payments to former LLC member the year after the LLC is sold

[DTNY07]

I have a new LLC client (multi member and it is taxed as a partnership).  Two partners.  In 2020,  they had bought  LLC that they both previously worked for.  It is an architecture firm.   One of those two partners was an individual client of mine for about 15 years

Anyway, in 2020, it was just one of these 2 partners as 99% owner and the two partners that were bought out as .05% owners.   Even though I did  quarterly estimates for 2021, I had no idea that they were still paying out to the two previous owners of the LLC from when they bought it.

The prior .05% partners did not have their 2020 K-1s marked as final.  Didnt realize that until today.  Their capital accounts were zero, but it still had an ending capital percentage of .05% at the end of 2020.

So, my questions are:

How does the $60,960 in payments to the prior partners get treated.  In 2020 it was guaranteed payments.  Which made sense as they were still partners.  But now in 2021 they wouldn't be.  Unless that is why the 2020 K-1 wasn't marked as final and I am still supposed to issue a K-1 with the $60,960 as guaranteed payments, but no other activity on the K-1.  

Or do I issue a 1099 to that partner?  I don't think it would be a 1099-NEC.   Maybe Box 3 on a 1099-MISC?

I asked them now for a copy of the sale.  So I can see if it has a breakdown of what they paid for.  Mainly to see if part or all of these are Section 736 (b) payments.  I assume they paid something for the assets and something for the clients.   So it may be a combination of Section 736 (a) and Section 736 (b).  There is nothing on the 2020 K-1s to the outgoing partners that make it look like there was a sale.  Nothing on Box 9c or Box 10 of the K-1

I feel like a dope for not realizing they were still paying the old partner in 2021.  But, when i did the estimates, I just had a P+L Total, not a P+L detail where  I would have then probably noticed a category for this.

Any help on this = I greatly appreciate it 

[DTNY07]

I realize now that I need more information.  I asked the client for a copy of the sale agreement and the partnership agreement.  As you can see, I haven't dealt with any sales of partnership interests before as I am clueless.  While I do have partnership returns, most of the time when they are done, it is the entire business ceasing operations (and not a sale, just going out of business).

[qbteachmt · Accepted solution]

You need to refer to the Sale Date. That way, you can determine if you have partner payments or installment payments for the sale.

Payments after the sale date, from the LLC, are not to a partner. They are on behalf of the partners that exist in the new relationship, and that means they would be considered as personal taking, used to make a payment that is outside of the LLC. The LLC didn't sell itself, in other words.

The new partners can use the resources from their LLC for any personal thing they want to, including to pay for their ownership in the LLC because they didn't already pay for it personally, but are making payments. Or, to buy a boat. Or, for a vacation.

Perhaps the sale documents includes an accrued AR, and those payments are representing that carry over, such as:

I sell you a business with AR yet to be collected, and you will pay me over two years as that AR comes is, up to an amount we agree on (giving you consideration for value over time, noncollectables, and a discounted rate for your time and efforts to collect).

Perhaps the sale document includes Customer Prepayments, and until that work is done and the funds are released, the LLC is sitting on client money. This is like selling a property management firm with tenant prepayments in trust. When you sell that type of business, you have to evaluate whose money is on hand and why, as to an Asset or a Liability, against work to be performed or funds to be refunded. This also will vary by State. In my State, architects do not have to maintain prepayments in trust, but you sure would not want to sell the practice and not also deal with customer prepayments in that sale agreement. You might have some really mad customers, when you tell them, Sorry, your money went with the previous owner, so we need to be paid in full and don't have your retainer to apply.

[DTNY07]

I would love to give you 5 cheers for this answer.  I never would have thought of that, but yes, the current two partners weren't partners when this sale/transfer took place.  So, the first paragraph that you wrote makes sense to me now.

I still haven't received the sale documents.  I assume they will send it on Monday as they are usually quick to respond during their normal business hours.

There aren't any receivables listed on the 2020 Partnership return

I have no idea how the two prior partners recorded the sale during 2020 on their personal return.  As they aren't clients of mine.  But, does this mean that that they don't receive K-1s or a 1099 for 2021?  

I don't know yet how it is listed in the sale agreement.  But the old partners were paid $60,960.  They were thinking they were receiving 1099s, which is why i made my original post yesterday 

[qbteachmt]

"But, does this mean that that they don't receive K-1s or a 1099 for 2021?"

The old partners are no longer owners of the entity on the Sale date and afterwards.There is no K-1 for the people who sold. You might have a short year, though. You need to know the date of the sale.

You have to know why the payments are being made. Was the sale paid in full at that point of the sale? Is debt for the purchase? AR? It could even be Both events.

"They were thinking they were receiving 1099s,"

1099-What? You would never get a 1099-anything from your own entity. So, sure, they could be expecting a reporting form. But, reporting What?

[DTNY07]

I didn't think there would be a 1099 issued (for the reason you mentioned), so that I agree with.  I don't deal with the former partners, but they had posed that question to the two new partners.  The K-1 = I thought depending on how the wording of the sale agreement was, they could still have it as guaranteed payments.  Just no other activity. That and the prior CPA didn't mark their K-1s as final (which confused me).  But, reading your response, your reasoning is correct and makes sense to me now.      I was off base with my reasoning for asking it.  Thanks for your help.  

The date of sale was definitely 2020.  The new partner that was already a client of mine told me about it before it was happening.  I should have asked for the sale agreement when i did the first quarterly estimates during June 2021.  

So I guess then it is up to the previous partners to report everything correctly on their 2021 personal returns.  I don't know what they did in 2020, nor should I care as I am not their CPA.  Part of the reason for my original question was did I need to issue anything in 2021 from the LLC to the 2 previous partners.

[qbteachmt]

You stated it's still the same entity. There would be continuity of tax returns for the entity, then. Just because there are old partners, there still would be no break between tax returns, but that's why I brought up the consideration of a short (or allocated) year.

You cannot get Guaranteed Payments from something you do not own. You are not entitled to that, unless you own it. You can get paid for other reasons (lender, employee, service provider, sales, etc). Maybe the prior CPA wasn't given the full story.

"when i did the first quarterly estimates during June 2021."

Estimate of what?

"I guess then it is up to the previous partners to report everything correctly on their 2021 personal returns."

There might be some required reporting on your taxpayer's part as a result of whatever this activity is (on 1065, on 1040), but don't mix perspectives.

"did I need to issue anything in 2021 from the LLC to the 2 previous partners."

Maybe. Perhaps your taxpayer is supposed to have something from 2020?

[DTNY07]

Estimates = I had the two "new" partners pay personal income tax on their estimated share of the profits/ guaranteed payments on the 2nd, 3rd and 4th quarters.  They didn't need any in the 1st quarter.  So the first estimates I did were for 6/15.  This is based in NYC, so there were also the UBT estimates.

Understood about the guaranteed payments.  The prior CPA = you are right, maybe he/she didn't have all the information and that is why the K-1s weren't marked as final and they still had an ending percentage

Yes, I do realize there may be something for me to report on the partnership return.  Once they send me the sale agreement, I should be able to figure that out.  

The point you made about the taxpayer maybe having had to receive something during 2020 = that crossed my mind when you answered my last response.  Figured the same thing, the sale agreement will hopefully have that information.  I mistakenly thought the guaranteed payments in 2020 were towards that.  But as you already pointed out, no guaranteed payments to them at the point they were no longer owners

I really appreciate you answering all of this.  I don't ask many questions on here. But this is one time where one person has really gone above and beyond on here for me.  I do come on here sometimes to see if i can answer questions.  I need to do that more often

[qbteachmt]

No problem. Come on back and update us when you get your details; especially if that helps you resolve the various issues we are thinking through, now. That way, I can vacation without any concerns, later 🙂

[DTNY07]

A sense of humor I see.  I figure they will send me what I need tomorrow (as I replied to them Friday evening and they would be closed on the weekend).  I normally am closed Sunday, but am in today, as I had to take off Monday instead. So hopefully when i come in Tuesday, I will have the sale document.

[DTNY07]

They don't have a sale agreement  (which surprised me).  They said they paid for the client base/ goodwill only, no physical assets.

I guess these weren't   Section 736 A payments as they aren't guaranteed payments.  Since the sale of the partnership interest was during 2020, there can't be guaranteed payments in 2021 to those partners as they were gone by the end of 2020.  

So, it is Section 736 B with goodwill being the asset.  Which means it is a capital gain/loss between those payments and their basis.  I don't know what those partners recorded in 2020.  Nor, am i doing their personal return for 2021.  But, does anything get issued to them in this case.  Or should they just know what to have filed based on the 2020 K-1 that was issued to them

[qbteachmt]

"Or should they just know what to have filed based on the 2020 K-1 that was issued to them"

Okay, no surprise; I am a bit lost as to which "they" this is. The old partners or the new partners got this 2020 K-1? Or, all of them? “Anyway, in 2020, it was just one of these 2 partners as 99% owner and the two partners that were bought out as .05% owners.”

As of When? They don’t get to skip on having a Date of ownership change. What about the Secretary of State? E&O Insurance changeover? AIA?

So, it was a three-person partnership and now it is two, and your client bought out the minor 2 people at .5% each = 1%? Or, there were two terminating partners, their 1% rolled back to what would now be the Sole Proprietor, and he decided to let your client "buy in?" See how that is different?

"as they were gone by the end of 2020"

Then they have nothing to do with 2021.

"They said they paid for the client base/ goodwill only, no physical assets"

?

“$60,960” That’s a LOT for a customer list and no assets. And they didn’t need to buy the list of that LLC, because you told us: “they had bought  LLC” with one existing partner still a partner and the entity still is the entity. It already owns that list. Or, another perspective: your taxpayer client paying nearly $70,000 for a 1% stake in the partnership means the partnership valuation is $6 million?

An architectural firm is going to have lots of equipment, computers, plotters, and AutoCAD is an asset. Office equipment, web presence, space lease, ongoing contracts with clients? Calling those projects "client base" is fine, but what about prepayment deposits, and unpaid invoices? And you should have some sort of partnership document that shows the change of partners, the percentages, and the ownership purchase date for your client.

Is this what happened: the business was dead. The 2 old partners wanted to walk away. One or both wanted to be paid as if they had Salary yet to collect?

LLC is the Entity. Architecture is the Business. These are not synonyms. The one is the Operations (architectural firm) and there is an Entity that is the legal construct (LLC, or everyone else is an employee and works for the one Sole Proprietor; or, an S Corp).

Tell them you can't make a tax return out of thin air. Someone is doing a 1065, and you get that person's K-1 to use for their 1040. If you have to put up a firewall, that is where you draw the line, I guess. If you are doing the 1065, it appears you have a problem. You might need to rope in a local to help mentor you all through this process; perhaps a tax attorney, because there seem to be some overlooked legal issues.

Yes, there could be a 1099-Int required. Hard to tell. I'm doing my best to give some perspective, not by going from what people are stating, but translating into, "Is this what that means?"

This is not an issue of how to use ProSeries.

[DTNY07]

After I looked into it further, there are net depreciable assets on the balance sheet of over $100,000.  So this can't all be goodwill.  one of the current partners reached out to the prior CPA and he said it was ok to contact him.  I just sent an email.   Thanks for your prior help.  

[qbteachmt]

Thanks for the follow up, but this fits right in with my other comments:

"there are net depreciable assets on the balance sheet of over $100,000"

Doesn't apply. So far, your taxpayer didn't buy anything not already owned by the LLC, which is what they bought into. LLC details won't matter. There is no separation or price to establish for tangible and intangible assets, if I buy your LLC from you. Everything comes with it, and the LLC has not changed. The ownership is different, but the LLC just carries on.

That's why I made the remark for valuation: "your taxpayer client paying nearly $70,000 for a 1% stake in the partnership means the partnership valuation is $6 million?" Not buying Assets. Not buying Goodwill. Buying a proportional ownership of a partnership. The LLC is not selling off its parts.

[DTNY07]

It is not for a one percent ownership.  It was for 100%.  The transfer was late in 2020. 1st payment wasn't until 2021.  I thought I had written that somewhere  previously.  But I hadn't.   I also asked if they still owe more payments during 2022.    

[qbteachmt]

"It was for 100%."

I keep rereading this and I am sorry, but I am so confused. You first told us: "it was just one of these 2 partners as 99% owner and the two partners that were bought out as .05% owners"

And:

"The prior .05% partners did not have their 2020 K-1s marked as final."

And so now, instead of thinking you had the decimal incorrect (100% minus the individual person owning 99% = 1%), what you might have meant is:

"There were two previous partners still in the partnership and still have these minimal % ownership for 2020 and got their guaranteed payments and their K-1."

Because in that case, they would be Partners, still unless they sold in 2020.

And, in 2021, they were getting some sort of payment? And their participation is whatever it is based on their relationship to the LLC (unless they sold their portion or forfeited it?), and there is no notation for why they are getting over $60k in 2021?

Your title includes: "the year after the LLC is sold"

Which sure led me to understand: "Two partners. In 2020, they had bought LLC that they both previously worked for."

So, to cut to the chase: Anyone who bought the LLC, gets everything with it. Because this sale does not change or affect the LLC. It's like musical chairs. The people in the chairs, might have changed. The LLC is like the Room, and the room did not change. No one bought the chairs, the piano, etc, and carried them out to do business with them elsewhere.

So, going back to: "But now in 2021 they wouldn't be. Unless that is why the 2020 K-1 wasn't marked as final and I am still supposed to issue a K-1 with the $60,960 as guaranteed payments, but no other activity on the K-1."

Well, someone needs to know why they kept getting money. Someone needs to know what happened to their ownership position.

"Or do I issue a 1099 to that partner?"

You cannot use that word "Partner" and "1099" because you don't get a 1099 from your own entity, unless there is a separate business you are conducting or a separate entity and the two entities have done some reportable business between them. Such as, the LLC is paying interest on debt to that person as a lender, and that is 1099-Int. Or, the LLC is renting equipment or an office space and that would be reportable on 1099-Misc.

Sometimes too much information really is too much information. You will need to learn about 2020, take everything sequentially, follow what appears to be loose ends, and then 2021 should make more sense.

[DTNY07]

I spoke to the prior CPA.  He said there should have been an agreement.  But the prior owners didn't want one.  That right there = ugh.  But they aren't my clients, so can't do anything about that.  The .05% was left for each of the two outgoing partners, because the 2nd new partner wasn't coming aboard as a partner until 1/1/21.  The 1099-NEC that was mentioned was because they did $3,000 of service work for the LLC during 2021.  Had nothing to do with them being prior owners.  The new owners did mention that they did some work after I had started this thread, so that part makes sense.  No guaranteed  payments to the old partners (which you had already mentioned). He also mentioned it was all goodwill, nothing in assets bought.   So there is nothing for me to issue to the outgoing partners other than the 1099-NEC for the work done.  I know some of this (especially no sale agreement) shouldn't have been done this way.  Thanks for your help with this. I will mark it solved now,

[taxiowa]

The Arrowsmith Doctrine might apply here.  That doctrine holds that payments to ex-stock holders or ex-partners treat subsequent payments as they treated their original sale.  Which would most likely be a capital gain or loss.  So then these payments would be considered capital gains.

https://en.wikipedia.org/wiki/Arrowsmith_v._Commissioner

And if that is not the right Aerosmith, then try this

https://www.google.com/search?client=firefox-b-1-d&q=aerosmith+sweet+emotion&stick=H4sIAAAAAAAAAONgF...

[qbteachmt]

"He also mentioned it was all goodwill"

There is No Sale of Goodwill. The only thing you seem to have is that the leaving partners either abandoned or sold their portion. Nothing is sold regarding the LLC.

The only "something" that took place is between people. Someone bought or sold their portion to the other person who remained, who later sold some of their portion to the new people that came on board.

You have to stop trying to have something affect the LLC goodwill, assets, etc. Nothing happened to that LLC. It carried on, every day, the same as before.

Your person simply has a new ownership position (investment) in the LLC and the 1065 should reflect it.

You don't send the 1099-NEC unless you are preparing the LLC 1065. Or, working for the LLC.