State Tax Considerations Around the Sale of a Partnership Interest

The following article, State tax considerations around the sale of a partnership interest, originally appeared in the May 2022 issue of The Tax Adviser.



One of the most significant decisions the owner of a business classified as a partnership for U.S. federal and state income tax purposes can make is choosing whether to sell his or her interests. Sale transactions have become more common as the appeal of passthrough entities (PTEs) —including partnerships, limited liability companies (LLCs) taxed as partnerships, and S corporations— to business owners and investors grows due to their benefits, such as a single layer of taxation (unlike with C corporations) and certain legal protections available to some owners. The most recent IRS data shows that the number of PTEs has more than quadrupled since 1980.Approximately 3.8 million entities filed returns as partnerships in 2019, the most recent year for which data is available. Additionally, economic uncertainty caused by the COVID-19 pandemic, potential increases in interest rates and income tax rates, an aging U.S. population heading into retirement, and other factors are spurring owners of PTEs, among others, to consider divesting from or selling certain business operations. However, failing to account for state and local income tax effects can add to the owner’s tax liability on these sales and minimize return on investment.  

To increase tax efficiency while minimizing risk, owners of PTEs that conduct business in multiple state and local taxing jurisdictions should evaluate how taxing authorities may treat the sale of partnership interests. This item highlights key considerations owners selling partnership interests should address as part of the sale, including which states may attempt to tax the entire gain, how taxation of the gain may be divided among the states where the partnership does business, compliance considerations, and technical developments and trends that may affect the transaction. While states generally tax PTEs similarly to each other, there are nuances among them that are not addressed in this discussion (e.g., entity-level taxation or treating single-member LLCs as regarded entities).