partnership distribution due to divorce

[neighborhoodwatchdog]

Hi There!

My ex-wife was a minority partner in a business that we ran together (we were the only shareholders).  When we split, the business was valued and she agreed to a buyout.  The shares were sold back to the business and I am the sole owner of the LLC.  She was paid the entire settlement amount in tax year 2021 from the business.. is this transaction deductible to the business, and if so, what type of 1099 would I issue to her for the transaction?  

[Mike9241]

do we have a partnership (files 1065)  or corporation (files 1120S)?

if an S-Corp - not deductible reported on k-1 as a distribution to the shareholder

Since one of the requirements of an S Corporation is that it only have one class of stock, a disproportionate distribution can invalidate the S Corporation election. If a disproportionate distribution has occurred, the corporation must take immediate action to correct the error by equalizing the distributions.

if a partnership - the payout is governed by IRC sec 736 and reg 1.736-1(b)

payment would be a deductible guaranteed payment to the extent of unrealized receivables (only applicable to cash basis partnership because income is ordinary but only taxed when the receivable is collected)

the rest of the payment is a distribution reported as such on k-1 - no tax deduction for the partnership. in addition with only one partner left, the partnership terminates on 12/31/21 requiring a final return

(1) Payments made in liquidation of the entire interest of a retiring partner or deceased partner shall, to the extent made in exchange for such partner's interest in partnership property (except for unrealized receivables and good will as provided in subparagraphs (2) and (3) of this paragraph), be considered as a distribution by the partnership (and not as a distributive share or guaranteed payment under section 736(a)). Generally, the valuation placed by the partners upon a partner's interest in partnership property in an arm's length agreement will be regarded as correct. If such valuation reflects only the partner's net interest in the property (i.e., total assets less liabilities), it must be adjusted so that both the value of the partner's interest in property and the basis for his interest take into account the partner's share of partnership liabilities. Gain or loss with respect to distributions under section 736(b) and this paragraph will be recognized to the distributee to the extent provided in section 731 and, where applicable, section 751.

(2) Payments made to a retiring partner or to the successor in interest of a deceased partner for his interest in unrealized receivables of the partnership in excess of their partnership basis, including any special basis adjustment for them to which such partner is entitled, shall not be considered as made in exchange for such partner's interest in partnership property. Such payments shall be treated as payments under section 736(a) and paragraph (a) of this section. For definition of unrealized receivables, see section 751(c).

[Carl]

Basically, on the date of sale the multi-member LLC was closed permanently and forever. A multi-member LLC "must" have at least 2 owners/members at a minimum. So you'll be filing a "final" 1065 which will include "final" K-1's to both of you.

Then you will open a new single-member LLC which is reported on SCH C as a part of your personal 1040 tax return.

Any and all assets, as well as inventory will be removed from the multi-member LLC as either return of capital distributions to you (in the case of business assets) or as removed for personal use by you (in the case of inventory).

All assets will then be entered into the Business Assets section of the SCH C using an in service date of at least one day after they were removed from the 1065. You'll use a cost basis on these assets that is adjusted to take into account any and all prior depreciation already taken on the asset(s).

If inventory is involved here, your beginning of year inventory on the SCH C "must" be zero. No exceptions here.

[Rick19744]

Some additional comments:

• As you can see from the responses, regardless of the size of the entity, partnership tax law can become complicated very quickly.  Depending on the $$ involved, you may want to consider a one on one with a tax professional.
• While we don't have sufficient facts, and this type of forum is not really conducive to back and forth, your ex-wife most likely is receiving a liquidating distribution under Section 736(b); meaning no deduction at the partnership level (LLC level).
• The one statement that concerns me is where you state "..She was paid the entire settlement amount in tax year 2021 from the business".  Hopefully this means she was paid the value of her LLC interest only and not the entire divorce settlement.
• Depending on the assets held by the LLC, her interest most likely include some hot assets; depreciation recapture, receivables if cash basis accounting, possibly some inventory.  Her portion of these items will need to be reported as ordinary income when she determines her gain or loss on redemption.  You will need to provide this information to her. 
• Finally, related to your part of the transaction, if a distribution is made in complete liquidation of a partner's interest, the basis to the partner of property other than money is the adjusted basis of the partner's interest (meaning your outside tax basis) minus any money distributed in the same transaction.  There is a specific allocation method required under Section 732.  This can become tricky.
• As you can see, it may be best if you consulted with a tax professional.