Capital Account Balance on Freeze Out

Any non-Tax accounting topics go here.
#1
Posts:
8
Joined:
21-May-2021 9:25am
Location:
Florida
In an LLC when a freeze out occurs, is the member that has been "squeezed out" entitled to their capital account balance? Where does this balance go? Is the member entitled to payment of the capital account balance and how does this work for taxation purposes?

For instance, can the LLC simply zero out the capital account without payment to the member for K-1 Section L purposes?

Does anyone know where I could find any sort of secondary source, statute, case law, etc. on this very specific issue. Capital account balance upon dissolution seems to be very straight forward, however there is a lack in information upon a squeeze out.
 

#2
sjrcpa  
Posts:
6477
Joined:
23-Apr-2014 5:27pm
Location:
Maryland
What does the Operating Agreement say? Start there. Then look to state law.
 

#3
Posts:
6043
Joined:
22-Apr-2014 3:06pm
Location:
WA State
Agree with sjr...Generally, the owner of any asset is entitled to fair compensation of being relieved of that asset. That's a value proposition, which doesn't have anything to do with the capital account balance.
This is more of a contract/business law issue than tax law. Tax law will guide you on how to handle the consequences of the first issue.
~Captcook
 

#4
Posts:
8
Joined:
21-May-2021 9:25am
Location:
Florida
The OA and state law are silent regarding a freeze out, and only addresses dissolution/liquidation. The tax issue that would guide my understanding is what happens to the capital account when something like this happens, specifically for the K-1. Is the capital account simply zeroed out? Or should that money be paid out when the member is squeezed out? Is the capital account essentially already the "property" of the member? Or can the capital account be zeroed out and the member merely paid fair valuation? If so, where does this money from the capital account go if not to the frozen member?
 

#5
sjrcpa  
Posts:
6477
Joined:
23-Apr-2014 5:27pm
Location:
Maryland
Why are they being squeezed out? Maybe it is addressed in the OA using other terminology.
 

#6
Posts:
8
Joined:
21-May-2021 9:25am
Location:
Florida
The squeeze out is happening because the member has a large interest in the LLC with a small monetary contribution. Therefore a high capital account because of small distributions. Essentially the contract is set up so the member would not be able to afford the high amount of taxes and low distribution. However the member did keep up with the taxes. Therefore the other members turned to squeezing the member out because the above is not working as quick as they hoped.

The issue is whether the frozen member may be paid only fair valuation and have their capital account zeroed out? If they currently have a capital account of $2 million and the fair valuation upon determination is $2.5 million, does the frozen member receive only their fair valuation? For tax purposes can the LLC deduct the $2 million from the capital account to zero it out? Or should the frozen member be entitled to their fair valuation plus capital account?
 

#7
Posts:
8
Joined:
21-May-2021 9:25am
Location:
Florida
I am essentially trying to get a solid understanding of how the capital account is handled separately from fair valuation upon a squeeze out and not dissolution. More importantly where I can find sources that speak to this issue.
 

#8
Posts:
6043
Joined:
22-Apr-2014 3:06pm
Location:
WA State
Set the capital account aside for a moment...

What is the partner entitled to as it relates to their interest?
This should be addressed in the OA. If it's not, you probably have messy litigation in front of you.
Once that is determined, the tax result becomes clear. They will have received something (or nothing) in exchange for their interest and the capital account will be reflective of that.
~Captcook
 

#9
Posts:
8
Joined:
21-May-2021 9:25am
Location:
Florida
They are entitled to fair valuation under the OA. But there is no mention of what happens to the capital account.
 

#10
Posts:
8
Joined:
21-May-2021 9:25am
Location:
Florida
So if fair valuation is say $5 mill. and the capital account balance is $2 mill. Can the LLC simply deduct $2 mill. and zero out the capital account and pay the member the difference, $3 mill.?
 

#11
Posts:
6043
Joined:
22-Apr-2014 3:06pm
Location:
WA State
jcappock wrote:They are entitled to fair valuation under the OA. But there is no mention of what happens to the capital account.


This is what I would expect.
It appears to me that you are still confused about this concept. The capital account is simply a representation of the partner's share of the net equity shown on the business books and nothing more. "What happens" to the capital account depends on the manner of the partner's exit.

If other partner(s) purchase the interest and there is NO 754 election in place, the departing partner receives their fair value and the capital account balance simply transfers to the purchasing partner(s).
With a 754 election in place, any amount paid by the purchasing partner(s) in excess of the capital account (assuming tax basis capital) gets allocated among the assets of the business as though each of those assets had been purchased from a third party (a 743(b) ADJ).
If the partnership purchases the interest directly and a 754 election is in place, then the excess is allocated among the assets in a similar manner (a 734(b) ADJ).

In all cases, the exiting partner will have been considered to have sold their percentage of the assets of the partnership. You will likely need the assistance of the partnership's tax preparer to determine the details.
I will usually provide a detailed schedule to the tax preparer of departing partners in this instance.
~Captcook
 

#12
Posts:
8
Joined:
21-May-2021 9:25am
Location:
Florida
This clarifies alot. Thank you!
 

#13
Posts:
8
Joined:
21-May-2021 9:25am
Location:
Florida
CaptCook wrote:
jcappock wrote:They are entitled to fair valuation under the OA. But there is no mention of what happens to the capital account.


This is what I would expect.
It appears to me that you are still confused about this concept. The capital account is simply a representation of the partner's share of the net equity shown on the business books and nothing more. "What happens" to the capital account depends on the manner of the partner's exit.

If other partner(s) purchase the interest and there is NO 754 election in place, the departing partner receives their fair value and the capital account balance simply transfers to the purchasing partner(s).
With a 754 election in place, any amount paid by the purchasing partner(s) in excess of the capital account (assuming tax basis capital) gets allocated among the assets of the business as though each of those assets had been purchased from a third party (a 743(b) ADJ).
If the partnership purchases the interest directly and a 754 election is in place, then the excess is allocated among the assets in a similar manner (a 734(b) ADJ).

In all cases, the exiting partner will have been considered to have sold their percentage of the assets of the partnership. You will likely need the assistance of the partnership's tax preparer to determine the details.
I will usually provide a detailed schedule to the tax preparer of departing partners in this instance.


Essentially you are saying the purchase price is separate from the capital account which runs with the shares and is more like a tax basis?

Suppose the following hypothetical:

There are two partners both 25% owners (100 shares each), one with a capital account of $50,000 and one with a capital account of $2,000,000.

Do the shares with the capital account of $2,000,000 have a higher FMV?

The operating agreement provides that in the event of a dissolution the owners are paid in proportion to their capital account and not per the number of shares they have. The difference in the capital account value is because the capital contributions for the shares are drastically different and the OA provides for distributions in accordance with capital contribution not capital account or percent owner.
 

#14
Posts:
6043
Joined:
22-Apr-2014 3:06pm
Location:
WA State
jcappock wrote:Do the shares with the capital account of $2,000,000 have a higher FMV?


Generally, the answer to this question is 'no'.

More specifically, this question is wholly dependent on the terms of the operating agreement. Each interest may need to be valued separately, with the specific terms you note being taken into account. The value of an interest should be reflective of expected future cash flows.
~Captcook
 


Return to General Accounting



Who is online

Users browsing this forum: No registered users and 11 guests