If 2 of 3 members of an LLC sell their interest for $7,500 each, with ending capital of $1,350 each, what do they have to claim on their individual tax return? And where?

[dj-singer]

At time of sale of interest in rental property (LLC)*:
  Total Assets = $165,000
  Total Liabilities = $161,000
  Total Equity = $4,000

* numbers are rounded

[Rick19744 · Accepted solution]

Actually if two of the three members sell their interest and there is only one member left, it is an actual termination instead of a technical termination; this is a Section 708(b)(1)(A) versus a 708(b)(1)(B).

A complete response is beyond this forum as selling a partnership interest is like selling your share of the underlying assets.  As you will see upon reading the publication noted by TT Richard, this can be a complicated area and often either not understood or handled incorrectly.

The other fact not disclosed is who bought out their interest.  Based on what I currently see in the facts, it appears that this entity is no longer a mutli-member LLC and that is why I indicated it appeared to be a complete termination instead of a technical termination.  If the facts are different, and it continues on as a multi-member LLC, than it may very well be a technical termination.

The general rule is that upon disposition of your LLC interest, the member would compare their proceeds to their basis in their LLC interest.  The difference is capital gain or loss.  Where this gets complicated, is some of the gain could be recharacterized as ordinary income (hot assets) in lieu of capital gain.  It can also result in recognition of ordinary income and a capital loss.  This determination is made at the member level and not the LLC level.  As such, the impact is handled directly on their respective 1040 and applicable schedule.

[dj-singer]

Thanks, Rick19744. I didn't realize that the 3rd LLC member acquiring the other 2/3 would be considered a termination of any kind of the LLC. He had his accountant file a short period return, and I received a K-1 noting that I should claim the $7,500 less my ending capital balance ($1,334) as a capital gain on my personal tax return. I'm still not clear if that's correct, but if you think it's beyond this forum I'll contact a tax person.

[Rick19744]

As noted in my response, this is not a technical termination, it is a complete termination of the partnership / LLC.

You need to have more than one member in the LLC for the entity to be treated as a partnership.  Based on your facts, once you only have one member, it is no longer a partnership.  It becomes a single member LLC.

I am also providing a link to IRS revenue ruling 99-6 which has some discussion of your situation.  You are situation 1, except that you have members A, B and C and not just A and B as noted in the example.  The end result of the transaction is the same though.

<a rel="nofollow" target="_blank" href="https://www.irs.gov/pub/irs-drop/rr-99-6.pdf">https://www.irs.gov/pub/irs-drop/rr-99-6.pdf</a>

A short period tax return should be filed for the period that the entity was a true partnership.  I do not agree with the advice that you should recognize any gain or loss as a result of this transaction.  That position is supported in the attached revenue ruling.  You will take a basis in the assets distributed equal to either the adjusted basis that the LLC had in the assets, or equal to your basis in your LLC interest.  This is where this gets somewhat complicated, however, there is no gain or loss.  There is an exception to this rule, however, I do not believe you fall within that exception; and the exception is only to be able to recognize a loss.

[dj-singer]

Thank you so much for all of the information! I think I have it now. At the time of the sale of my interest in the LLC, assets (building/land) were $165,000, a third of which were mine. So my basis would be $55,000, which I would subtract from the $7,500 I was paid for my 1/3 interest, resulting in a negative, and would not be claimed on my 1040. The liabilities that were assumed by the remaining member would be considered a contribution on his part to the new LLC and would not be factored in. Do I have that right?

[dj-singer]

Thank you so much for all of the information! I think I have it now. At the time of the sale of my interest in the LLC, assets (building/land) were $165,000, a third of which were mine. So my basis would be $55,000, which I would subtract from the $7,500 I was paid for my 1/3 interest, resulting in a negative, and would not be claimed on my 1040. The liabilities that were assumed by the remaining member would be considered a contribution on his part to the new LLC and would not be factored in. Do I have that right?

[Rick19744]

No.  It is not that simple.  The $55,000 you are referring to is your share of the "inside basis" of this asset.  You also need to determine your "outside basis" or also known as your tax basis.  It was not clear before that you were one of the selling members so some of what was discussed previously is not applicable.

You need to determine your tax basis as noted above.  Once you adjust this for the final K-1 impact you will be able to determine your gain or loss; "yes" you will have a gain or loss since you are one of the selling members.

The liabilities do have a part in this, however, in most cases it only reflects as an addition to basis and then a subtraction netting to zero.  

Once you have determined your updated tax basis you will then subtract your liquidating distribution.  If you still have basis remaining after this liquidating distribution this remaining amount will be a capital loss (potentially).  If the liquidating distribution causes your basis to go negative, you will have capital gain to the extent of this negative amount (essentially getting your basis back to zero).

Finally you need to know your share of hot assets which includes depreciation recapture.  The entity will need to tell you this.  At this point you may have to pick up some ordinary income and have a larger capital loss.  This is the part that gets complicated so you may want to discuss this with a tax professional.

[dj-singer]

Thanks again, Rick19744. I've always used TurboTax for my taxes so I figured the software would walk me through this. I guess I will need to find a tax professional that knows how to handle this.

[Rick19744]

TT is great software, however, you have a more complicated situation than is usually encountered by those who want to prepare their own taxes.  It's not that you can't do what is needed with the software, it is just that you would need a higher understanding of how to accomplish the end result.  Best of luck.

[RichardK]

If the LLC is being taxed as a partnership, and more than 50% of the ownership changes it is considered a "Technical Termination". See IRS Publication 541, on how to handle a Partnership Termination.

If the LLC is taxed as a corporation, the sale of the members interest would be treated as a capital gain, the sale price being $7,500 and the cost being the members basis.

[dj-singer]

Thanks, TurboTaxRichardK. We were taxed as a partnership, and I didn't realize that the 3rd LLC member acquiring the other 2/3 would be considered a Technical Termination of the LLC. He had his accountant file a short period return, and I received a K-1 noting that I should claim the $7,500 less my ending capital balance as a capital gain on my personal tax return. I'm still confused as to whether or not that's correct.