What triggers a “technical termination” of a business for tax purposes according to the IRS?
If more than 50% of the interests in a partnership or a multi-member LLC is 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.
A technical termination can occur even where partial sales occur in different calendar years. So if 25% of a business’s interests is transferred in September 2014 and another 25% are transferred in July 2015, this would still count as a sale of 50% of the business in a year.
A termination can also occur 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.
This “technical termination rule” is not the end of the world for a business, but it’s something to be consider and address with proper paperwork. For example, a special tax return is due within a few months after the “termination” occurs. Recently, according to public IRS cases, one family business was hit with more than $12,000 in IRS penalties and interest because the family did not realize they needed to file their “special return.”
The partnership or LLC undergoing a transfer or sale 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.
So, the obvious lesson here is be sure to consult with your CPA before closing on a sale or transfer of a portion of your business.
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