In addition to C corporations, S corporations, partnerships, and sole proprietorships, four other business entities are particularly common: limited liability companies (LLCs), limited liability partnerships (LLPs), limited partnerships (LPs), and professional corporations (PCs). When forming one of these entities, it is important for you to know the tax consequences if you sell your interest in the business. Selling your interest in a business will generally result in capital gain (or loss) (or in some cases, dividends) or ordinary gain (or loss).
When considering any sale of an interest in a business, be sure to examine all relevant documents or laws for restrictions or conditions placed on the sale of your interest in the business. These might include the document creating the business, a stock certificate, a buy-sell agreement, a loan agreement, or state or federal laws. Restrictions or conditions might be placed on (1) who you can sell your interest to; (2) whether, when, or under what conditions you can sell your interest; or (3) the price that you can sell your interest for.
Impact on Specific Business Entities
Tax treatment will vary, depending on the type of business entity you select.
Limited Liability Companies (LLC)
A limited liability company is a business entity created and regulated under state law. LLC laws allow companies that operate as partnerships to benefit from the limited liability characteristics of corporations. This means that LLCs give their owners, who are called “members,” protection from the claims of business creditors. The liability of an LLC member for business debts is generally limited to the value of his or her individual ownership interest in the LLC. Moreover, unlike limited partners in a limited partnership, all LLC members can take an active role in the operation of the business without exposing themselves to personal liability.
For federal tax purposes, the LLC can generally choose to be treated as a partnership or as a corporation. In general, LLCs choose to be taxed according to partnership rules to avoid the double taxation imposed on C corporations. Therefore, it is a good idea to review the partnership tax rules. Generally, the sale of your interest in a partnership results in a capital gain or loss. However, certain payments for unrealized receivables and inventory items are taxed as ordinary income or loss.
An LLC with a single owner will be treated like a sole proprietorship for federal income tax purposes if it does not elect to be taxed as a corporation. However, you should be aware that some states do not recognize or permit LLCs with a single owner. A sole proprietor and his or her business are indistinguishable for tax purposes. Thus, the sale of a sole proprietorship is treated as a sale of the assets of the sole proprietorship.
Generally, if the LLC is taxed as a corporation, the sale of interest in the LLC results in a capital gain or loss. Thus, a sale to another person or an entity other than the LLC typically results in a capital gain or loss. However, a redemption of your interest in the LLC by the LLC may be treated as a sale or exchange of the stock or as a dividend.
Limited Liability Partnership (LLP)
Most states allow certain professionals (such as doctors, lawyers, and accountants) to form an entity similar to the limited liability company. This entity is called a limited liability partnership (LLP). An LLP is a partnership organized under state statutes that gives a degree of liability protection to individual partners. Partners in a general partnership are liable for all partnership obligations, including the negligence or malpractice of other partners. Once an LLP business is properly registered, however, the partners of the LLP do not have liability for the malpractice of the other partners but still remain liable for their own acts.
For federal tax purposes, an LLP follows the same entity classification rules as the LLC. That is, it can elect to be taxed as a corporation or as a partnership. Most LLPs choose to be taxed as partnerships, however.
Generally, the sale of your interest in a partnership results in a capital gain or loss. However, certain payments for unrealized receivables and inventory items are taxed as ordinary income or loss.
Limited Partnerships (LP)
A limited partnership (LP) is defined as a partnership with one or more general partners and one or more limited partners. General partners are liable for all partnership debts and obligations, whereas a limited partner is only liable for the value of his or her individual ownership interest in the partnership. Although LPs are similar to LLCs and LLPs, there are a number of differences as well. For instance, although most states forbid limited partners from participating in management decisions, LLC members are free to participate in management.
Basically, LPs are taxed as partnerships for federal tax purposes. Generally, the sale of your interest in a partnership results in a capital gain or loss. However, certain payments for unrealized receivables and inventory items are taxed as ordinary income or loss.
Professional Corporations (PC)
Professional corporations (PCs), or qualified personal service corporations (as they are sometimes called), are a special type of corporation composed of professionals. Under the federal tax code, a qualified personal service corporation is defined as a state formed corporation in which substantially all of the activities involve services in the fields of health, law, engineering, accounting, actuarial science, performing arts, or consulting. Keep in mind that the sale of an interest in a PC can usually only be made to another licensed professional or to the PC itself.
For federal tax purposes, the definition of a PC will vary, depending on the tax law that applies. The tax treatment will depend largely on how much of the outstanding stock is owned by employee shareholders. PCs can sometimes choose to be treated as S corporations. For more information, contact an accountant or tax attorney. Like a C corporation, a PC is normally treated as a separate tax entity from its owners—the employee shareholders.
Generally, the sale of your stock in a PC results in a capital gain or loss. Thus, a sale to another person or an entity other than the PC typically results in a capital gain or loss. However, a redemption of your stock by the PC may be treated as a sale or exchange of the stock or as a dividend.
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Disclosures: The following information is reprinted with permission from Forefield, a division of Broadridge Financial Solutions, Inc. This article is meant to provide valuable background information on particular investments, NOT a recommendation to buy. The investments referenced within this article may currently be traded by Henssler Financial. All material presented is compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. The contents are intended for general information purposes only. Information provided should not be the sole basis in making any decisions and is not intended to replace the advice of a qualified professional, such as a tax consultant, insurance adviser or attorney. Although this material is designed to provide accurate and authoritative information with respect to the subject matter, it may not apply in all situations. Readers are urged to consult with their adviser concerning specific situations and questions. This is not to be construed as an offer to buy or sell any financial instruments. It is not our intention to state, indicate or imply in any manner that current or past results are indicative of future profitability or expectations. As with all investments, there are associated inherent risks. Please obtain and review all financial material carefully before investing. Henssler is not licensed to offer or sell insurance products, and this overview is not to be construed as an offer to purchase any insurance products.
