Generally, the LLC and its members do not recognize gain or loss on a distribution of cash or property. Gain or loss would only be recognized when deferral is impractical or when it would result in a change of character. It is extremely important to have an LLC Operating Agreement so that the manner in which cash will be distributed to the members is well documented.
Internal Revenue Code Section 731 provides for nonrecognition of gain or loss to all parties when LLC property or money is distributed. In the case of a cash distribution, the distributee simply reduces his/her outside basis by the amount of money received, preserving any inherent gain or loss in his/her LLC interest. A member’s initial outside basis equals the amount of cash the member contributes to the LLC, the basis the member had in any property contributed, and the member’s share of the LLC’s debt.
In the case of a property distribution, the distributee’s outside basis is allocated among both the property or properties received and his/her continuing interest in the LLC (if any). Any pre-distribution inherent gain or loss in the distributee’s LLC interest is preserved either in the property received or in his/her continuing interest in the LLC. Gain or loss is recognized only when deferral is impractical or would change the character of income or loss.
RECOGNITION OF GAIN
Distributions generally trigger a gain if a member receives a distribution of money in excess of his/her outside basis or when an LLC with “hot assets” makes a non-pro rata distribution. In general, “hot assets” are defined as unrealized receivables or inventory of the LLC. However, when an LLC distributes property to a member, the inherent gain or loss in the member’s interest can be preserved by adjusting the basis of the distributed property.
RECOGNITION OF LOSS
A member recognizes a loss only in a liquidating distribution, and then only under certain circumstances. A loss is never recognized in a current (non-liquidating) distribution. In a situation where a liquidating distribution consists only of cash, unrealized receivables and inventory, the distributee will recognize a capital loss if his/her outside basis exceeds the sum of money distributed plus the basis he/she takes in the distributed property. This is because, in this situation, the distributee receives no capital asset in which to defer the loss.
For example: Steve has an outside basis of $150 in his LLC interest. In a liquidating distribution, Steve receives $75 cash and accounts receivable with a basis and value of $50. Steve has sustained a $25 loss from the LLC interest. The loss cannot be deferred in the cash, but could be deferred by giving Steve a basis in the accounts receivables of $75. This would produce a $25 ordinary loss when the receivables are collected. To prevent Steve from converting his capital loss into an ordinary loss, Steve is required to recognize the capital loss at the time of the distribution.