LLC Partner Buyout: What Are the Tax Implications?

The tax implications of an LLC partner buyout turn less on the price than on how the deal is structured and what sits inside the LLC. A departing member of a multi-member LLC taxed as a partnership can pay long-term capital gains rates on part of the payout, ordinary income rates on another part, and self-employment or net investment income tax on top, and the same dollar amount can produce very different bills depending on whether the transaction is a sale of interest or a redemption, how much of the value is tied to “hot assets,” and what the operating agreement says about goodwill.

Everything downstream depends on getting a few foundations right first.

Start With Outside Basis

Before calculating gain or loss, the selling member needs their outside basis: the running tax investment in the LLC interest. It begins with cash or property contributed at entry, increases each year by the member’s share of LLC income and any additional contributions, and decreases by distributions received and the member’s share of losses.

Debt is the piece that catches people off guard. A member’s share of LLC liabilities counts as part of outside basis.¹ A member with a negative capital account can still have a positive outside basis if their share of LLC debt is large enough. When the buyout closes and the departing member is relieved of that debt, the relief is treated as cash received, which can create a taxable event even when no actual money changes hands.

The formula is simple, and the stakes for getting it wrong are not: taxable gain equals total amount realized (cash plus debt relief plus the value of any property received) minus outside basis. Every dollar of underestimated basis inflates the gain, and every dollar of overestimated basis creates an underreporting problem with the IRS.

Sale of Interest vs. Redemption

The tax outcome for everyone involved depends on which of two structures the parties choose. Each produces different reporting requirements, different basis consequences for buyers, and different deduction opportunities for the LLC. The operating agreement should address the choice, but it’s often negotiated at the time of the buyout.

Sale of Interest

In a sale of interest, the departing member sells directly to one or more remaining members or to an outside buyer. The LLC is not a party. Cash moves from buyer to seller, the seller reports gain or loss on the sale of a partnership interest, and the buyer takes a cost basis in the acquired interest equal to what they paid.²

The LLC’s balance sheet isn’t directly affected, which keeps things simpler for the entity. But a mismatch between what the buyer paid and the LLC’s internal asset values can create problems down the road, particularly if no Section 754 election is made.

Redemption by the LLC

In a redemption, the LLC itself buys out the departing member’s interest using entity funds, assets, or borrowed money. The member’s interest is completely liquidated. Payments follow a separate set of rules under Section 736, which splits them into payments for partnership property and “other payments” that may be ordinary income to the seller and deductible by the LLC.³ That split is where most of the planning opportunities live, and it’s also where audits tend to focus.

What the Selling Member Owes

Capital Gain Is the Default, With a Big Exception

Gain from the sale of a partnership interest is treated as capital gain.² Held for more than a year, the gain qualifies for long-term rates topping out at 20% for most taxpayers, a significant advantage over ordinary rates that run as high as 37%.

Section 751, the “hot asset” rule, swallows a large part of that benefit for many LLCs. It forces the seller to treat any portion of the proceeds tied to certain LLC assets as ordinary income rather than capital gain.⁴ The recharacterization applies whether the buyout is a sale or a redemption.

Hot Assets Under Section 751

Two categories of assets trigger the rule. The first is unrealized receivables, which for most LLCs means accounts receivable a cash-basis business hasn’t yet reported as income. The definition is broader than most people expect: it also includes the ordinary income that would be recaptured if the LLC sold its depreciable equipment at fair market value. That depreciation recapture component is what makes Section 751 so aggressive.

The second category is substantially appreciated inventory, meaning assets held for sale to customers whose fair market value exceeds 120% of the LLC’s adjusted basis in those assets.⁴ The purpose of both categories is the same: prevent a departing member from converting what would have been ordinary business income into lower-taxed capital gain just by selling the interest instead of waiting for the LLC to collect or sell.

To calculate the Section 751 portion, the seller determines what their share of ordinary income would have been if the LLC had sold every hot asset at fair market value immediately before the buyout. That hypothetical ordinary income gets carved out of the total gain and taxed at ordinary rates. The remaining gain keeps its capital character. The LLC is required to provide enough asset data for the seller to perform this calculation.

Depreciation Recapture

Depreciation recapture surprises more sellers than any other hot asset. If the LLC owns equipment, vehicles, or other depreciable property, every dollar of depreciation previously claimed by the members would become ordinary income if the LLC sold those assets at a gain.⁵ The seller’s share of that built-in recapture is treated as an unrealized receivable under Section 751 and taxed as ordinary income in the year of the buyout.

LLCs that used Section 179 expensing or bonus depreciation often have significant built-in recapture, because the entire cost of the asset was deducted upfront while the asset still holds substantial market value. A member who enjoyed those large deductions in prior years pays for them at ordinary rates when they sell.

Debt Relief and Phantom Income

When a departing member is relieved of their share of LLC debt, the tax code treats that relief as a cash distribution equal to the debt amount.⁶ The deemed distribution increases the total amount realized on the sale, which increases the gain.

The dangerous scenario arises when the debt relief exceeds the member’s outside basis. The excess is taxable gain, even though the seller never received cash to cover it. If a member’s share of LLC mortgage debt is $200,000, outside basis is $150,000, and the buyout price is zero because equity is negligible, the member still recognizes $50,000 of taxable gain. This phantom income problem is most common in real estate LLCs with heavily leveraged properties, and it is one of the most common causes of unpleasant surprises at tax time.

When the Buyout Produces a Loss

If the amount realized is less than outside basis, the seller recognizes a loss. That loss is generally a capital loss, which can only offset capital gains plus up to $3,000 of ordinary income per year ($1,500 if married filing separately).⁷ Any excess carries forward. If a portion of the loss is attributable to hot assets, that portion is treated as an ordinary loss, which is more valuable because it can offset any type of income without the annual cap.

How Section 736 Splits Redemption Payments

When the LLC redeems a departing member’s interest, Section 736 divides the payments into two buckets with fundamentally different tax treatment. Payments for the member’s share of LLC property (the Section 736(b) bucket) are treated as a distribution. The departing member recognizes capital gain only to the extent the distribution exceeds outside basis, which often means little or no immediate tax on this portion.

Everything else falls into the Section 736(a) bucket and is treated either as a guaranteed payment or as a distributive share of LLC income.³ Either way, the departing member reports it as ordinary income. The advantage for the remaining members is that guaranteed payments are deductible by the LLC, directly reducing their taxable income. This creates a built-in tension in negotiations: the seller wants more in the 736(b) bucket (capital gains), while the remaining members want more in the 736(a) bucket (deductions).

The Goodwill Question in Service Partnerships

Where goodwill falls in the Section 736 split depends on two things: what type of business the LLC operates, and what the operating agreement says. For service-oriented LLCs where capital is not a material income-producing factor (law firms, consulting practices, accounting firms), payments for goodwill and unrealized receivables are pushed into the 736(a) bucket unless the operating agreement specifically provides for a payment for goodwill.³ That means ordinary income for the seller and a deduction for the LLC.

For capital-intensive LLCs (manufacturing, real estate, retail), goodwill payments are Section 736(b) payments by default, giving the seller capital gain treatment but providing no deduction for the remaining members. The operating agreement’s treatment of goodwill is therefore one of the most consequential provisions in any LLC buyout. A service partnership that wants to give the departing member capital gain treatment on goodwill must explicitly provide for goodwill payments in the agreement. A reasonable valuation set by an arm’s-length negotiation is generally accepted by the IRS.⁸

What the Buyer and Remaining Members Should Know

The Section 754 Election After a Sale of Interest

When one member buys another member’s interest, a common problem emerges: the buyer paid fair market value, but the LLC’s internal records still show the old, lower basis in its assets. Without an adjustment, the buyer will eventually be taxed on gains that economically belonged to the seller.

The fix is the Section 754 election, which the LLC files to allow a special basis adjustment under Section 743(b). The adjustment applies only to the purchasing member and aligns their share of the LLC’s asset basis with what they actually paid.⁹ In practice, this typically means higher depreciation deductions for the buyer or smaller gains when the LLC later sells assets.

The election is usually optional, but it becomes mandatory when the LLC has a “substantial built-in loss,” meaning the total basis of LLC assets exceeds their fair market value by more than $250,000, or the transferee would be allocated more than $250,000 in losses if the assets were sold at fair value.¹⁰

The tradeoff is administrative burden. Once filed, the election applies to all future transfers and distributions, requiring the LLC to maintain separate basis accounts for every member. Revoking requires IRS permission through Form 15254, and the IRS will deny a revocation request if the primary purpose is avoiding a downward basis adjustment.¹¹ Smaller LLCs sometimes skip the election to avoid the bookkeeping, but the buying member should understand the tax cost of that decision before agreeing.

Section 734 Basis Adjustments After a Redemption

When the LLC redeems a partner’s interest and the departing member recognizes gain or loss on the distribution, the LLC may need to adjust the basis of its remaining assets under Section 734. This adjustment is not automatic in most cases. It requires either an active Section 754 election or a “substantial basis reduction,” defined as a discrepancy exceeding $250,000 between the distribution’s basis consequences and the LLC’s asset basis.¹² When it does apply, the adjustment benefits the continuing members by realigning the LLC’s asset basis with economic reality.

Extra Taxes That Can Apply

Net Investment Income Tax

High-income sellers face an additional 3.8% Net Investment Income Tax on their gain from the buyout. The surtax applies to individuals with modified adjusted gross income above $200,000 (single) or $250,000 (married filing jointly).¹³ The NIIT applies to gains from the sale of a partnership interest to the extent the seller was a passive owner. Members actively involved in managing the business may be able to exclude some or all of the gain, but the determination depends on the seller’s specific level of participation.

Self-Employment Tax on Section 736(a) Payments

Section 736(a) payments classified as guaranteed payments or distributive shares may be subject to self-employment tax, which adds up to 15.3% on top of income tax. The rules for LLC members are notoriously unclear. The statute excludes a “limited partner’s” distributive share (other than guaranteed payments for services), but the IRS has never issued final regulations defining whether LLC members qualify as limited partners for this purpose.¹⁴

Under proposed regulations from 1997 that were never finalized but that the IRS has said it will respect, an LLC member is generally treated as a limited partner unless they have authority to contract on behalf of the LLC, have personal liability for entity debts, or participate in the business for more than 500 hours per year. Members of service-oriented professional LLCs are excluded from limited partner treatment entirely under those proposed rules. The practical effect: departing members of service LLCs should expect self-employment tax on their Section 736(a) payments, while passive investors in capital-intensive LLCs have a stronger argument for exclusion.

When It’s a Two-Member LLC

If one member of a two-member LLC buys out the other, the partnership terminates entirely, because the entity can no longer exist as a partnership with only one owner. The LLC becomes a disregarded entity for tax purposes. Revenue Ruling 99-6 sets out the IRS’s position on how this works.¹⁵

The seller’s treatment is simple: report a sale of the partnership interest and calculate gain or loss the same way as any other buyout. The buyer’s treatment is more complex. The IRS treats the transaction as if the LLC made a liquidating distribution of all assets to both members, and the buyer then purchased the assets that were distributed to the seller. The buyer ends up with two different basis layers: a cost basis equal to the purchase price for the seller’s share, and a carryover basis from the liquidating distribution for their own former share.

Holding periods split the same way. For assets attributed to the purchased interest, the buyer’s holding period starts the day after the sale. For assets attributed to the buyer’s original interest, the holding period includes the time the LLC held those assets.¹⁵ This dual-basis, dual-holding-period framework makes the buyer’s recordkeeping considerably more involved than a standard asset purchase.

Installment Payments

Many buyouts are paid over several years rather than in a lump sum. When at least one payment is received after the close of the tax year in which the sale occurs, the transaction qualifies as an installment sale under Section 453.¹⁶ The selling member can spread the capital gain portion across the payment period, which significantly improves cash flow compared to recognizing the entire gain upfront.

The seller calculates a gross profit percentage (total gain divided by total contract price) and applies that percentage to the principal portion of each payment received during the year. The result is reported on Form 6252.¹⁷ Interest received on the note is reported separately as ordinary income. The installment method applies automatically unless the seller elects out by reporting the full gain in the year of sale.

Hot Asset Income Cannot Be Deferred

Ordinary income attributable to Section 751 hot assets and depreciation recapture must be recognized in the year of the sale, even if no cash payment covers it.¹⁶ Only the capital gain portion qualifies for installment reporting. This creates a cash-flow mismatch: the seller owes tax on ordinary income in year one while the actual payments may trickle in over five or ten years. Sellers need to budget for this upfront tax bill, and buyers should understand that the seller’s willingness to accept installment terms depends partly on how large the hot asset component is.

Minimum Interest Rate on the Note

The installment note must charge interest at or above the IRS’s Applicable Federal Rate (AFR) for the month of the sale. If stated interest is too low or absent, the IRS will recharacterize part of each principal payment as imputed interest, which converts capital gain into ordinary income for the seller and changes the buyer’s deduction timing.¹⁷ The AFR varies by the term of the note and is published on the IRS website before the beginning of each month.

Reporting the Transaction

The LLC has its own reporting obligations when a buyout involves hot assets. It must file Form 8308 to report any sale or exchange of a partnership interest where part of the payment is attributable to unrealized receivables or inventory.¹⁸ Form 8308 is attached to the LLC’s Form 1065 for the tax year that includes the date of the exchange.

The LLC must also furnish copies of Form 8308 to both the seller and the buyer by January 31 of the year following the exchange.¹⁹ If the LLC discovers the exchange after it has already filed its return for the year, it must file Form 8308 with an amended return within 30 days of learning about the transaction. Failure to file can result in penalties, and because Form 8308 signals the presence of Section 751 assets, its absence is something the IRS actively looks for when reviewing partnership returns.

The selling member reports the transaction on Schedule D and, if applicable, Form 4797 for the ordinary income portion. If installment payments are involved, Form 6252 is filed each year a payment is received.²⁰ Section 751 gain must be properly separated from capital gain, and mischaracterizing ordinary income as capital gain is one of the more common triggers for partnership audit adjustments. The seller should retain the LLC’s asset data supporting the hot asset calculation for at least as long as the statute of limitations remains open on the year of the sale.

1
Internal Revenue Service. Partner’s Outside Basis
2
Office of the Law Revision Counsel. 26 USC 741 – Recognition and Character of Gain or Loss on Sale or Exchange
3
Office of the Law Revision Counsel. 26 USC 736 – Payments to a Retiring Partner or a Deceased Partners Successor in Interest
4
Office of the Law Revision Counsel. 26 USC 751 – Unrealized Receivables and Inventory Items
5
Office of the Law Revision Counsel. 26 USC 1245 – Gain From Dispositions of Certain Depreciable Property
6
Office of the Law Revision Counsel. 26 USC 752 – Treatment of Certain Liabilities
7
Internal Revenue Service. Topic No. 409, Capital Gains and Losses
8
eCFR. 26 CFR 1.736-1 – Payments to a Retiring Partner or a Deceased Partners Successor in Interest
9
Office of the Law Revision Counsel. 26 USC 754 – Manner of Electing Optional Adjustment to Basis of Partnership Property
10
Office of the Law Revision Counsel. 26 USC 743 – Special Rules Where Section 754 Election or Substantial Built-In Loss
11
Internal Revenue Service. FAQs for Internal Revenue Code (IRC) Sec. 754 Election and Revocation
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Office of the Law Revision Counsel. 26 USC 734 – Adjustment to Basis of Undistributed Partnership Property Where Section 754 Election or Substantial Basis Reduction
13
Internal Revenue Service. Questions and Answers on the Net Investment Income Tax
14
Internal Revenue Service. Self-Employment Tax and Partners
15
Internal Revenue Service. Internal Revenue Bulletin 1999-06 – Revenue Ruling 99-6
16
Office of the Law Revision Counsel. 26 USC 453 – Installment Method
17
Internal Revenue Service. Topic No. 705, Installment Sales
18
Internal Revenue Service. About Form 8308, Report of a Sale or Exchange of Certain Partnership Interests
19
Internal Revenue Service. Instructions for Form 8308
20
Internal Revenue Service. About Form 6252, Installment Sale Income