How Law Firm Partnership Retirement Payments Are Taxed: IRC §736

Most equity partners know their capital account gets returned when they retire. Fewer know that the tax rate on those payments — potentially 20% capital gains vs. 37% ordinary income — depends on a single IRC section most financial advisors have never read. The split is largely determined by your partnership agreement, and the planning window closes when you announce your departure.

The two-bucket rule under IRC §736

When a law firm makes payments to a retiring equity partner in liquidation of their interest, IRC §736 sorts every dollar into one of two categories:

• §736(b) payments — payments for the partner's share of partnership property. Taxed as a distribution under §731: first reduces your outside basis dollar-for-dollar (tax-free), then any excess is long-term capital gain. At 2026 rates: 20% LTCG + 3.8% NIIT = 23.8% for high earners.¹
• §736(a) payments — everything that doesn't qualify as §736(b). Taxed as ordinary partnership income or a guaranteed payment. Up to 37% federal, plus 2.9% Medicare self-employment tax. The firm can deduct these; you pay the full rate.²

What always falls into §736(a): the unrealized receivables trap

Here's what catches most partners off guard. Under §736(b)(2)(A), unrealized receivables — defined in §751(c) to include work in progress and uncollected accounts receivable for a cash-method law firm — are explicitly excluded from §736(b) treatment.³ Payments for your share of firm WIP and receivables come out as §736(a) ordinary income, regardless of how long you've been a partner.

At a large firm with $200M in outstanding WIP and receivables, a 2% equity partner has a $4M economic share of that pipeline. The retirement payment attributable to that share is ordinary income. This is often the single largest ordinary-income item in a partner's exit year — and it's unavoidable under the code unless the payments are structured carefully over time.

Goodwill: the one item you can control

For service partnerships like law firms — where capital is not a material income-producing factor — goodwill value in a retirement payment is §736(a) ordinary income by default. But there's an exception: if the partnership agreement expressly provides for a payment in exchange for goodwill, that amount is reclassified as §736(b) and taxed at capital gains rates.²

This is where significant money is won or lost before departure:

• A senior partner at an AmLaw 50 firm may have $500K–$2M of firm goodwill attributable to their practice group. Without express partnership agreement language, that's ordinary income.
• With a properly drafted goodwill provision negotiated before retirement, that same amount is capital gain — a tax difference of $70K–$300K on goodwill alone.

The window to negotiate this is before you announce intent to retire, while you still have leverage. Post-announcement, the firm's incentive to accommodate special tax structuring diminishes.

Your paid-in capital: the cleanest bucket

The capital you contributed at partnership — your original buy-in plus any subsequent capital calls — is clearly §736(b) property. When you receive it back, you first reduce your outside basis. For most partners, the outside basis roughly equals paid-in capital, meaning a significant portion of the return is tax-free, with any appreciated value taxed as LTCG. This is the most tax-efficient part of any exit payment.

Multi-year payment schedules and bracket sequencing

Most large law firms return capital over 5–10 years on an installment schedule. This structure creates planning opportunities — and traps:

• WIP payments spread over time: If the firm pays your receivable share as collections come in rather than as a lump sum at departure, the §736(a) ordinary income recognition stretches over 1–3 years. This may land in lower brackets if your other income drops sharply post-retirement — or may coincide with NQDC distributions in a way that compresses all your income into year one.
• NQDC stacking: If you elected lump-sum NQDC distribution on separation from service, the departure year may simultaneously include: final quarterly K-1 distributions, §736(a) WIP income, capital return interest, and NQDC distribution. Combined marginal rates in that year can exceed 50% when New York or California state taxes are included.
• Lump sum vs. installment decision: For §736(b) capital gain, a lump sum in a year where you've already incurred heavy §736(a) ordinary income typically makes sense only if you've exhausted your bracket management options. Model it both ways before agreeing to firm-standard terms.

IRMAA and the Medicare premium cliff

IRMAA applies Medicare Part B and D surcharges based on MAGI from two years prior. In 2026, single filers above $109,000 pay surcharges, and the top tier (above $500,000) adds $487/month to Part B alone — or roughly $11,700/year per person in additional premium.⁴

A partner with a high-income final year — even if retirement income drops significantly afterward — will face elevated IRMAA for two full Medicare years. If your departure year stacks $800K+ of income (K-1 distributions, §736(a) WIP, capital return interest, and NQDC), that IRMAA exposure persists until year three of retirement. For a couple, this can total $40,000–$50,000 of avoidable premium cost.

State tax exposure on §736(a) payments

New York and California — where the majority of Big Law partners spend their careers — assert income tax jurisdiction over guaranteed payments and distributive shares from in-state partnerships even after you've relocated. Partners who spent decades in New York and retired to Florida may still owe New York income tax on §736(a) payments attributable to their New York partnership interest. This is an active audit area. Document your firm-career apportionment by state before departure.

The planning checklist before you leave

1. Read the goodwill clause in your current partnership agreement. If it's silent, assess whether you have leverage to negotiate a goodwill payment provision before retirement discussions begin.
2. Get a firm financial statement showing WIP and receivables. Your §736(a) exposure is proportional to your equity interest in these amounts. Partners are often surprised by the size.
3. Map your NQDC distribution schedule against your projected §736(a) and §736(b) payment timeline. Year-one stacking is the most common avoidable tax mistake at partner retirement.
4. Model IRMAA exposure. If you're approaching Medicare age, understand which income years will determine your Part B and D premiums in years one through four of retirement.
5. Get state tax analysis for every state in which you've had allocable partnership income. The filing obligations and audit risk don't end when you leave.