Reduced Interest LLC Member Negative Capital Account

[Mike]

Looking for a sanity check here. Any other ideas appreciated.

Year 1:
LLC has 4 members each with negative capital accounts from
losses allocated in the prior year. LLC has sufficient
liabilities for partners to have enough basis to deduct the
losses on their individual returns.

Year 2:
One of the members moves on but retains a 3% ownership
interest. He is no longer allocated profits or losses. He
will receive an interest in a successor company if and when
the LLC is acquired, goes public, or other.

Question:
The member's share of liabilities is now zero and his
capital account is negative. The LLC has no capital account
restoration provision. On the surface, I'm thinking the tax
consequences are:

* The member's reduction in share of liabilities is an
effective distribution that reduces his tax basis (below
zero until the next bullet)

* For the prior year's allocations to have substantial
economic effect, this partner, since he will NEVER be
allocated income again in the future, must be allocated
enough income via qualified income offset in year 2 to
restore his capital account to zero.

Other Options:
Any help appreciated??

 

[Thomas Healy]

Looking for a sanity check here. Any other ideas appreciated.

Year 1:
LLC has 4 members each with negative capital accounts from
losses allocated in the prior year. LLC has sufficient
liabilities for partners to have enough basis to deduct the
losses on their individual returns.

Year 2:
One of the members moves on but retains a 3% ownership
interest. He is no longer allocated profits or losses. He
will receive an interest in a successor company if and when
the LLC is acquired, goes public, or other.

Question:
The member's share of liabilities is now zero and his
capital account is negative. The LLC has no capital account
restoration provision. On the surface, I'm thinking the tax
consequences are:

* The member's reduction in share of liabilities is an
effective distribution that reduces his tax basis (below
zero until the next bullet)

* For the prior year's allocations to have substantial
economic effect, this partner, since he will NEVER be
allocated income again in the future, must be allocated
enough income via qualified income offset in year 2 to
restore his capital account to zero.

He needs to look at Form 6198 and Pub 925. When basis drops
below zero and he had prior year losses, he has income
recapture that is reported on Line 21 of the Form 1040. The
LLC does not have to distribute any income to him.

 

[Mike]

Thanks for your feedback Tom. We ended up specially
allocating gross revenue to the partner until his capital
account reached zero. Unfortunately, this created ordinary
income to the partner. But, this seems appropriate since
his deductions last year offset his other ordinary income.
The other members now aren't faced with having to absorb
this guy's negative capital account and get the benefit of
additional allocated losses in 2004.