Question: I am one of several members of an LLC taxed as a partnership, and we are selling the business. If we sell our membership interests to the buyer, is our gain a capital gain?
Answer: Mostly, yes, but with important exceptions. Here is how the tax rules work on the sale of limited liability company interests, and why buyers often prefer a different structure.
Selling your membership interest
Like corporate stock, an LLC membership interest is generally a capital asset. So if you held it for more than one year, most of your gain is taxed at long-term capital gain rates.
However, there is a key exception for “hot assets” under Section 751. These include unrealized receivables and inventory. For example, depreciation recapture on business equipment often counts as a hot asset. The part of your gain tied to hot assets is taxed as ordinary income, even though you sold an ownership interest. For more detail, see IRS Publication 541, Partnerships.
Also, higher-income sellers who don’t actively work in the business may owe the 3.8% net investment income tax on their gain.
How the sale of limited liability company assets differs
Instead of buying the interests, the buyer may buy the LLC’s assets. In that case, the LLC allocates the price among its assets. Gain on some assets, such as inventory and depreciation recapture, is ordinary income. Gain on others, such as goodwill held long-term, is capital gain. Then the gain passes through to the members on their K-1s.
For an LLC taxed as a partnership, the tax results of the two structures are often similar. That is because of the hot asset rules above. By contrast, the choice matters much more for a C corporation, where an asset sale can lead to two levels of tax.
Why buyers often prefer an asset purchase
Buyers usually prefer to buy assets rather than ownership interests, for two reasons:
- Liability protection. Buying assets helps the buyer avoid claims tied to the business’s past activities.
- Higher tax basis. The buyer gets a stepped-up basis in the assets. As a result, the buyer can take larger depreciation and amortization deductions.
When a buyer purchases all the interests of a multi-member LLC, the tax law generally treats the buyer as buying the assets anyway. So the buyer still gets a basis step-up in many cases. Similarly, a partnership can make a Section 754 election to adjust asset basis when a new member buys in.
Get help with the sale of limited liability company interests
The price allocation and deal structure can change your tax bill significantly. So get tax advice before you sign a letter of intent. To discuss your sale, call (415) 842-2940 or book a free 15-minute call.