Selling an LLC Interest With a Negative Capital Account

Selling an interest in a Limited Liability Company (LLC) when the member’s capital account has a negative balance can create a taxable gain larger than the cash received. This outcome, known as “phantom income,” arises when a member has received distributions or been allocated losses that exceed their financial contributions. The taxable gain is a real liability to the IRS, even if the seller receives little cash. The issue lies in how a member’s investment is tracked for tax purposes, which goes beyond the capital account balance on the LLC’s books.

Understanding Your Capital Account and Tax Basis

A member’s capital account is an accounting entry on the LLC’s books that tracks their equity. It begins with cash and property contributed, increases with allocations of LLC profits, and decreases with distributions or allocations of LLC losses. A capital account can become negative if a member receives cash distributions funded by LLC debt or is allocated losses that surpass their cumulative contributions. This negative balance means the member has taken more value out of the LLC than they have put in or been allocated.

The capital account is distinct from the “tax basis,” which is the figure used to calculate gain or loss for tax purposes. While the two start with a member’s contribution, the tax basis calculation includes an element the capital account does not: the member’s share of the LLC’s liabilities. A member’s tax basis is increased by their share of LLC debt and decreased as that debt is paid down. This inclusion of debt is why a member can have a negative capital account but still have a positive tax basis.

If an LLC borrows to fund operations or distributions, each member’s tax basis increases by their share of that new liability. This additional basis allows members to receive distributions or deduct allocated losses without an immediate taxable gain, even if it drives their capital account into negative territory. This debt-related basis is not a free pass. It represents a future tax consideration that comes due when the interest is sold.

Calculating the Gain or Loss on the Sale

Calculating the taxable gain from selling an LLC interest requires determining the “amount realized” and the “adjusted tax basis.” The amount realized is the total of all consideration, including cash, the fair market value of any property received, and the seller’s share of LLC liabilities from which they are relieved. This relief of debt is treated as a cash equivalent received by the seller. The seller’s share of liabilities can be found on their final Schedule K-1.

The inclusion of this debt relief is the primary driver of phantom income. A seller might receive a small amount of cash but be relieved of substantial underlying LLC debt, creating a large amount realized for tax purposes. This accounts for prior benefits the seller received from the debt-fueled increase in their tax basis.

The adjusted tax basis at the time of the sale includes the original contributions, adjusted for income, losses, distributions, and the seller’s share of liabilities. The taxable gain or loss is the amount realized minus the adjusted tax basis. For instance, a member sells their interest for $5,000 in cash with a negative ($40,000) capital account and a $70,000 share of LLC liabilities. Their amount realized is $75,000 ($5,000 cash + $70,000 debt relief).

If their adjusted tax basis is $30,000 (negative $40,000 capital account + $70,000 share of liabilities), their taxable gain is $45,000 ($75,000 – $30,000). This gain is nine times the cash they received.

Determining the Character of the Gain

After calculating the total gain, its character must be determined as either capital gain or ordinary income. Generally, an LLC interest is a capital asset, and its sale results in a capital gain or loss. Long-term capital gains are typically taxed at preferential rates, which are lower than the rates for ordinary income for most taxpayers.

An exception exists under Internal Revenue Code Section 751, which addresses “hot assets.” This provision prevents members from converting what would be ordinary income into lower-taxed capital gains. Hot assets are defined as unrealized receivables and inventory items. Unrealized receivables include rights to payment for goods or services not yet included in income, while inventory includes property held for sale to customers.

When an LLC holds hot assets at the time of a sale, a portion of the seller’s gain must be recharacterized as ordinary income and taxed at the seller’s regular marginal income tax rates. The LLC is responsible for providing the selling member with a statement that details this allocation. This statement specifies how much of the total gain is treated as ordinary income and how much remains as capital gain.

Required Information and Tax Reporting

Required Information

To report the sale, a seller must gather several documents. The first is the fully executed purchase and sale agreement, which specifies the cash and any property exchanged. Another is the seller’s final Schedule K-1 (Form 1065) from the LLC, which reports their share of income, losses, deductions, and their share of liabilities at the time of the sale. The seller will also need the specific IRC Section 751 statement provided by the LLC to identify the portion of the gain that must be reported as ordinary income.

Tax Reporting

The final step is reporting the transaction to the IRS, which involves separating the capital and ordinary income components. The capital gain portion is reported on Form 8949, Sales and Other Dispositions of Capital Assets, and the totals are then carried over to Schedule D (Form 1040), Capital Gains and Losses. The ordinary income portion of the gain, as detailed in the Section 751 statement, is reported on Form 4797, Sales of Business Property. The instructions accompanying the final K-1 package from the LLC will generally guide the seller on the specific lines to use.