Allocation of Income When a Partner Leaves a Partnership

John, a white man with dark brown hair, wears a pale blue shirt, lime green and blue tie, and black suit. By John G. Hodnette

The allocation of income when the ownership of an S corporation changes is discussed in my previous article Section 1377(a)(2) Elections for S Corporations. That article explains the default method for allocations of income when an ownership change occurs as to an S corporation is the proration method. However, one can make a Section 1377(a)(2) election and instead use the closing of the books method. In contrast, in the case of partnerships, the default is the opposite.

Pursuant to Reg. § 1.706-4(a)(3)(iii), “absent an agreement of the partners . . . to use the proration method, the partnership shall use the interim closing method.” Reg. § 1.706-4(f) defines “agreement of the partners” to mean either (i) an agreement of all the partners to select the method in a dated, written statement maintained with the partnership’s books and records or (ii) a selection made by a person authorized to make such selection under state law or the partnership agreement, provided that person’s selection is in a dated, written statement maintained with the partnership’s books and records. The interim closing method is similar to the S corporation closing of the books method. The interim closing method generally treats each change in partnership ownership as the time to close the books for such interim period. That means only partners who were owners in such period are allocated income and loss that occurred during the period. However, the regulations provide great flexibility in determining the length of interim periods.

Where a partnership has many changes in ownership throughout the year, the default interim closing method can become complicated and costly, with numerous interim periods.  Accordingly, the regulations allow the partners to elect the proration method. As the name suggests, that method allows income to be prorated over a period (for example, the entire tax year) and then allocated among the owners based on their ownership on each day of such period. This method provides simplicity but can create imbalances where a business has a concentration of income in a certain period. For example, if a partner sells his or her interest in the partnership in February when the partnership has had no income for the year, but the partnership realizes a large amount of income in the remainder of the year and elects the proration method, the exiting partner will be allocated income even though the partnership recognized no income prior to his or her exit. To further complicate matters, the regulations allow a mixture of the interim closing method and the proration method within the same year. However, the regulations state the Commissioner may provide limits on using both methods in the same year.

John G. Hodnette is an attorney with Fox Rothschild in Charlotte.