Discussion:Installment sale of LLC interest. No cash rec'd, but negative capital balance.

From TaxAlmanac, A Free Online Resource for Tax Professionals
Note: You are using this website at your own risk, subject to our Disclaimer and Website Use and Contribution Terms.

From TaxAlmanac

Jump to: navigation, search

Discussion Forum Index --> Tax Questions --> Installment sale of LLC interest. No cash rec'd, but negative capital balance.

ScottCPA (talk|edits) said:

4 January 2007
I have an interesting one.

2 brothers own an LLC 50/50 with rental real estate in it.

1 brother sold his 50% share of the LLC to other brother for $425,000 on installment (no principle rec'd yet in 06).

The seller has negative capital balance of 450,000 (from losses, cash distr, etc) - losses deductible cuz of debt in LLC allocated to each partner.

So looks like the seller has 875,000 gain (425,000 note received plus neg. cap bal of 450,000).

They assumed the real estate was worth 4,200,000 and the debt on the property (in the LLC) was 3,350,000 = net fmv equity of 850,000. So seller is selling his 1/2 for $425,000. The seller is being released from the debt on the property that's inside the LC.

So.... the question is - how much installment gain to report in 06 when no principle was received?

 I think that the debt in the LLC that the seller is relieved of (1/2 = 1,675,000) is to be considered "payment received" in year 06.  If so, then I've got a total sale price of 2,100,000 (1,675,000 debt relief + 425,000 note received).  

 so.....under this theory, the installment gross profit % would be:

         875,000 /  2,100,000   =  .4167  GP %
       (total gain)    (total sale)     (gross profit %)

     So for 06, taxable amount would be:    .4167 X 1,675,000(debt relief only) =  698,000 !!!

      Then there would be 425,000 X .4167 = 177,000 taxable over time as the 425,000 installment note is paid off.   So total reportable would be the 875,000.

Any way that the 875,000 would only be taxable as the 425,000 note is paid off? So nothing taxable in 2006? If so, the GP% would have to be like 206% (2.06 X 425,000 = 875,000 total taxable).

I know there was a thread about a similar situation just discussing how the sec 1250 & 1245 recapture is handled. I can handle that, it's the topic above I couldn't seem to find in that earlier thread.


Riley2 (talk|edits) said:

5 January 2007
The amount of debt relief allocated to the selling partner would be treated as part of the sales price of the partnership interest.

FTF65 (talk|edits) said:

January 5, 2007
Scott - it doesn't work that way. The gross profit percentage is equal to the amount of gross profit ($875,000) divided by "contract price." The contract price is equal to the sales price reduced by the amount of "qualifying indebtedness," which is the amount of debt that does not exceed the basis of the property sold. In this case, the contract price equals $875,000, which is computed as the $2.1 million sales price less qualifying debt of $1,225,000 (i.e., the $1,675,000 total debt exceeds the basis in the partnership by the amount of the deficit capital account, so basis in the partnership interest equals $1,225,000). The gross profit percentage is therefore 100% ($875k gross profit / $875k contract price). The amount of the debt in excess of the basis (i.e., the $450k deficit capital account) is treated as cash received in the year of sale. Any payments on the note are treated as gain when paid. As a general rule: whenever the debt assumed in an installment sale exceeds the basis of the property sold, the gross profit percentage will be 100%.

Dennis (talk|edits) said:

5 January 2007
And let us not forget Reg. 1.1(h)-1

FTF65 (talk|edits) said:

January 6, 2007
Scott - two additional comments on this:
  1. You can "theortically" increase your "contract" price and thereby lower your GP% by using a wrap-around mortgage instead of the buyer assuming the existing debt (note: I say "theortically" because there are a number of "practical" considerations, as mentioned below, that could render this idea unworkable). A wrap-around mortgage (i.e., All Inclusive Trust Deed or "AITD" loan) is a note for the full purchase price that "wraps" around the existing debt so as to avoid assuming such debt. Applying this to your facts produces the following: selling brother takes back a $2.1M "wrap-around" note from the buying brother who remains "on the hook" for his $1.675M share of the partnership debt. Under this scenario the contract price = the sales price of $2.1M, the gross profit is still $875k, and the GP% is the number that you computed 41.67%. As the buying brother makes payments on the $2.1M wrap-around note to selling brother, the selling brother makes a payment to the bank for his $1.675M share of the underlying "partnership" debt and teats 41.67% of every payment as gross profit. At least under this scenario, the selling brother doesn't have to pay tax on the deficit capital account with no cash in pocket. Note, this idea does not work for every situation. As I mentioned above, the selling brother will have to remain "on the hook" for his share of the partnership debt - this may be a problem for him. In addition, the lender and buyer may have concerns that the selling brother will not pay down his share of the debt as he receives the $2.1M. What happens if the buying brother defaults? etc., etc. Although there may be work arounds for some or all of these issues, you would be wise to discuss this idea with someone who has experience before you do anything.
  2. As an option to the installment sale, have you considered redeeming the selling brother via retiremnent payments as provided under Sec. 736?

PGattoCPA (talk|edits) said:

8 January 2007
FTF65: re option 2, I'm not a p'ship guy, but doesn't §736 (I assume you mean §736(b)) only work if the retiring partner has basis? The OP states that the only reason the brother who is leaving was able to take losses was because of LLC debt. Or are you saying that treating it under §736(b) "effectively" gives him installment sale treatment because the payments will be considered distributions (rather than distrubitive shares of profits) and, therefore, only be includible in income as received (since his basis is zero)?

If so #1, then the "staying" brother ("SB") probably needs to make capital contributions to the LLC before the LLC makes distributions to the "leaving" brother ("LB"). Is there a step-transaction doctrine issue here? (I don't know - just thinking out loud.) Or perhaps there is enough positive cash flow to distribute to LB and then SB makes capital contributions as operating needs dictate.

If so #2: LB has to have been a general partner. (§736(b)(3)) In LLCs are all partners considred to be GPs or only the managing member? Or is is a participation concept? (Again, I don't know - just thinking out loud.) Regards

FTF65 (talk|edits) said:

January 8, 2007
PGattoCPA - With respect to Sec. 736 (and yes, I meant Sec. 736(b)) - I really didn't give it much thought other than that I was trying to think of a tax efficient alternative to a wrap note. Under my logic, $425k of distributions made to LB would be taxable as received with $450k of gain recognized at the end of the payment stream when LB's share of the debt was lifted (I think I was incorrect about this - see below). As far as the funding of those distributions, I presumed that they would come from operating cash flow (I am assuming that there is positive cash flow). Note: if SB made contributions to fund the LB distributions, I agree there would be step-transaction issue and would likely constitute a disguised sale of a partnership interest - but not really sure what difference it would make. In addition (as I mentioned above), I was banking on the fact that SB would still have debt basis since, even though he is retiring, he is still treated as being a partner under Sec. 736 -- in hindsight, I do not think that I am correct. Rather, SB will likely be relieved of the debt on day one and will be deemed to have received a cash distribution under Sec. 752 which will end up triggering the deficit capital account anyways. I knew I was reaching when threw Sec. 736 into the mix, but I guess I was hoping that ScottCPA or someone like yourself would come along and finish the thought. Although I am a partnership guy, I don't have occasion to use Sec. 736 very often - we used to use it a lot in the days of basis strips, but the tax shelter rules have pretty much put an end to that era.

As for your "If so #2" comment: the "general partner" limitation that you refer to only applies to limit the "Special Rules" under Sec. 736(b)(2) which concerns payments for unrealized receivables and goodwill so I'm not certain that I see the relevance; however, I am curious as to why you think that is an issue (after all - I am still learning too!)

PGattoCPA (talk|edits) said:

8 January 2007
FTF65: I forgot about the ordinary income portion of §736 - you are correct that (b)(3) only applies if (b)(2) applies.

As for "reaching", isn't that one of the things that a good tax advisor does? You may find that you do not get the desired outcome when you began to reach, but if you don't reach you (and your clients) will never find out. I thought it was clever that you thought of §736. Regards

ScottCPA (talk|edits) said:

8 January 2007
Thanks much for the input! Looks like the conclusion is $450,000 taxable in yr 06, and $425,000 taxable over time as the installment payments come in. That's better than my initial thougt that maybe $698k would be taxable in first year. My conclusion was that the selling partner just had to remain "on the hook" for the debt to get out of this first year tax problem. The wrap around mortg is an idea, but of course the client has already done the deal, never calling me, and the remaining brother refinanced, etc. with his name only on the debt. So doubt we can go back and restructure everything. Also, sec 736 is interesting, but it sounds like it won't solve the problem either. But I'll look at it a little more.

So, now the only question is, how long will it take me to make the call to client to tell him he owes about $110k total taxes, and doesn't have the cash to pay it?!! MAN I HATE THIS PART OF THE JOB! I still like the $200 tax returns that take 1/2 hr and the client is happy as a lark getting a $2k tax refund e filed quick to his bank acct in 1 week!

THANKS AGAIN for the input!

FTF65 (talk|edits) said:

January 9, 2007
Scott - if your client is having difficulty with the concept of gain and no cash to pay the tax, just remind him that he already received the benefit in previous years (either tax deductions or cash distributions) and now he just needs to pay the piper (he is obviously not the one that funded his deficit capital account). Good luck.

ScottCPA (talk|edits) said:

9 January 2007
Exactly - at least this client does understand and appreciate the "time value of money" he's had! Thanks again

To join in on this discussion, you must first log in.
Personal tools