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Liquidation of an LLC member interest.

The dramatic increase in the past few years of limited liability companies (LLCs) treated as partnerships as the entity of choice has lead to an increase in liquidations of member interests.

At first glance, the rules for a complete liquidation The collection of assets belonging to a debtor to be applied to the discharge of his or her outstanding debts.

A type of proceeding pursuant to federal Bankruptcy
 of a partner's interest appear simple. For example, because a membership interest is a capital asset of the member, a sale of the capital asset would be expected to result in a gain or loss equal to the difference between the sales proceeds and the basis. However, this simple model frequently is not correct. In fact, no gain is recognized in a distribution of property and cash to a partner, even in a liquidation of interest, unless the cash distributed exceeds the partnership basis. Loss is never recognized by a partner in liquidation unless the property distributed consists entirely of cash, unrealized receivables, inventory or a combination of the three. Property received by the liquidated DAMAGES, LIQUIDATED, contracts. When the parties to a contract stipulate for the payment of a certain sum, as a satisfaction fixed and agreed upon by them, for the not doing of certain things particularly mentioned in the agreement, the sum so fixed upon is called liquidated damages. (q.v.  member has a basis equal to the basis in the partnership interest, reduced by cash received in the liquidation.

The holding period for the distributed property will generally begin when the partnership interest was acquired. If the membership interest was originally received in exchange for a contribution of property, the holding period would have begun when the property was acquired by the contributor rather than when the partnership interest was received. A contribution of inventory would be an exception to this holding-period tacking The process whereby an individual who is in Adverse Possession of real property adds his or her period of possession to that of a prior adverse possessor.

In order for title to property to vest in an adverse possessor, occupancy must be continuous, regular, and
. Multiple contributions of cash or other property to the partnership will result in multiple holding periods for the distributed assets. Generally, distributions do not trigger gain or loss to the partnership, regardless of whether the distribution is cash, property or a combination of both.

Complicating com·pli·cate  
tr. & intr.v. com·pli·cat·ed, com·pli·cat·ing, com·pli·cates
1. To make or become complex or perplexing.

2. To twist or become twisted together.


Further investigation of Subchapter K dissolves the facade facade (fəsäd`), exterior face or wall of a building. The term implies ordered placement of its openings and other features and thus seems inapplicable to a wall without design.  of simplicity, as numerous parts of Subchapter K can come into play on a liquidation of a partner's interest. Sec. 751 requires recognition of gain from "hot assets" as ordinary income. Sec. 704(c) gain on contributed property may need to be recognized under Sec. 737. If the liquidated partner makes a contribution prior to the liquidation and receives property in liquidation, Sec. 707 may recast re·cast  
tr.v. re·cast, re·cast·ing, re·casts
1. To mold again: recast a bell.

 the liquidation as a disguised sale. A Sec. 754 election to allow for a basis adjustment of partnership assets under Sec. 734 may be necessary. The new rules under Sec. 734 may require a mandatory "step-down" even if a Sec. 754 election is not in place. If the liquidating payments are determined with regard to LLC (Logical Link Control) See "LANs" under data link protocol.

LLC - Logical Link Control
 income, Sec. 736(a) (1) would preclude pre·clude  
tr.v. pre·clud·ed, pre·clud·ing, pre·cludes
1. To make impossible, as by action taken in advance; prevent. See Synonyms at prevent.

 classification of this as the sale of a capital asset. If payments are made for past services or use of capital, Sec. 736(a)(2) would result in guaranteed payment treatment for the distribution.

Under Sec. 751(b), "hot assets" include unrealized receivables, substantially appreciated inventory and depreciation recapture depreciation recapture

See recapture of depreciation.
. In keeping with the complexity of Subchapter K, what constitutes an unrealized receivable is not intuitive, and the definition extends its reach to items not normally thought of as "unrealized receivables "Whenever a partner's share of these asset categories is disproportionately dis·pro·por·tion·ate  
Out of proportion, as in size, shape, or amount.

 reduced, the withdrawing member must recognize this reduction as ordinary income. Although theoretically logical, the calculation and allocation of this income can be challenging, especially when there are other factors (such as loans, special allocations and multiple member withdrawals) to consider.

The disproportionate dis·pro·por·tion·ate  
Out of proportion, as in size, shape, or amount.

 reduction in gross Sec. 751 assets is ordinary income. This would include gross cash-basis trade receivables, not netted with the related cash-basis accounts payable. Sec. 751 includes the receivables in the definition of assets covered by the section, but the definition does not include cash-basis accounts payable. The income is treated as ordinary to the liquidated partner, but the related accrued expense Accrued Expense

An accounting expense recognized in the books before it is paid for. It is a liability, usually current. These expenses are typically periodic and documented upon a company's balance sheet due to the high probability of collection.
 is not. This can produce surprising results.

Example: LLC, T, has $100 of cash-basis accounts receivable accounts receivable n. the amounts of money due or owed to a business or professional by customers or clients. Generally, accounts receivable refers to the total amount due and is considered in calculating the value of a business or the business' problems in paying  (AR.), $90 of cash-basis accounts payable and net equity of $10. It liquidates a 20% partner's interest for $15. The member's share of AR was $20, and it is reduced to zero. Thus, there is up to $20 of Sec. 751 gain to recognize as ordinary income. As a result, the entire $15 of cash distributed, less basis, will be ordinary income. This will be reported on the Schedule K-1 of the liquidated partner as ordinary income.

Under Sec. 737, distributions made within seven years to a member that contributed property with Sec. 704(c) built-in gain (BIG) triggers a special allocation of the BIG. The definition of distributions under Sec. 737 does not differentiate between liquidating and nonliquidating distributions. Thus, Sec. 737 can be triggered in a liquidating distribution. The contributing partner must recognize gain equal to the lesser of the remaining unrecognized Sec. 704(c) gain or the excess of the current fair market value (FMV FMV - full-motion video ) of the distributed property over the adjusted basis of the member's interest.

Thus, Sec. 704(c) requires BIG on contributed property to be specially allocated to the member that contributed it. If the contributing partner is no longer a member at the time the underlying property is sold, this cannot be accomplished. However, Sec. 737 operates to ensure that the contributing partner recognizes the gain on property that the partner has effectively converted to another form, either through cash distributions from the LLC or through receiving other property. Gain recognized is limited to the difference between the FMV of the property received over the LLC basis at the time of distribution. The potential for a special allocation of the Sec. 704(c) gain is then gone when the contributing partner leaves.

The partner who contributed the property has then paid tax on the pre-contribution gain from the original property. Sec. 737(c)(2) provides the partnership with a step-up in basis Step-Up In Basis

The readjustment of the value of an appreciated asset for tax purposes upon inheritance. With a step-up in basis, the value of the asset is determined to be the higher market value of the asset at the time of inheritance, not the value at which the original party
 equal to the gain recognized by the departing partner.


The above discussion of the Subchapter K provisions that can apply to a liquidation of a partner is only a simple overview of a complex subject. The effect of each provision would require a lengthy analysis. This discussion is meant only to alert tax advisers that the tax consequences from the liquidation of a partner's interest are not as easy as they may appear.

LLCs offer many advantages in flexibility over other entity choices, often at a price of additional complexity. The liquidation of a member interest is an area in which this is evident.

FROM CAROL WRIGHT, CPA (Computer Press Association, Landing, NJ) An earlier membership organization founded in 1983 that promoted excellence in computer journalism. Its annual awards honored outstanding examples in print, broadcast and electronic media. The CPA disbanded in 2000. , DETROIT MI
COPYRIGHT 2006 American Institute of CPA's
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 2006, Gale Group. All rights reserved. Gale Group is a Thomson Corporation Company.
Larry Mosher (Member): Liquidation of an LLC member interest 6/17/2009 1:17 PM
An excellently written article on a very complex subject. Thanks much!

 Reader Opinion




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Title Annotation:limited liability companies
Author:Wright, Carol
Publication:The Tax Adviser
Date:May 1, 2006
Previous Article:Treasury and IRS guidance sheds light on Sec. 199 deduction.
Next Article:Corporate estimated tax requirements.

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