Updated July 29, 2026. Quick answer: The statute splits the payments in two, and which side a dollar lands on decides its character. IRC §736(b)(1): payments made in liquidation of a retiring partner’s interest are treated, to the extent they are “made in exchange for the interest of such partner”, as a distribution. Everything that is not that falls to §736(a) — and §736(a) payments are not capital gain.
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.
Note the paragraph (2) carve-out inside §736(b)(1): certain payments are excluded from (b) treatment even though they look like payments for the interest. That is where unrealised receivables and, in some circumstances, goodwill enter the analysis — the exact place a cash-basis professional firm holds most of its value. This page does not resolve that; it points at the provision that governs it.
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
IRC §736(a) and §736(b), including §736(b)(1) and the paragraph (2) carve-out; Treas. Reg. §1.736-1. Fetched July 2026.
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.