LLC redemption

First time dealing with Partnership redemption as follows:

3 member LLC - one partner - call him J - leaving via a redemption of his interest for $400k, with $100k down, $300k note payable over 3 years. Income has been allocated up to the date of redemption (05/31).
Partnership has no receivables and inventory of $75k but the FMV of it does not exceed it's tax basis by 120%. Tax basis in the inventory is $65k. Partnership does have some LHI on the books as well.

Questions:

For the $300k note, should it be DR remaining partners Capital and CR Note payable? The down payment was posted to J capital account.
Do we need to do a step up since no hot assets? If so, when does step happen? This year or when totally paid out?
If after allocating the income up to the date of redemption, the leaving partner (J) still has a capital account balance, what happens to it? Allocated to remaining partners to zero out?

Can elect step-up create goodwill and start amortizing?????

“For the $300k note, should it be DR remaining partners Capital and CR Note payable?”

No. You will hit J’s capital account.

After this and after current year allocations, what is the balance in J’s capital account?

If I post the $300k note payable to J's capital account, after current year income allocations I am left with a negative of $255k, since I have now posted the $100k down payment and $300k note to his capital account.

Are we dealing with Sec 736(a) or 736(b)…or both? I’m assuming 736(b).

As to the LHI…was any bonus depreciation claimed on those? I bring this up because that is a method other than straight-line, possibly invoking Sec 751.

Does the installment note involve an interest charge or no? I’m guessing no and that’s okay – it’s not required in a partnership redemption.

A few FYI’s:

1. The Sec 754 adjustments take place as gain is recognized by the departing partner. See RR 93-13.

2. The default is that the departing partner doesn’t recognize gain until his basis is entirely exhausted.

3. You can book this whole thing up at once, although doing so has no tax effect. The Liability isn’t a real one for 752 purposes. The departing partner should get a K1 until the final payment is made (even though they won’t include any income/loss allocations), so you may as well just leave his capital account as is and simply record the payments to him, as distributions, as they are made. This will also help with matching his capital account, as it goes negative, to the 734 adjustments described in #1 above, assuming those will be made.

4. Sec 751(a) wouldn’t apply…and it sounds like Sec 751(b) doesn’t either…at least at present.

5. Unrecaptured Sec 1250 isn’t an issue, since we’re dealing with a redemption.

Thanks for the reply.

1. It is a 736b transaction.
2. LHI - yes some of it has bonus depreciation.
3. Note is at 5% interest for 3 years.
4. Under the scenario of not booking the entire transaction at once, are you saying I would not record the Note Payable on the books, but rather just record the note payments to the departing partners capital account? Sure would make life easier this way it seems!
5. Departing partner equity at time of redemption is $144,572. Payments made in 2019 were $143,821, so we have not exhausted his capital account yet, therefore it seems I would NOT do a section 754 election until 2020.

Thanks again.

are you saying I would not record the Note Payable on the books, but rather just record the note payments to the departing partners capital account?

Exactly, at least the principal on the note. As mentioned, the default is no gain recognition (except for any mandatorily recognizable gain under 751) until basis is exhausted. As gain is recognized, the Sec 734 adjustment comes into play. That’s just the default. If he elects to apportion his basis, then the timing of the gain changes, and so does the timing of the 734 adjustment.

Payments made in 2019 were $143,821, so we have not exhausted his capital account yet, therefore it seems I would NOT do a section 754 election until 2020.

Right, assuming the $143,821 is principal and assuming an election is not made to apportion basis.

2. LHI - yes some of it has bonus depreciation.

Well, whatever’s in excess of S/L is potential, regular Sec 1250 recapture. It’s “potential” because you’d actually need to have a gain on a hypothetical sale of the asset for FMV. Who determines that FMV, by the way?

Thanks again. This is a new client we picked up about one month ago. Upon further review:

Partnership did have A/R at the time of redemption (May). Do I need to file a 8308 for this, even though payments made to to the departing partner have not exhausted his capital account yet? Or is this done in 2020 when he starts to recognize gain in excess of capital? Since A/R is hot asset does that portion get recognized now?

Do I need to file a 8308 for this, even though payments made to to the departing partner have not exhausted his capital account yet?

You don’t do an 8308 [751a transcation] for a redemption [which is a 751b transaction].

You have a disproportionate distribution.

So it seems pretty straight forward for 2019 on the partnership side- departing partner capital account not fully exhausted, but he does have some ordinary income recognition on his portion of the A/R correct? I would think his K-1 would need to note that?

For 2020, when capital account goes negative, the 754 election is made for the amount of gain over the tax basis capital account for 2020? That then becomes a tax depreciation item on the 1065 as 754 depreciation to the two remaining partners? I assume I eventually zero out his capital account once all payments have been made - to what?
Inventory is not 120% appreciated and the LHI is on the building roof which the building is owned by the same partners in another LLC.

Thanks Jeff

Thanks for the reply.

1. It is a 736b transaction.
2. LHI - yes some of it has bonus depreciation.
3. Note is at 5% interest for 3 years.
4. Under the scenario of not booking the entire transaction at once, are you saying I would not record the Note Payable on the books, but rather just record the note payments to the departing partners capital account? Sure would make life easier this way it seems!
5. Departing partner equity at time of redemption is $144,572. Payments made in 2019 were $143,821, so we have not exhausted his capital account yet, therefore it seems I would NOT do a section 754 election until 2020.

Thanks again.

Hi Huggies, I am also dealing with an LLC redemption but I'm quite a bit behind you on the analysis over here. How did you determine that your buyout situation falls under Sec 736b versus 736a? Did the partnership agreement specify that terminating payments be made for goodwill, thus sec 736b?

So it seems pretty straight forward for 2019 on the partnership side- departing partner capital account not fully exhausted, but he does have some ordinary income recognition on his portion of the A/R correct?

A disproportionate distribution is rarely straightforward. He’s deemed to get a distribution of the zero basis A/R and then the partnership is deemed to buy it back from him. In other words, some of that cash he got is effectively treated as sales proceeds for an asset that was deemed distributed to him. This gives the partnership basis in the A/R without the need for a 734 adjustment.

I would think his K-1 would need to note that?

There’s a bunch of stuff you’re required to attach. See 1.751-1(b)(5) and 1.734-1(d).

For 2020, when capital account goes negative, the 754 election is made for the amount of gain over the tax basis capital account for 2020? That then becomes a tax depreciation item on the 1065 as 754 depreciation to the two remaining partners? I assume I eventually zero out his capital account once all payments have been made - to what?

When his capital account goes negative for the first time at the end of 2020, you could do this if you’ll be making a 754 election and if you’ll be recording the 734 adjustment on the books: Debit the appropriate asset(s) on the Balance Sheet and credit his capital account. That will bring it up to $0. And you do the same thing each subsequent year.

and the LHI is on the building roof which the building is owned by the same partners in another LLC.

That doesn’t mean anything to me.

Hi Huggies

LOL. Now he’s a diaper.

I would think his K-1 would need to note that?

There’s a bunch of stuff you’re required to attach. See 1.751-1(b)(5) and 1.734-1(d).


Is the attachments for 2020 or 2019, or both? There is no gain in 2019 since the distributions to the departing partner has not reduced his tax basis capital below zero. It will in 2020 however.

Since the assets being sold (no debt on books) do NOT include appreciated inventory or unrealized receivables (its an accrual basis taxpayer), that speaks to the gain being all capital?

The 754 election happens in 2020 as well based on the amount paid to departing over his tax basis?

(its an accrual basis taxpayer)

Ok, you didn’t say that before. Sounds like you’re taking the position that there are no hot assets (no “unrealized” receivables…no appreciated inventory…and if the building were to be sold, the partnership wouldn’t get any of the proceeds…meaning we wouldn’t have any gain on the roof situation, further meaning we wouldn’t have any regular 1250 recapture because of the bonus issue).

If all of that’s correct, and we’re dealing exclusively with 736b, then you have it right: There are no Sec 751 issues and Sec 754 is inapplicable for 2019. Sec 754 will come into play, for the first time, in 2020. You’ll make the election with the 2020 tax return. You’ll also make the 734 computation attachment, for the first time, with the 2020 tax return. His cap account will go negative for the first time in 2020, because of “distributions” (i.e. redemption payments consisting of principal) but will be brought back up to $0 @ 12/31/2020. It will go negative again in 2021, then will be brought back up to $0 @ 12/31/2021. And so on and so forth. In each year, you’ll have a Sec 734 adjustment and will have to make the required computational attachment to the F1065. If each year’s adjustment ends up being depreciable or amortizable, as per Sec 755, then you’ll take those deductions.

For 2019 do I have to note on the K-1 that the partner received liquidating distributions (just not in excess of capital) I am assuming his personal account would need to know that!

Like information, but it takes a 754 election to get anything to the balance Sheet (Goodwill or asset assignment) otherwise I think you you adjust the other capital accounts. They used up an asset cash - to get a bigger ownership % in the LLC.

For 2019 do I have to note on the K-1 that the partner received liquidating distributions (just not in excess of capital) I am assuming his personal account would need to know that!

You will need to know if the partner is making the 1.736-1(b)(6) election to recognize pro-rata gain. That will impact your 734 adjustment, because that adjustment mirrors the gain recognized by the partner. Again, see Rev Rul 93-13.

If the partner won’t be electing to recognize gain, then you’d show all of the principal payments as regular Distributions. If you want to make a K1 footnote, fine, but it is the partner or his accountant that will be telling you if a gain recognition will be made. In other words, the partner’s accountant should already be in the loop. Under this fact pattern, once his capital account goes negative, you’d bring it back up to zero with a credit to capital and a debit to the applicable Balance Sheet asset(s) that will receive the 734 adjustment (if you will be booking the 734 adjustment onto the books). And you follow that model in and every future year. If a gain recognition election is made by the partner, the accounting is slightly different. In that case, you’d have a 734 adjustment even though his capital account hasn’t gone to zero yet.

I do think a 1099 is also required to the departing LLC member if LLC buys him out.

I do think a 1099 is also required to the departing LLC member if LLC buys him out.

Just provide us with the authority for that statement and we might believe you…

Jeff do not believe