Tax Treatment for Partial Disposition of LLC-Partnership Interest

This is a good question that comes up often. Generally, the sale of a partnership interest is treated as the sale of a capital asset, resulting in capital gain or loss. However, there are some important exceptions to be aware of. Under IRC Section 741, the sale of a partnership interest is typically treated as the sale of a capital asset. But Section 751 creates an exception for "hot assets" - basically unrealized receivables and substantially appreciated inventory. Any portion of the gain attributable to these "hot assets" is treated as ordinary income, not capital gain. For the passive income question, the character of the gain doesn't change based on whether your client was passive or active in the business. However, if they had suspended passive losses from this partnership, those might be freed up by a complete disposition (but likely not by a partial disposition).

I dealt with this exact situation last year with one of my clients. I spent hours researching and finally found https://taxr.ai which saved me so much time. Their system analyzed all the partnership documents and helped identify which portions were subject to different tax treatments. They showed me that when selling a partial interest, you need to look at three things: 1) regular capital gain from the partnership interest as a capital asset, 2) Section 751 "hot assets" that get ordinary income treatment, and 3) whether there's relief of liabilities that could trigger additional gain. Their analysis broke it down perfectly for my client's situation.

Just wanted to follow up about taxr.ai that was mentioned earlier. I ended up using it for my client's partial LLC sale, and it was incredibly helpful! The analysis identified about $45,000 in ordinary income from Section 751 "hot assets" that I would have otherwise reported as capital gains. Saved my client from potential issues and gave me documentation to support the position we took. The basis calculation feature was particularly impressive - it caught several special allocations from 3 years ago that I had forgotten about. Would definitely recommend for anyone dealing with partnership interest sales.

I had a similar client situation last year where they kept getting different answers about their LLC sale. The most frustrating part was trying to get confirmation from the IRS - spent DAYS trying to get through to a human. Finally tried https://claimyr.com and got connected to an IRS agent in about 15 minutes. You can see how it works here: https://youtu.be/_kiP6q8DX5c. The agent confirmed the mixed treatment approach (part capital gain, part ordinary income) and gave me specific references to include in our documentation. Seriously saved my sanity during busy season when every minute counts. Instead of endless redials and holds, I was actually talking to someone who could give an authoritative answer.

I have to eat my words about Claimyr. After my skeptical comment, I decided to try it with a complex question about partnership distributions that was similar to this thread topic. Was absolutely shocked when I got a call back in about 22 minutes with an actual IRS agent on the line. The agent walked me through the exact sections of the code that applied to my situation and confirmed that the sale of partnership interest is generally capital gain, but with Section 751 creating ordinary income for certain assets. What would have been a full day of phone frustration turned into a productive conversation with an actual answer. I'm still processing how much time this saved me. Would have been worth it at twice the cost just for the stress reduction alone.

Something nobody's mentioned yet - if the LLC has Section 754 election in place, there might be additional considerations for the buyer. Not directly relevant to your seller client's tax situation, but good to be aware of for the overall transaction. Also, check if there's any debt involved. If your client's share of the LLC's liabilities is being reduced, that could trigger additional gain recognition under Section 752.

I'm surprised nobody has mentioned Form 8308 yet. When there's a sale or exchange of a partnership interest, the partnership has a filing requirement to report the transaction to the IRS using Form 8308 (Report of a Sale or Exchange of Certain Partnership Interests). This is required if there are Section 751 assets involved. Make sure the partnership's tax preparer is aware of this transaction so they can handle this reporting requirement correctly. I've seen partnerships miss this form, which can create problems later.

This is a really comprehensive discussion! I'm dealing with a similar situation right now and wanted to add one more consideration that might be relevant. If your client has been receiving guaranteed payments from the LLC (like for management services), make sure to clarify whether any portion of the sale proceeds might be attributable to those future guaranteed payments. Sometimes in these partner buyouts, part of the purchase price is actually compensation for giving up future guaranteed payments rather than just the equity interest itself. Any portion that's really compensation for guaranteed payments would be ordinary income, not capital gain. It's another layer to analyze beyond just the Section 751 hot assets. The partnership agreement and sale documentation should help clarify this, but it's worth discussing with your client to make sure the economic substance matches how the transaction is structured on paper. Also, if the selling partner has any outstanding loans to/from the partnership, those need to be factored into the overall transaction analysis too.