LLC Partner Buyout Tax Implications

An LLC partner buyout, where a member’s ownership is acquired by either the company or its remaining members, is a common business transaction. The tax consequences of a buyout are complex and differ for the departing member, the remaining members, and the LLC itself. Understanding these implications is important for navigating the process effectively. The structure of the buyout dictates the flow of funds and the resulting tax treatment, so the financial and legal arrangements must be carefully considered to align with the objectives of all parties.

Key Buyout Structures: Redemption vs. Cross-Purchase

The method used to structure an LLC member buyout determines the tax and financial outcomes. The two primary structures are a redemption and a cross-purchase, each with a distinct flow of funds and transfer of ownership.

In a redemption, the LLC itself is the purchaser. The company uses its own funds to buy the ownership interest directly from the departing member, reducing the total number of membership interests. The remaining members’ percentage of ownership in the company increases as a result, but they are not personally part of the purchase.

A cross-purchase agreement involves a direct transaction between the members. In this scenario, the remaining members use their personal funds to purchase the departing member’s interest. The purchasing members’ ownership stakes increase because they have personally acquired more equity. In a redemption, the company’s assets are used for the buyout, which can impact its balance sheet and available capital. In a cross-purchase, the financial burden falls on the individual remaining members, who may need to secure personal financing.

Tax Implications for the Selling Member

The tax consequences for a departing LLC member begin with calculating the total gain or loss, which is the difference between the amount realized from the sale and the member’s tax basis in their LLC interest. The amount realized includes cash and any relief from LLC debt.

A member’s tax basis, or “outside basis,” is their investment in the LLC for tax purposes. It starts with their initial contribution, increases with their share of LLC income and additional contributions, and decreases with distributions and their share of LLC losses.

The character of the gain or loss is a primary concern, as a portion may be taxed as ordinary income due to “hot assets,” as defined by Internal Revenue Code (IRC) Section 751. These assets include unrealized receivables and inventory items. Payments for the selling member’s share of these hot assets are taxed as ordinary income. For example, if a total gain is $100,000, but the member’s share of unrealized receivables is $30,000, that $30,000 is ordinary income, while the remaining $70,000 is a capital gain.

Payments for goodwill can also have specific tax treatment. Under Section 736, payments for goodwill are treated as a capital gain. However, the LLC’s operating agreement can specify that payments for goodwill are treated as guaranteed payments, resulting in ordinary income for the seller and a potential deduction for the LLC.

Tax Implications for the Remaining Members and the LLC

The tax consequences of a buyout extend to the remaining members and the LLC, with effects varying based on the structure. These differences primarily revolve around the tax basis of the members’ interests and the LLC’s assets.

In a redemption, the remaining members’ outside bases in their LLC interests do not change. Although their ownership percentage increases, their individual investment amount for tax purposes remains the same. The LLC may be able to deduct certain payments, such as those designated as guaranteed payments, but the members do not get a direct basis increase.

A cross-purchase provides a direct tax benefit to the purchasing members. When remaining members use personal funds to buy the departing member’s interest, they increase their outside basis by the amount paid. This “step-up” in basis reduces their taxable gain if they later sell their own interests.

It is important to distinguish between a member’s “outside basis” and the LLC’s “inside basis” in its assets. The inside basis of the LLC’s assets does not automatically adjust in a buyout, which can create a mismatch and lead to the remaining members being taxed on gains that were economically realized by the selling partner.

The Section 754 Election and Basis Adjustments

To address the potential mismatch between the inside and outside basis after a buyout, an LLC can make a Section 754 election. This is a formal choice on the partnership’s tax return to adjust the inside basis of its assets when an interest is transferred. The goal is to align the inside basis of the assets with the outside basis of the members’ interests.

The specific basis adjustment depends on the buyout structure. In a cross-purchase, a Section 743 adjustment applies to the purchasing partner, giving them a unique inside basis in their share of the LLC’s assets that reflects their purchase price. This prevents the new partner from paying taxes on built-in gain already accounted for in their purchase price. In a redemption, a Section 734 adjustment may apply if the departing member recognizes a gain, increasing the basis of the LLC’s remaining assets for the benefit of all remaining members collectively.

To make the election, the LLC must attach a statement to its timely filed Form 1065 for the tax year of the buyout. The statement must include the partnership’s name, address, and a declaration that it elects to apply the relevant basis adjustment provisions. Once made, this election is binding for that year and all subsequent years and can only be revoked with IRS consent.

Partnership Termination and Reporting Rules

A buyout can sometimes lead to the termination of the partnership for tax purposes, particularly if it results in only one remaining owner. When a multi-member LLC becomes a single-member LLC, the original partnership is considered terminated. This triggers a deemed liquidation of the partnership, where its assets are treated as being distributed to the sole remaining member, and the business is then taxed as a sole proprietorship or a disregarded entity.

Specific reporting requirements are also triggered by a buyout. If any part of the payment to the departing member was for their share of “hot assets,” the LLC must file Form 8308, Report of a Sale or Exchange of Certain Partnership Interests. This form discloses the transaction details to the IRS and is attached to the LLC’s Form 1065 for the year of the sale. The partnership must provide copies of Form 8308 to both the selling and purchasing members by January 31 of the year following the transaction, with detailed calculations for gains attributable to hot assets, collectibles, and unrecaptured Section 1250 gain.