Contents
- Sale of an LLC interest: why it’s “two sales at once”
- Hot assets: the ordinary income landmines
- Installment sales: liquidity traps and forced recapture
- Redemptions & liquidations: nonrecognition… until it isn’t
- Mixing bowl rules: the 7-year swap police
- NIIT: the deemed asset sale exception for active owners
- Compliance & state issues: Form 8308, 1446(f), California sourcing
1) Sale of a membership interest: the 741 baseline vs 751 override
The default rule (Section 741) treats a partnership interest like a single capital asset—so gain is capital. But Section 751 overrides that simplicity with a look-through approach designed to prevent converting ordinary income into capital gain. The result is a bifurcated outcome: part ordinary, part capital. :contentReference[oaicite:2]{index=2}
Amount realized includes “phantom cash”
Debt relief counts: when the buyer assumes the seller’s share of LLC liabilities, it increases amount realized, sometimes creating taxable gain beyond the actual cash proceeds. :contentReference[oaicite:3]{index=3}
You can have ordinary income inside an overall loss
The 751 hot-asset slice can be positive even if the deal is “down” overall—creating ordinary income now and a capital loss that may be limited for individuals. :contentReference[oaicite:4]{index=4}
2) Hot assets: where “ordinary” hides
Hot assets are primarily (i) unrealized receivables and (ii) inventory items. In practice, for many operating LLCs, the biggest “receivable” is depreciation recapture embedded in equipment and certain property—pulled into ordinary income via the 751 look-through. :contentReference[oaicite:5]{index=5}
Common hot-asset categories in real deals
- • Cash-basis A/R (law/medical/pro services)
- • Inventory (even small appreciation can matter on sale of interest)
- • Section 1245 depreciation recapture on equipment
- • Real estate: unrecaptured 1250 gain (a special 25% bucket, separate from “ordinary,” but still a rate surprise)
These mechanics drive the ordinary/capital split and the final effective tax rate. :contentReference[oaicite:6]{index=6}
3) Installment sales: the recapture trap and “payment” surprises
Installment reporting can defer gain when you take a note—but it does not defer everything. Two big hazards: (1) inventory/hot-asset portions may be immediately taxable, and (2) depreciation recapture is forced into year one under Section 453(i), potentially creating a cash-flow crisis. :contentReference[oaicite:7]{index=7}
453(i): pay tax before you get paid
If the LLC is equipment-heavy, the seller’s share of 1245/1250 recapture can be due immediately—even if the down payment is tiny. :contentReference[oaicite:8]{index=8}
Debt relief can accelerate gain
In leveraged deals, liabilities assumed by the buyer can count toward year-of-sale “payments,” especially when debt exceeds outside basis. :contentReference[oaicite:9]{index=9}
4) Redemptions & liquidations: 731/732/736 mechanics
Distributions are often nonrecognition events, but liquidation is ruled by ordering and classification rules that can change outcomes dramatically: cash-over-basis gain, limited loss recognition, and strict basis allocation tiers for property received. Retiring-partner buyouts add another layer via Section 736. :contentReference[oaicite:10]{index=10}
Three concepts to remember
- • Gain generally only when money (including debt relief) exceeds outside basis
- • Loss on liquidation is narrowly allowed (and only in specific “all hot assets + money” scenarios)
- • Basis allocation follows tiers: cash → hot assets → everything else
These rules govern whether basis “steps up” into distributed assets or gets trapped. :contentReference[oaicite:11]{index=11}
5) Mixing bowl rules: the 7-year lookback that ruins “asset splits”
If partners contributed appreciated property and the LLC later distributes property in a way that looks like a swap, Sections 704(c)(1)(B) and 737 can trigger recognition—often within a seven-year window. This matters in divorce-like “divide the assets” exits and partner breakups. :contentReference[oaicite:12]{index=12}
6) NIIT (3.8%): active owners may exclude some gain—if you do the work
NIIT often applies to gain from selling a partnership interest. But if the seller materially participates, regulations can require a deemed asset sale allocation that can exclude gain attributable to active trade-or-business assets—while still taxing the investment-asset slice. Documentation and proper allocation matter. :contentReference[oaicite:13]{index=13}
7) Compliance & state reality: Form 8308, 1446(f), and California sourcing
Exit tax planning is now also a reporting and withholding problem. Revised Form 8308 pushes more 751 calculation burden onto the partnership. Foreign sellers can trigger buyer-side withholding under 1446(f), with secondary liability shifting to the partnership if mishandled. And states may “look through” too—California’s approach can source the hot-asset portion to California even when the seller is a nonresident. :contentReference[oaicite:14]{index=14}
Form 8308 got harder
Partnerships may need to compute and report the seller’s 751 ordinary gain—often requiring FMV estimates at transfer time. :contentReference[oaicite:15]{index=15}
1446(f): foreign partner withholding
Buyers may have to withhold a percentage of amount realized; if they don’t, the partnership can become responsible via future distribution withholding. :contentReference[oaicite:16]{index=16}
Bottom line
The cleanest exit model starts with a hypothetical asset sale: quantify 751 ordinary income, recapture timing under 453(i), debt relief effects on amount realized, and then layer on NIIT and state sourcing. Do that early—before deal terms are locked. :contentReference[oaicite:17]{index=17}