A purchase or sale agreement for limited liability company (LLC) interests requires due diligence to obtain a complete picture of the exchange in order to properly document the transaction.
One of the primary concerns is whether the transaction should be structured as a sale of membership interests from the departing member (“Departing Member”) to a remaining member, or a redemption (or “liquidation distribution”) of Departing Member’s interest by the LLC. The LLC operating agreement usually contains provisions that include transfer restrictions, procedures, and notice requirements. Additional requirements may apply if the transaction is a sale as opposed to a redemption. A transfer that violates provisions of the operating agreement can be deemed invalid.
Assuming that the LLC is treated as a partnership for federal income tax purposes, the Departing Member transfers the entire interest, and the partnership status of the LLC continues with two or more members (“Remaining Members”) after the transaction, then there may be the following tax consequences:
Under Subchapter K of the Internal Revenue Code (“IRC”), LLC members have some flexibility in the allocation of their tax burdens by structuring the transaction as a sale or a redemption. The tax differences between a sale and a redemption can be substantial. A Departing Member’s gain and Remaining Members’ tax basis will be treated differently. Tax treatment may also be affected should the LLC assets include the so-called “hot assets” as defined by IRC Section 751 (i.e. inventory and unrealized receivables); if the payments to the Departing Member are made in installments; if the LLC distributes property instead of cash (or a mixture of both) to the Departing Member; if goodwill is considered as part of the LLC assets; if the redemption of Departing Member’s interest is funded by a promissory note from the LLC; and if Departing Member’s contribution to the LLC was in the form of service instead of cash and property.
There are instances where the IRS may look behind the parties’ chosen form and recharacterize the transaction. Two scenarios in which this happens are when the redemption appears to be funded by a Remaining Member’s contribution to the LLC or when the Remaining Members’ interests do not increase pro rata after the transaction. In these circumstances, a rebuttable presumption of a disguised sale can arise under IRC Section 707.
The interest of the Departing Member will not necessarily align with the interest of Remaining Members when choosing between sale and redemption. All parties, including the LLC, should consult with their own tax advisors for a comparison of different tax scenarios before negotiating, so that the parties can reach an informed decision.
Sales and redemptions require intentional structuring and proper documentation. A failure to comply with the LLC operating agreement can result in disruption of business operations and costly legal disputes. Departing Member and Remaining Members should seek the advice of legal counsel to make sure the transaction complies with the LLC operating agreement, and to prepare documentation consistent with the parties’ intentions and informed decision.
The information presented is not intended to be, and does not constitute, “legal advice.” Because each situation varies, and only brief summary information is provided here, you should not use this information as a basis for action unless you have independently verified with your own counsel that it applies to your particular situation.
Filed Under: Legal News & Tips Tagged With: LLC
Thank you for the information that’s very helpful. How does the IRS treat a redemption under the operating agreement – a capital gain or ordinary income, in the state of FL?