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Sale of business interests can trigger surprise tax result

Did you know that if more than 50% of the interests in a partnership or a multi-member LLC are transferred within a 12-month period, the entity technically ceases to exist under federal tax law?

That’s true even if the business continues to operate as normal for all other intents and purposes.

This “technical termination rule” isn’t the end of the world, but it’s something you need to be aware of. For one thing, a special tax return is due within a few months after the “termination” occurs. Recently, one family business was hit with more than $12,000 in IRS penalties and interest because the family didn’t realize they needed to file such a return.

The partnership or LLC must also make new federal tax elections and start over with new depreciation periods – which can significantly reduce tax write-offs. And if the business operates on a fiscal year, the owners might end up having to report more than 12 months’ worth of taxable income in the year the termination occurs.

A technical termination can happen even if partial sales occur in different calendar years. So if 25% of a business’s interests are transferred in September 2014 and another 25% are transferred in July 2015, that still counts as a sale of 50% of the business in a year.

A termination can also happen if a multi-member LLC becomes a single-member LLC – even if less than 50% is transferred. So if an LLC has two members, one with an 80% interest and one with a 20% interest, and the majority owner buys out the other owner, that’s still a termination according to the IRS.

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