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I founded a startup in late 2008, as a sole proprietorship LLC. I was the only member in the LLC. It stayed that way until August of 2011, less than a year ago, when I added a minority partner to the LLC. An Operating Agreement was put in place then (August 2011) describing the membership units held by each partner.

If I were to sell my company outright today, that is, sell the membership units together with my partner, would I be taxed for short term or long term capital gains for my portion of the membership units? I've been the owner of the company since 2008, so well over a year, but the actual membership units weren't defined until August 2008, less than a year ago.

My confusion is this: I've been the owner of the company for over three years, so it seems like I would be taxed at the long term capital gains rate (15% I believe). But since the membership units weren't defined until less than a year ago, would it actually be the short term rate? Thanks.

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Assuming that you never put anything new into the business, then any profit you made in the current tax year is taxed as income, and the rest is all long-term capital gains. (But, see caveat below).

The easy part is that going from a disregarded entity to a partnership doesn't change the amount of tax you pay -- you had some basis in what you contributed, and that basis carried on when you added the partner. An LLC membership interest is a different beast than a share of stock -- you didn't really 'acquire' it when you added the partner; you had it before you added the partner.

The hard part is figuring out the tax. Here's why:

Let's say that up until August 2011, the LLC made a total of $100,000 in profit, but you never took any of the money out -- instead, you used it to buy equipment that stayed in the LLC. You, personally, paid tax on that $100,000. So, you don't pay tax on that again.

In a nutshell, you add what you put into the LLC and your share of LLC profits, subtract your share of LLC losses, subtract out any distributions you took from the LLC, and that's your tax basis. Subtract that basis from the selling price and you have your gain. (See http://www.mmmlaw.com/media-room/publications/articles/federal-income-taxation-of-llc-members ) for an explanation of all this.

Ok, that said, you're talking about partnership taxation issues here, and partnership tax is a tricky area of the tax code. The IRS has rules to try to keep people from treating income as capital gains and, depending on what your business does, you may run into those rules. The take away: See an accountant. You're going to want one anyway just to file your taxes.

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Hi Chris, thanks for the answer. (I'd upvote, but I don't have enough rep it seems.) I am planning to see an accountant, I was just hoping to get a general idea for a potential deal. Just to clarify, in your above paragraph, when you say "Subtract that basis from the selling price and you have your gain" does this imply that whatever's left after this subtraction is considered a capital gain? – arbingersys Mar 22 '12 at 4:01
Yes. Your LLC should be keeping a "capital account" for you, which is your tax basis in your membership interest. If you sell for more than the value of the capital account, then you have a capital gain. The value of that capital account is the "what you put in + profits - losses - distributions." thing that I mentioned in the answer. – Chris Fulmer Mar 22 '12 at 11:33
Awesome, thanks for your help. – arbingersys Mar 22 '12 at 13:56

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