A partner who sells out rarely pays one tax rate on the whole price. Section 741 of the tax code treats the sale of a partnership interest as the sale of a single capital asset, taxed at capital gains rates, but section 751 carves out one exception that does most of the real work: whatever part of the price stands in for the firm's unrealized receivables or appreciated inventory is taxed as ordinary income, no matter how the rest of the deal is priced. On a partner leaving a service business with real receivables on the books, that slice is rarely zero.

Whether the buyer is the remaining partners personally or the partnership itself changes the mechanics almost as much as the price does. A sale to the other partners runs through sections 741 and 751 directly. A redemption, where the partnership itself buys back the departing partner's interest, runs through section 736 instead, which can turn the same receivables into ordinary income by a different route, or into capital gain, depending on one sentence in the partnership agreement about goodwill. This is general information, not tax advice for one specific return; a partnership's accountant should run the actual numbers before a sale or redemption is priced, and the figures below are current as of 2026.

Sale to the other partners: capital gain, minus the hot assets

When a partner sells directly to the remaining partners, section 741 applies first: the gain or loss is the difference between the price and the seller's outside basis, taxed as a capital gain or loss. Section 751 then pulls out the part of that price attributable to "unrealized receivables" (amounts the business has earned but, on the cash method, has not yet recognized as income) and "inventory items" (goods that would not be capital assets if the partnership sold them itself). That portion is reclassified as ordinary income, and it usually carries little or no offsetting basis, since a cash-method business has not yet been taxed on receivables it has not collected.

A $300,000 sale with $60,000 of receivables

Say a partner sells a 25 percent interest for $300,000. The firm uses the cash method and $60,000 of the price is attributable to receivables it has billed but not yet collected, which carry zero basis for tax purposes. The partner's outside basis in the whole interest is $140,000, all of which applies against the non-receivables part of the price.

Total price$300,000
Attributable to unrealized receivables (section 751)$60,000
Basis in those receivables (cash method)$0
Ordinary income on the receivables$60,000
Amount realized on the rest of the interest$240,000
Outside basis (applied entirely here)$140,000
Capital gain on the rest$100,000

Total gain is $160,000: $60,000 taxed as ordinary income because it stands in for receivables the firm has not yet collected or been taxed on, and $100,000 taxed at capital gains rates because it is paid for the partner's actual stake in the business. A partnership with no receivables or appreciated inventory skips the ordinary-income step and the whole gain is capital.

A redemption runs through a different section

If the partnership itself buys back the interest rather than the other partners buying it personally, the payments are governed by section 736 instead of 741. Payments for the partner's share of actual partnership property are treated as a distribution under 736(b): capital gain only to the extent they exceed outside basis, the same economics as a direct sale. But payments for unrealized receivables, or for goodwill, are treated under 736(a) as a distributive share or a guaranteed payment, which is ordinary income to the recipient, unless the partnership agreement specifically provides for a payment with respect to goodwill. That one clause decides which column the goodwill payment falls into, so it is worth writing deliberately into the agreement before anyone is bought out, not after.

Sale to the partners versus redemption by the partnership

Sale to the other partners Redemption by the partnership
Governing section 741, with 751 pulling out hot assets 736
Payment for partnership property Capital gain or loss under 741 Treated as a distribution under 736(b); capital gain only above outside basis
Payment for receivables or goodwill Ordinary income under 751, regardless of how the deal is priced Ordinary income under 736(a), unless the agreement provides for a goodwill payment, in which case it shifts to 736(b) capital treatment
Who controls the split Buyer and seller, in the sale agreement The partnership agreement's goodwill clause

Installment payments and Form 8308

A buyout paid over several years can usually use the installment method under section 453 for the capital-gain portion, spreading that gain into the years the cash actually arrives. The ordinary income attributable to unrealized receivables is treated differently: it is generally recognized up front, in the year of the sale, rather than stretched out with the payments, so a seller financing a buyout should expect a tax bill on the receivables slice before most of the cash is in hand.

Once both sides understand the split between ordinary income and capital gain, how the deal is structured becomes a real negotiating point, not just a tax formality. A seller with large unrealized receivables may prefer a sale to the other partners over a redemption with no goodwill clause, since the mechanics land in roughly the same place either way; a seller in a business with real goodwill but no receivables problem may care much more about getting that goodwill clause into the agreement before the buyout is priced. How to buy out a business partner and how to finance a partner buyout cover the price and the payment plan; this is the tax bill that sits on top of either one.