Question: I am one of several members in a limited liability company treated as a partnership for tax purposes which is being sold. If we sell our membership interests to the buyer, can the gain be reported as capital gain?
Answer: Business owners who conduct their businesses through separate legal entities must carefully consider the tax consequences upon sale. Shareholders operating a business in the corporate form typically prefer to sell shares of stock of the corporation rather than having the corporation sell its assets. Gain from the sale of corporate stock will be treated as capital gain which will be taxable at capital gains rates if the shares were held for a period of more than one year prior to sale. When a corporation sells its assets as opposed to the shareholders selling their stock, the consideration received from the sale is allocated to the corporation’s assets where some of the resulting gain will likely be taxable at ordinary income tax rates. In a corporate asset sale, an additional tax may be incurred when the sale proceeds are distributed by the corporation to its shareholders.
The tax consequences upon the sale of a limited liability company which is treated as a partnership are similar in some respects. Like shares of stock of a corporation, a membership interest is a capital asset and, generally speaking, gain upon the sale of a membership interest will be taxable at capital gains tax rates if the interest was held for a period of more than one year prior to sale. As with a corporation, when a limited liability company sells its assets, the consideration received is allocated to each asset and some of the gain may result in ordinary income rather than capital gain. In both the sale of a corporate business and a limited liability company treated as a partnership, buyers typically prefer to purchase assets rather than ownership interests of the entity itself. Aside from the non-tax benefit of avoiding potential claims against the business for pre-acquisition activities, purchasers acquiring the entity’s assets will usually obtain a higher tax basis in the acquired assets which translates to larger depreciation and other deductions that can lower taxable income.
There are, however, special look-thru rules that apply upon the sale of membership interests in limited liability companies treated as partnerships. Even when an interest in the entity is sold, any gain allocable to the entity’s unrealized receivables and inventory items will be taxable as ordinary income. That is, some portion of the purchase price must be allocated to unrealized receivables and inventory, so-called “751 Assets”. Unrealized receivables include accounts receivable on the company’s books which have not been reported as income. Such receivables arise in connection with a business reporting its income when cash is received as outstanding accounts receivable have not previously been includable in taxable income. Unrealized receivables are also defined to include certain depreciation and similar deductions previously taken which are recaptured as ordinary income on sale. Inventory items generally consist of items held for sale in the ordinary course of business. Any gain allocable to 751 Assets will be treated as ordinary income with the balance of any gain reportable as capital gain.
As an initial step in the sale process, you should determine the magnitude of the gain you will report on the sale. If your business reports taxable income when cash is collected and has accounts receivable or if the business has depreciable assets and/or inventory items, you can assume that any gain attributable to these assets will be treated as ordinary income, whether the sale is one of interests in the entity or of the entity’s assets. Furthermore, if substantially all of the entity’s assets consist of 751 Assets, then most of the gain from the sale will be reportable as ordinary income, regardless of the transaction structure.
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