IRS takes 23% of that payment or 37%. That’s not a rounding error. On a $2 million buyout, that’s a $280,000 difference.

I’ve seen people shake hands first and call an accountant second. The sequence matters enormously.

The First Question: What Kind of Entity Are You Buying Out Of?

LLC (taxed as a partnership) and S-corp are the two structures most small business owners are dealing with. The rules are completely different between them.

Buying Out a Partner in an LLC (Partnership)

When one partner exits an LLC taxed as a partnership, the payment structure is governed by IRC Section 736. That section splits the payments into two buckets, and the bucket determines the tax treatment for both sides of the deal.

Section 736(b) payments are payments for the exiting partner’s share of the business’s assets — their proportionate cut of the equipment, inventory, receivables, real estate, goodwill. The departing partner treats this as a capital gain (or loss) on the difference between what they receive and their tax basis in the partnership interest. The remaining partners get no deduction.

Section 736(a) payments are payments that go beyond the asset value — guaranteed payments, essentially. The exiting partner pays ordinary income tax on these. The partnership can deduct them.

Most deals are structured primarily as Section 736(b). But here’s the problem: “hot assets” under IRC Section 751 — unrealized receivables and substantially appreciated inventory — get pulled out and recharacterized as ordinary income regardless of how the deal is papered. You can’t avoid that by calling it something else.

Example: Your LLC has $300,000 in outstanding receivables that haven’t hit the income statement yet. Your departing partner’s 50% share of those receivables — $150,000 — gets taxed as ordinary income to them, not capital gains. If they’re in the 37% bracket, they pay $55,500 in federal tax on that slice alone, versus $30,000 at capital gains rates. That’s $25,500 more — just on the receivables.

The Section 754 Election: Why the Buyer Should Ask for It

When you buy out a partner’s interest in an LLC, you’re paying for their share of the underlying assets. But your inside basis — your share of the basis in the company’s actual assets — may not reflect what you paid.

A Section 754 election lets the LLC step up the buying partner’s share of the inside basis to match the purchase price paid. This creates additional depreciation and amortization deductions that can reduce the buyer’s taxable income for years.

Example: You pay $1.2 million for a 50% interest in an LLC. The LLC’s assets have a total inside basis of $600,000 (50% = $300,000). Without a 754 election, your basis in those assets is $300,000. With the election, you get a $900,000 step-up — the difference between what you paid ($1.2M) and your share of the inside basis ($300,000). That’s $900,000 in additional basis you can depreciate or amortize over time.

It’s a non-trivial number. Buyers should push for this. Once a 754 election is made by the LLC, it applies to all future transfers and distributions too — which is worth knowing if you’re negotiating the deal terms.

Buying Out a Partner in an S-Corp

In an S-corp, there are no “partnership interest” rules — there’s just stock. The departing shareholder sells their shares. For them, that’s a capital transaction: the gain is the difference between what they receive and their basis in the stock. Usually long-term capital gains rates, assuming they’ve held the shares more than a year.

For the buyer, the downside is that you’re buying stock — which gives you a new cost basis in the shares, but does nothing for the underlying assets the company owns. The equipment, the goodwill, the real estate inside the S-corp still carry the old depreciated basis. If those assets are significant, you’re losing years of future depreciation you’d otherwise get in an asset deal.

The 338(h)(10) Election: Getting Asset Basis Without an Asset Deal

Here’s where it gets interesting. For S-corps, there’s an election under IRC Section 338(h)(10) that lets the buyer and seller treat a stock sale as if it were an asset sale for federal tax purposes.

The buyer gets a stepped-up basis in the company’s assets — the full purchase price allocated across equipment, goodwill, customer lists, everything. That’s the same as buying the assets directly. The buyer can depreciate all of it from day one.

The seller, in exchange, pays tax on the “deemed asset sale” — which means some of the gain may be recharacterized as ordinary income on depreciated assets (recapture) rather than all capital gains. That’s typically worse for the seller.

This is the negotiation. The buyer wants 338(h)(10) because of the asset basis step-up. The seller resists because it costs them more in taxes. Deals get structured with a higher purchase price to compensate the seller for the extra tax hit. How much more depends on what’s inside the company — heavy equipment, real estate, and short-life assets all affect the calculus differently.

Both parties have to consent to the election. You can’t unilaterally elect it as the buyer.

Running the Real Numbers

Let me make this concrete. Two partners in an S-corp, each with a 50% interest. One buys out the other for $2 million. The selling partner has a $300,000 basis in their stock.

Without 338(h)(10): Selling partner has a $1.7 million capital gain. At 23.8% (20% + 3.8% NIIT), that’s $404,600 in federal tax. Buyer gets $2M in stock basis, but the underlying assets inside the company may still be mostly depreciated out.

With 338(h)(10): The gain now gets allocated across the company’s assets. Some of it — say $400,000 attributed to equipment the company already depreciated — gets recharacterized as ordinary income at 37%, versus 23.8%. That extra tax to the seller might be $53,000. The buyer, in exchange, gets to step up the basis on all the company’s assets and take $2 million in fresh depreciation and amortization. If those deductions save the buyer $200,000 in taxes over five years, there’s room to negotiate a purchase price bump of $70,000 to $100,000 that makes the seller whole.

This is why deal structure is a tax conversation, not just a legal one.

What to Watch for in New York

New York conforms to the federal partnership and S-corp rules on buyouts, so the same character-of-income analysis applies at the state level. New York taxes ordinary income at up to 10.9% and capital gains at the same ordinary rates (no preferential capital gains rate in NY). So the ordinary-vs-capital distinction matters even more here than it does federally.

Also: if goodwill is part of the buyout price and it’s not explicitly addressed in the purchase agreement, the IRS may argue about how it’s allocated. Get it documented.

For context on how your underlying entity structure affects long-term tax outcomes, the LLC vs. S-Corp calculator is a useful place to start.

This post is for general informational purposes only and does not constitute legal or tax advice. Tax treatment of business transactions depends on specific facts and circumstances. Consult a qualified tax professional or attorney before structuring any business transaction.