LLC Capital Account – Its impact on FMV of LLC interest? Tax Basis in Year of Sale of Interest

[Ripken818]

Situation:

• Two partner LLC (50/50 split) exists where one partner is selling interest to another partner for an agreed upon independent valuation.
• As a pass through entity, income earned from the LLC flows through to the partners 50/50 and is tax at the individual’s ordinary income rate. As a portion of a partner’s profits is typically tied up in inventory, the associated income taxes may be due prior to real dollars actually being distributed to the partner. The actual distributions lag the tax dues on the income.  
• When one partner sells their 50% LLC interest to the other partner, no further distributions will be made to the partner after the sale. We assume the undistributed net income would be added to the partner’s capital account (in line with 50/50 split) for the period up to the sale of the interest.

Example:

• The FMV of the LLC is appraised by business evaluators to be $1,000,000. $500,000 to be paid to the selling partner, before any adjustments.
• The sale date is 9/30, with year to date Net Income of $100,000 (9 months), $50,000 to be added to each partner’s capital account, less any distributions made (we can assume $0).
• The starting 1/1 balance for the partner’s capital accounts was $50,000. So Ending balance at time of sale is $100,000 for each partner.
• If we break down the $100,000 of the selling partner’s capital account:
• We expect $50,000 to be subject to ordinary income tax (what was earned in year of sale).
• We are unsure if the partners tax basis is $100,000 or the remaining $50,000.
• We would expect the difference in sale price $500,000 and the tax basis ($100,000 or $50,000) to be taxed at capital gains rate.

Questions:

1. One straightforward question is: what would the selling partner’s tax-basis be ($100k or $50k)?
2. We are more so curious about the impact to the valuation:
1. Is the FMV of the LLC impacted/adjusted by the level of the partner’s capital accounts? It would seem not, if an EBITDA multiple approach was taken, for example.
2. What if just before the sale, both partners took distributions of their capital accounts, i.e., each partner took out $50,000 (assume this is from their starting 1/1 balance)

1.       Would this impact the valuation? Again, would seem not. So in this case the selling partner walks away with the $500k from sale and the $50k from capital account = $550,000

1. Said differently, how are capital accounts handled when an LLC interest is sold (in real dollar terms, separate from the tax-basis question).

[M-MTax]

Sounds like a hypo or a tax homework question....you need a tax pro.

[Ripken818]

Thank you for the help!

To simplify things, stripping the tax aspect of the question....

If two equal partners in an LLC each have $50,000 in their capital account and one partner sells to the other at an agreed upon valuation of $500,000 for the 50%. Does the selling partner receive $500,000 for the FMV of their interest AND the $50,000 in their capital account?

If the $500k valuation is based on the go-forward earnings of the business... the valuation is going to be $500k whether the partner takes out his $50k or leaves it in the business. 

We are trying to determine if the selling partner should walk away with $500k or $550k.

[Critter-3]

First if one partner leaves then the partnership is dissolved and a final return must be filed.  Seek local professional assistance on this complicated situation. Advice from a faceless public forum is not the best choice since we don't know all the facts and could give a completely wrong answer. 

[Anonymous]

what did you agree to and is it in writing? another question what year because there is a final return due the 15the day of the third month after the sale. so if bought/sold in 2019 the return is late and there is a penalty of about $3000 increasing by about $400 per month.  if sold in 2020 before July the 2020 return is probably late.  the answer is what does the buying partner want to pay and get in partnership assets for buying out the other partner and what does the selling partner want to get. there is also a messy part to buying and selling a partnership interest.  as others have said see a pro.