By: Martin M. Shenkman, CPA, MBA, JD
In certain cases, the sale of your interest in a partnership or an LLC will be taxed as ordinary income and not the more favorably taxed capital gains. This may occur where the LLC has realized substantial income (and met other complex and rigid mechanical tests) from unrealized receivables. The objective of this tax concept is to prevent you from using an LLC (or other entity) to convert Ordinary Income (taxed at rates of up to 39.6%) to capital gains (taxed at 28%). For example, if your LLC manufactured widgets to sell in the ordinary course of its business, ordinary income would be realized. However, if just before making the sales, you sold all your LLC interests to someone else who would then sell the widgets, you would appear to have capital gains on the sale of your interests (since Membership interests in an LLC are generally a capital asset producing capital gains). However, the widgets may be characterized as unrealized receivables, and you may have to report some or all of the gain on selling your LLC as ordinary income.
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