LLC Liquidation - Capital Gains vs. Regular Income

[TonyCC]

We liquidated our multi-member LLC in 2021, and sold all its assets (vehicles and equipment), most of which having been depreciated to zero, and all of it held over a year.  The combined basis of the Members in the LLC exceeds the total value of the liquidation.

Turbo Tax is reporting the revenue from the liquidation as Ordinary Income (K-1, Line 1), as opposed to a Capital Gain (K-1, Line 9a).  I thought it would have been a long-term capital gain. Under what circumstances should/could a liquidation like this be reported as a Capital Gain, instead of Ordinary Income?

[Mike9241]

we can't see the books and records of the LLC. however, first, the LLC would recognize ordinary income on the sale of its assets up to the amount of depreciation taken or ordinary income recapture if the item was expensed.   there would be an ordinary loss if the asset was sold for less than its tax basis. the LLC would have capital gain to the extent an asset was sold for more than its original tax basis.  both the ordinary income/loss and capital gain add to (in the case of net income) or subtract from (in the case of a net loss)  the members' basis.   they have a capital gain if the distributions exceeded their tax basis otherwise a loss.

in many situations, (no new members after it started and no special allocations of income or loss not in accordance with ownership %).  proper tax reporting by the LLC and members their tax basis would equal the distributions so no gain or loss other than what's on their k-1.

.  

if things have not been equal or a partner/member contributed an asset other than cash, you may be required to do a corrective allocation/minimum gain chargeback  under subsections of IRS reg 1.704-2 

[DaveF1006]

There is a misconception on what capital gains is. Capital gains tax are levied for sales of capital assets owned by individuals. It could be an asset an individual owns and uses in a business or a personal asset such as stocks and bonds, collectibles, homes etc. The key to this is that the assets are individually owned.

In your case, your partnership is a disregarded entity thus the liquidation of your partnership and assets will be treated as an ordinary gain or loss because these aren't individually owned.  They are owned by the partnership.

There are no circumstances that I can think of on how to treat this as a capital gain or loss as defined by IRC 735. Please read the details here.

[TonyCC]

Hi Mike - 

Thanks for your help!  Reviewing our records, most of our assets sold for less than their accumulated depreciation - so if I'm interpreting your comment correctly, that income would be reported as ordinary income.  We did have a couple of assets sell for more than their accumulated depreciation.  In those cases, shouldn't TurboTax be treating the difference as a capital gain?

Thanks again for your help.

[TonyCC]

Hi Dave - 

Thanks for your help!   Just curious - under what circumstances would K-1 Line 9a be used (Net Long Term Capital Gain)?  If I'm interpreting your comments correctly, I'm not sure why Lines 8 and 9a are even on a K-1.

Thanks again - 

Tony

[Mike9241]

if a fully depreciated asset is sold for less than its original cost then the gain is ordinary (depreciation recapture)

if a fully depreciated asset is sold for more than its original cost then the gain is ordinary to the extent of the depreciation is ordinary income. only the excess would be capital gainunder some circumstances 

non-fully deprecited asset

cost $5,000

depreciation is taken $3,000

1) sold for $1000 - you have a $1,000 ordinary loss

2) sold for $2,000 - no gain or loss or depreciation recapture since the proceeds are equal to its tax basis

3) sold for $3000 - you have a $1,000 ordinary income due to depreciation recapture, sold for $4,000 - $2,000 ordinary income, sold for $5,000 - $3,000 ordinary income

4) held more than 1 year.   here's where it gets tricky. sold for $6,000 - $3000 of ordinary income. the $1000 sales price over cost can be capital gain if there is no prior year unrecaptured 1231 loss (depreciable property was sold at loss)  or ordinary income to the extent of prior year unrecaptured 1231 loss

5) held 1 year all less, the entire gain is ordinary income.

all the sales should be transferred to form 4797

and from there to the k-1's

https://www.irs.gov/pub/irs-pdf/f4797.pdf  blank form

https://www.irs.gov/pub/irs-pdf/i4797.pdf instructions

[Rick19744]

A few additional comments:

• Keep in mind, that the 1065 and K-1 reporting are tied to the entity activity.  Partnerships and LLC's taxed as a partnership can certainly have ST and LT gains and losses.  Those would be reported on lines 8 and 9a.  
• The members basis at this point has no bearing on what you are reporting at the 1065 level.  Once again, this is entity level reporting.
• Once each LLC member receives their K-1, this information will be reported on their respective 1040.
• Finally, each member will need to adjust their tax basis for the final K-1 activity.  At that point, each member will then determine whether they have a capital gain or loss on the liquidation.