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Taxes on profit of LLC shares

Dear Tax Talk,
I own 15 percent of a limited liability company, LLC, established in New Jersey three years ago. I had an original investment of $165,000. I will be selling my shares for $275,000. What is my tax rate on the $110,000 profit? -- Paul

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Dear Paul,
Your tax rate depends on how the LLC is treated for tax purposes. An LLC is usually classified as a partnership, unless it elects to be treated as a corporation for tax purposes. If you made the corporate election, then you'll be treated as selling shares in a corporation. The sale of corporate stock held for more than a year is treated as a long-term capital gain, taxed at 15 percent. So your tax would be $16,500, and you don't have to read on.

If the LLC is treated as a partnership, this means you should get annual Schedule K-1 forms. Your original $165,000 investment would be increased for income that you paid tax on when you reported it on your individual return and decreased by any losses allocated to you and any distributions of cash or property you received. Your investment and adjustments are reflected in your capital account (see Box N of Schedule K-1). These allocations would change your gain so that it may be more or less than $110,000.

After analyzing your capital account, assuming again that the LLC is a partnership for tax purposes, you have to look at the underlying assets that make up your investment in the LLC. If there are any tainted assets, you may have to recognize ordinary income on part or all of your gain.

Tainted assets are assets that, if sold or collected by the partnership, would produce ordinary income. For example, if the partnership used the cash basis of accounting for its receivables, these would be ordinary income to the partnership when collected. Since when you sell your shares you're receiving money for these assets, it's only right that you should recognize ordinary income on your proportionate share.

Ordinary income, as opposed to capital gain, is subject to tax at the same rate that applies to your other income such as salaries and other business income. The maximum tax rate applied to ordinary income is 35 percent, plus any state tax that you may owe. The partnership should make these calculations for you and advise you of any tainted assets.

Bankrate.com's corrections policy
-- Posted: July 15, 2005
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