Let’s play Q&A for a moment. Upon the sale of a partnership or LLC interest, is the entire gain taxed at capital gain rates?
Answer: Maybe. When it comes to partnerships and LLCs taxed as partnerships, there may be ordinary income taxes due upon the lifetime sale of an owner’s interest. If you’re an owner, you may be surprised to learn that even upon your death, your estate may still be responsible for ordinary income taxes upon the sale of the partnership or LLC interest. How is this possible? Two words — “hot assets.” The portion of the sales proceeds that represent a payment in exchange for a partnership (or LLC) interest is generally a capital gain. However, the portion of the sales proceeds that represents payment for “hot assets” is generally ordinary income.
So what are “hot assets?” Examples of “hot assets” are inventory and unrealized receivables, which are rights to ordinary income that have not already been included in the owner’s gross income. For example, a law firm organized as a general partnership with three equal partners bills a client $60,000 in November for work performed the previous month and the client does not pay the bill until January. Assuming that one of the partners dies in December and that the partnership utilizes the cash basis method of accounting, the purchase price of the deceased partner’s interest will generally include his or her share of the unrealized receivables. This will result in $20,000 of the purchase price being taxed to the deceased partner’s estate as ordinary income.
Before you start hyperventilating and completely give in to panic, take a moment to pause. Now that you have a better understanding of how partnership and LLC taxation can impact your estate, you can proactively adapt. This is quite a nuanced topic; therefore, it would be wise to consult with tax and legal advisors to come up with a plan that best bits your situation.
Additionally, if part of the proceeds from the sale of a partnership or LLC interest are going to be eaten away by ordinary income taxes (perhaps up to nearly 40%!), careful thought needs to go into the way the purchase price is determined in the buy-sell agreement and the amount of disability and life insurance funding that is necessary to achieve your overall goals.