Buyout results in negative ending partner capital

[shimon]

I bought out my partner shares in a LLC partnership. I paid him $90,000, while his ending capital was only $60,000.

This results in a negative ending capital of $30,000 on K1 line L.

How do I zero his ending capital account?

Where would my partner enter his profit of $30,000?

Thanks

[Rick19744 · Accepted solution]

Your partner determines his gain completely separate from the LLC.

From your facts, it appears that you are going from a two member LLC to a single member LLC.  If this is correct, take a look at IRS Revenue Ruling 99-6.  You are situation 1 if my assumption is correct.

https://www.irs.gov/pub/irs-drop/rr-99-6.pdf

What's happened here is that you paid more for his LLC units than what his inside basis (capital account) is.  Essentially you paid some goodwill.

Let me know whether my assumption is correct.  I will then provide some additional guidance.

[shimon]

No, this LLC is going from 3 partners to 2 partners. I don't know how to zero his capital account in order to avoid next year problems.
Thanks

[Rick19744]

One follow-up question.  Did you purchase the other member's interest or was the member redeemed by the LLC?

[shimon]

I purchased my partner from my personal account. however, I added $90,000 to my capital account and subtracted $90,000 from his capital account. This was suggested by TurboTax tax advisor.

[Rick19744]

Did you actually contribute $90,000 to the LLC?
This is becoming messy and I believe you were misinformed as to what to do.  I will expand once you answer my question.

[shimon]

I paid him directly not the LLC.

[Rick19744]

Ok.  We are ready to go.  Partnership tax is complicated and this type of a forum is not really the best to handle this type of issue, but I will provide some general advice and comments.  You have a fair amount invested and it may be in your best interest to meet with a tax profession so you can have a one on one discussion here.

• The first thing you need to do is reverse the $90,000 adjustment you noted in one of your responses.  This is completely incorrect.  
• As a member in an LLC, you need to be maintaining a basis schedule of your investment.  Attached is some commentary from the IRS on how to maintain your basis schedule https://www.irs.gov/instructions/i1065sk1/ch01.html
• The $90,000 you paid your partner will be added to your basis schedule; this is your outside basis (tax basis).
• Since it appears that you may have paid your partner some goodwill, you will need to determine if the LLC should make what is known as a Section 754 election (step-up).  This can be complicated and beyond the scope of this forum, but it essentially is a worksheet that compares the tax basis of what you purchased  to the FMV (your purchase price).  The difference will become your step-up. Why this is difficult is because you technically bought an additional interest in each item of the LLC.  You can group it, but it will still take some work.
• The reason this is important is that if you did pay more for the interest, by making the Section 754 election at the LLC level, the LLC will be able to specifically allocate additional depreciation or amortization (goodwill) to you as a result of this "step-up".
• The LLC should put this step-up on the asset detail, depreciate or amortize it and as noted previously specifically allocate this to you each year.  This will be separately stated on your K-1 line 13W noted as "Section 754" deduction.
• If a Section 754 election is made at the LLC level, you will then need to attach a Section 743 statement to your personal tax return.  This schedule will detail to the IRS how the step-up was determined.
• The capital accounts on your books and records of the LLC are "inside basis" figures.  To eliminate the other member's capital you will just reallocate his capital account to the remaining member's in proportion to their new ownership.  
• Your former partner, who should have also been maintaining a basis schedule. will update his basis schedule for the final K-1.  He will then compare the amount you paid him to the basis schedule and determine his gain.
• This will also add some complexity.  Since he technically sold his share of all partnership items, some of the gain could be recharacterized as ordinary.  This would be the result of his share of what is called "hot assets".  One such item is his share of depreciation recapture.  The LLC will need to provide some assistance to him in this area.

[shimon]

WOW this is unbelievable. I don’t think that Section 754 applies here, since the difference between the 90K and the 60K is mostly due to accumulated depreciation over the last 15 years. I only paid $3,000 over the original purchase price of 15 years ago.
Assuming that I don’t need to file a step up Section 754, how can I resolve the following, using TurboTax:
1) How do I increase my capital account by $90,000
2) How do I zero my partner negative ending capital of $30,000

[Rick19744]

Your comment is exactly what a Section 754 is all about.  It is you paying more than the tax basis of the assets you are buying.  This provides you the ability to take depreciation on the value of the excess that you paid.  While I don't have all your details, but based on what you just stated, you do have a Section 754.

1) You do not adjust your capital account by your purchase price.  The capital account on your books and records has nothing to do with your purchase of the additional LLC units from another member.  This additional purchase price increases your "outside basis" as noted previously.
2) As indicated in my previous comment, you must reverse the $90,000 entry you were told to make.  That is completely wrong.  This will then leave that member with a $60,000 capital account.  You will then make an entry of $60,000 (decrease) to zero out the capital account and you would do this by running it through Schedule K-1 Section L on the other increase / decrease line.  You will then make a balancing entry for this same amount on the same line on your K-1; increase of $60,000.
3) As you can now see there is a $30,000 difference between what you paid for the interest.  This is EXACTLY why there is the ability to make a Section 754 election.
4) Finally, what was paid 15 years ago versus what you paid today has no bearing on anything in this transaction.
5) As stated previously, partnership tax can be complicated.

[shimon]

Thank you for your help. I am at lost, I contacted an accountant with the information you gave me. He is asking for a fee of $7,000 to do the section 754 + $1500 tax return. He said it may take a year for the IRS to respond. All this for a company that net about 20K a year. Something wrong here. I am not going to pay $8.5K, I must figure it myself.
Again thank you for your help.

[Rick19744]

That is outrageous.  That means he could spend 40 hours on this earning $175 / hr.  That is a pretty good gig.  That just means he does not want to do this work.  Someone that understand this area, albeit complex, could do this in a day at most (although I have not seen your balance sheet).

I would check around.  Make sure you ask if they have done this type of analysis before when you discuss it.  For some it may be beyond what they are used to handling.   You would have to provide most of the information related to the FMV of assets; some would be pretty straight forward.  This is getting to be a busy time of the year and also a new due date for partnership returns makes it different than prior years.  You may need to extend your tax return, but the Section 754 will only reduce your tax liability.

You don't technically need to make this election.  It is just in your best interest to do so based on what I see with the limited facts.  By not making the election you don't get the benefit until you sell your interest at some point in time.  It is really just a time value proposition.

[shimon]

Thank you Rick.
You said I technically don’t need to make the election now. I am willing to wait until I sell my company.
In this case how should I proceed this year? How could I zero my partner capital account and provide him with accurate K1 report. This just in case that I cannot locate reasonable accountant, I would like to have this option.

[Rick19744]

You need to do what I explained previously.  You need to reverse the $90,000 entry you made as discussed in your facts.  That should leave $60,000 in the capital account of the old member.  You then need to make an entry to eliminate that $60,000.  You will reduce the old member capital account by the $60,000 and do this on the other increase of decrease line of Schedule K-1 Line L.  You will then add this to your capital account on the same line.  This should net to zero and no impact.  Just a reclassification due to the buyout of the member.

[shimon]

Thanks that will work. However his K1 will not show his profit of 30K. But I understand that he can file his tax return showing the 30K profit regardless of the K1