Sold all my LLC interest to other partner, how to calculate partnership basis in TT base on K-1?

[Kwn999]

Started a LLC business with another partner in 2013 as a sleeping partner. Invested $45k. Sold partnership interest to the other partner in 2016 for $80k. No distributions or any contribution during these years.  3 years K-1 section shows like this...

  $65k    2013 Capital contributed

  -$5k  - 2013 loss

 - $10k  - 2014 loss

  +11k  -  2015 Gain

  +15k  -  2016 Gain

  -76k  -  2016 Distribution

    0.00 - 2016 Ending Capital

Base on the above calculation, is my partnership basis at $76k and ordinary gain at $11k?  I assume the zero ending capital is not my basis? Please advise.

I don't know how the CPA came up with $65k contributed capital and Distribution at $66k when I sold it for $80k. Does it matter with the actual differences?  I can't possibly use my numbers now since those were reported back 3 years ago. I never pay attention to all these numbers until I try to figure out my partnership basis. 

[Carl]

If you're just entering a K_1 on your personal tax return, you don't calculate squat. You enter the K-1 exactly as printed. The CPA should have done all the figuring for you when they completed the 1065 partnership return and issued you the K-1.

[TomYoung]

First thing to do is to contact that CPA and figure out why a $45K initial contribution magically changed into a $65K contribution.  What are we missing here?  That's a huge difference that needs to be understood.

The Schedule K-1 doesn't report your gain or loss on sale, it simply reports, among other things, the changes in your partnership capital account and the $76K vs. the $80K is simply zeroing out your capital account on the partnership's books.

[Rick19744]

Additional questions:

1) Your K-1 section L.  What box is checked?
2) When you invested the $45,000, was this all cash or did you contributed property where FMV was not equal to your adjusted basis?
3) Since you indicate you were a silent member, I assume you still have approximately $4,000 in suspended passive activity losses going into 2016?
4) Anything reported on line 19 of your K-1?

[Rick19744]

Second set of questions after reading your question again:

5) Did the LLC have any depreciation?
6) What was the method of accounting of the LLC?

These responses to these two additional questions could impact the character of your gain; will not change the overall gain (if you have a gain based on the responses to all the previous questions), just the character - capital / ordinary.

[Kwn999]

To answer Rick19744...
1)  Section L,  tax basis checked
2)  $45k all cash
3)  I don't understand what is suspended passive losses.  K-1 didn't show any $4000 at all.
4)  Yes. Distribution of $76k is listed in box 19 with an A.
5)  Yes. The 1065 line 16 shows depreciation of $7624
6)  Accounting method Cash

At this point, I am not going to try to trace back 3 yrs ago. I blamed my own negligence for not realizing the error.  I just want to complete it.

2016 section L, ending capital showed zero because of the $76k distribution.  I assumed the remaining partner paid me therefore list it as distribution from the business.

[Rick19744 · Accepted solution]

Thanks for the response.  I will provide some commentary and direction:

1. Partnership tax is complicated and you should consult with a tax professional to make sure you arrive at the correct gain and tax impact.
2. There are several items that you need to clear up with the preparer of the partnership return and your K-1:
1. The difference between what you indicate is contributed capital and what was on your initial K-1.  That $20,000 is significant and impacts the determination of your gain.
2. The difference between what you indicate you received for your interest and the amount reflected on the K-1 line 19 code A.  This $4,000 is significant and impacts the determination of your gain.  This $76,000 should not have been reflected on the K-1 unless it was a true distribution; the payment for your interest is not a distribution.
3. Once you clear up the issues in item 2, you need to prepare your basis.  While you indicate that your K-1 section L indicates that the information is on a tax basis, I don't have a real comfortable feeling about that.  You have everything you need to determine your tax basis based on what I see in your facts (assuming you get clarification on the discrepancies noted above and in your facts).  Your basis is a critical component in determining your overall gain and is what is needed to complete your Schedule D and applicable form 8949.
4. Your responses to my question on depreciation and method of accounting lead to additional complexity:
1. These two items are part of what is known as "hot assets" (Section 751 property).  In general, a sale of a partnership interest is considered a capital asset.  However, Section 751 provides an important exception; the seller realizes ordinary income for your share of the hot assets.
2. The preparer of the LLC return should provide some direction in determining your share of the hot assets.
3. Once you understand your share and know your overall gain, you will need to recharacterize some of what would normally be capital gain as ordinary income.  
4. By way of example, let's say your overall gain is $25,000 and your share of hot assets is $10,000.  This would mean that you have ordinary gain of $10,000 (reported on form 4797) and capital gain of $15,000 (reported on Schedule D and applicable form 8949).
5. Another example, let's say your overall gain is $15,000 and your share of hot assets is $25,000.  This would mean you have ordinary gain of $25,000 and a capital loss of $10,000 (same overall gain of $15,000).  These rules are confusing and a trap for the unwary.

As you can see, this is a complicated area.  Determining your overall gain is critical and there are several items that you need to understand before this can be determined.  I recommend you get some professional help as I am sure you want to report this correctly AND should you win the audit lottery will need to be able to support your computation.

[Ripken818]

Have a related question, trying to find where best to post....

Topic: LLC Capital Account – Impact on FMV of interest, Tax Basis in Year of Sale of Interest

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).

[Anonymous]

before the sale you should have contacted a tax advisor.  things may be complicated for both the buyer and seller.  the seller would be allocated income through the date of sale and that would include any income/loss from that pass-thru entity.  if the starting tax basis was $50K it would go up by the allocated income and down by any distributions before the date of sale.  but wait there could be .   

IRC Section 751 Treatment of Hot Assets (the partnership would need to report this on the sellers k-1)

The linchpin of taxing transfers of partnership interests is IRC Section 751. Under IRC Section 741, when a partner sells his interest, he is entitled to capital gain treatment, except as provided in IRC Section 751. Under IRC Section 731, when a partner receives a partnership distribution in liquidation of his interest, he is entitled to capital gain treatment, except as provided in IRC Section 751. Regarding sales of partnership interests to third parties, IRC Section 751 is pretty straightforward. But regarding sales of partnership interests back to the partnership, IRC Section 751 can get a little intricate.

Sale of Partnership Interest

When a partner sells his partnership interest to anyone other than the partnership, the partner is entitled to capital gain or loss treatment, except with respect to so-called "hot assets." "Hot assets" are "unrealized receivables" and "inventory items" as defined under IRC Section 751. These are basically ordinary income producing assets, such as accounts receivable not already recognized as income, LIFO reserves, appreciated inventory, and depreciation recapture. Thus, unlike the seller of corporate stock, a selling partner's tax

treatment depends upon the underlying partnership assets.

the buyer also faces tax issues as to where to properly allocated the purchase price above the tax basis of  what he's buying.

[Ripken818]

@Anonymous  Thank you so much! Makes sense on the tax treatment, will need to continue to think through the details. 

Quick follow up: 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.