Clear Money Guide
What this guide covers
A quick view of the questions and evidence developed below.
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Updated August 21, 2026. Quick answer: IRC section 736 splits a retiring partner’s payments in two, and which side a dollar lands on decides its character. Under §736(b)(1), payments made in liquidation of the interest are treated as a distribution to the extent they are “made in exchange for the interest of such partner”. Everything that is not that falls to §736(a) — which is not capital gain, and which is itself two different things: a distributive share under §736(a)(1) or a guaranteed payment under §736(a)(2). Two further paragraphs decide how much lands where, and one of them, §736(b)(3), is the piece most summaries leave out. All four are below, in the statute’s own words.
The split, in the statute’s own structure
IRC §736(b)(1) provides that payments made in liquidation of the interest of a retiring or deceased partner shall, “to the extent such payments (other than payments described in paragraph (2)) are determined … to be made in exchange for the interest of such partner”, be treated as a distribution. Read the structure: (b) is defined by what it is in exchange for, and (a) catches the remainder. A firm drafting a retirement agreement is, whether it notices or not, allocating dollars between two tax characters.
| §736(b) | §736(a) | |
|---|---|---|
| What it is | In exchange for the partner’s interest | Everything else |
| Treated as | A distribution | Not a payment for the interest — and not capital gain |
| Who prefers it | The retiring partner | The remaining partners, generally |
| Set by | The agreement, subject to the statute and its regulations — not by what anyone calls it | |
The interests are genuinely opposed, which is why this is worth reading before you sign. A payment characterised under §736(a) generally reduces the income of the remaining partners, so the firm has a reason to want dollars there. The retiring partner generally wants them under §736(b). Both sides are looking at the same total and pulling in opposite directions on its label — and the partner on the way out is usually the one negotiating alone.
First: whether section 736 reaches your deal at all
Before the split matters, the section has to apply, and its own regulation draws the boundary narrowly. Two conditions do the work, and a common way of buying a partner out falls outside both.
Section 736 and this section apply only to payments made to a retiring partner or to a deceased partner’s successor in interest in liquidation of such partner’s entire interest in the partnership — and apply only to payments made by the partnership and not to transactions between the partners. “Thus, a sale by partner A to partner B of his entire one-fourth interest in partnership ABCD would not come within the scope of section 736.”
— Treas. Reg. §1.736-1(a)(1)(i), condensed from the regulation’s own sentences; the quoted example is verbatim
So a cross-purchase is a different transaction. If the remaining partners buy your interest out of their own pockets, that is a sale between partners and this section is not the one that governs it. If the firm redeems you, and liquidates the whole of your interest rather than trimming you back to a smaller share, you are inside §736. A partial withdrawal that leaves you holding a reduced interest is not a liquidation of your entire interest.
One consequence worth knowing before you plan around dates: for tax purposes you are still a partner until the last payment is made. The regulation says a retired partner “will be treated as a partner until his interest in the partnership has been completely liquidated” — which is also why a two-partner firm being bought out under §736 is not treated as terminated on the day the partner walks out.
What section 736(a) actually does: distributive share, or guaranteed payment
The table above says a §736(a) payment is not capital gain. True, and not the whole answer. §736(a) has two characters, and the statute picks between them on a single test: whether the amount was set by reference to what the partnership earned.
Payments made in liquidation of the interest of a retiring partner or a deceased partner shall, except as provided in subsection (b), be considered—(1) as a distributive share to the recipient of partnership income if the amount thereof is determined with regard to the income of the partnership, or (2) as a guaranteed payment described in section 707(c) if the amount thereof is determined without regard to the income of the partnership.
— IRC §736(a), verbatim
| How the amount was set | §736(a)(1) | §736(a)(2) |
|---|---|---|
| Determined with regard to partnership income | Yes — a share of profits, a formula keyed to what the firm earns | No — a fixed sum, a set schedule |
| Character | A distributive share of partnership income | A guaranteed payment under §707(c) |
| Effect on the remaining partners | Taken into account under §702 in your income, and so reduces their distributive shares | Deductible by the partnership under §162(a) |
| Effect on you | Your share of what the firm earned | Ordinary income to you under §61(a) |
Route table from Treas. Reg. §1.736-1(a)(3) and (a)(4)
This is the mechanism behind the row above about who prefers what, and it is worth seeing plainly, because the page has so far only asserted it. Both §736(a) routes move the burden off the remaining partners — one by reallocating the firm’s income to you, the other by giving the firm a deduction. A §736(b) payment does neither: the regulation states that for those, the remaining partners are allowed no deduction, because the payment is a distribution or a purchase of your capital interest. That asymmetry is the whole negotiation.
Note what does not decide which of (a)(1) or (a)(2) applies: what the agreement calls the payment. The test in the statute is arithmetic — was the number computed off partnership income, or not.
The two exclusions in section 736(b)(2)
Look again at the §736(b)(1) rule quoted at the top of this page and you will find a parenthesis in it: it reaches payments “other than payments described in paragraph (2)”. Paragraph (2) names exactly two things, and they happen to be the two places a cash-basis professional firm keeps most of its value.
For purposes of this subsection, payments in exchange for an interest in partnership property shall not include amounts paid for—(A) unrealized receivables of the partnership (as defined in section 751(c)), or (B) good will of the partnership, except to the extent that the partnership agreement provides for a payment with respect to good will.
— IRC §736(b)(2), verbatim
(A) is your accounts receivable. §751(c) does not give a closed definition. It says the term includes “to the extent not previously includible in income under the method of accounting used by the partnership, any rights (contractual or otherwise) to payment for … services rendered, or to be rendered”, and, on a narrower footing, for goods delivered or to be delivered. A cash-basis practice bills after the work is done, so its unbilled and uncollected time sits squarely in that services limb.
(B) is the one clause here you can actually draft. Goodwill drops out of §736(b) except to the extent the partnership agreement provides for a payment with respect to goodwill. The document decides: silent, and goodwill payments fall to (a); provide for them expressly, and to that extent they stay in (b). The regulation adds a word the statute does not — it speaks of a reasonable payment with respect to goodwill, and says that a valuation reached by the partners at arm’s length, “whether specific in amount or determined by a formula,” is generally regarded as correct. That is a rule about what your agreement says. It is not an answer to the different and much harder question set out below, about whom the goodwill belonged to in the first place, and nothing here should be read as one.
The §736(a)/(b) split decides your tax bill. An advisor can help you negotiate it.
How a buyout agreement allocates payments between the two categories is often negotiable before you sign — and it changes what you owe. Worth a second set of eyes before the ink dries.
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The gate on all of that: section 736(b)(3)
Everything in paragraph (2) is switched on or off by the paragraph immediately after it. It is short, it is the newest part of the section, and it is the part that summaries of “736(a) versus 736(b)” most often omit.
Limitation on application of paragraph (2). Paragraph (2) shall apply only if—(A) capital is not a material income-producing factor for the partnership, and (B) the retiring or deceased partner was a general partner in the partnership.
— IRC §736(b)(3), verbatim
Read it as a switch, because that is how it behaves. Both conditions have to hold. If they do, the receivables-and-goodwill carve-out in paragraph (2) applies and those dollars are pushed out of §736(b) and into §736(a). If either one fails — capital is material to how the partnership earns, or the departing partner was not a general partner — then paragraph (2) does not apply at all, and this provision does not carve receivables or goodwill out of (b).
So the answer differs by what kind of partnership you are in, and that is the first thing to check. The consequence runs in opposite directions for a services partnership and for a capital-intensive one, on the same set of payments. If you have arrived at this page from a farm, a rental operation or an equipment-heavy business, do not carry the paragraph (2) result across without testing condition (A) first.
What this page will not do is tell you which side of condition (A) you are on. §736 does not define “capital is not a material income-producing factor”, and neither does the regulation: we read Treas. Reg. §1.736-1 in full and neither that phrase nor the words “general partner” appear anywhere in it. That is a real gap, and we are not going to fill it with a rule of our own.
Why the regulation and the statute do not line up
There is a reason the regulation is silent, and it is worth understanding before you lean on any worked example you find in it. Treas. Reg. §1.736-1 carries the date stamp “T.D. 6500, 25 FR 11814, Nov. 26, 1960, as amended by T.D. 6832, 30 FR 8574, July 7, 1965”. Its text is from 1960, last touched in 1965. Paragraph (b)(3) did not exist then: it was added by Pub. L. 103–66, §13262(a), enacted August 10, 1993.
The same 1993 section did a second thing, and the pairing is the clearest evidence of the drift. §13262(b)(1) went into §751(c) and struck section 736 out of its cross-reference to the recapture list — §1245 property, franchises, trademarks and the rest — substituting the words “(but not for purposes of section 736)”, which are in the statute today. Before 1993 that list did count as unrealized receivables for §736 purposes. So the regulation’s worked example treating §1245 property as an unrealized receivable in a §736 computation was right when it was written and is not the law now. The regulation also still describes goodwill as excluded “under some circumstances” with no mention of any limitation, because in 1965 there was none.
Where the two diverge, the statute is the later word. Read the regulation for the machinery it explains well — the allocation of instalment payments, the ordering, the treatment of the remaining partners — and check anything it says about receivables, goodwill or the reach of paragraph (2) against the current text of §736 and §751(c).
One date to hold on to: §736(b)(3) applies, by its own effective-date provision, in the case of partners retiring or dying on or after January 5, 1993, with an exception where a written contract to purchase the interest was binding on January 4, 1993 and at all times afterwards.
One question this site will not answer, and why. Whether goodwill in a practice sale belongs to you personally or to the entity is the most consequential question in a professional-practice deal. It rests on two Tax Court decisions whose primary text we have never been able to obtain from an official court source, and the one-line summaries in circulation overstate what are narrow, fact-bound holdings. So we do not state a rule on it. Anyone telling you the answer is simple, in either direction, is summarising cases they have probably not read either.
If the practice is a corporation rather than a partnership, the retirement question is a different one entirely, and a prior C-corporation history can put a tax at the entity level first.
Sources
26 U.S.C. §736 in full — (a)(1) and (a)(2), (b)(1), (b)(2) and (b)(3), with its 1993 amendment and effective-date notes — read at uscode.house.gov on 2026-08-21. 26 U.S.C. §751(c) (definition of unrealized receivables, and its “but not for purposes of section 736” limitation) and 26 U.S.C. §707(c) (guaranteed payments), same source and date. Treas. Reg. §1.736-1, paragraphs (a)(1) through (a)(6) and (b)(1) through (b)(5), read in full at ecfr.gov (current as of 2026-08-01) on 2026-08-21. Every quotation on this page is from one of those four documents.
This states what the cited authority says. It is not tax or legal advice. A practice sale turns on the entity form, the allocation actually agreed and the buyer's own tax position — and one of the most-asked questions in this area is deliberately not answered anywhere on this site, for the reason given on each page that touches it.