When Partnerships Become SMLLCs (and Vice Versa)

Partnerships are becoming more and more common these days, and for good reason: They have easy formation and flexible profit/loss allocation and distributions rules. But with that popularity comes more frequent tax issues, especially when those partnerships go through changes like becoming a single-member LLC (SMLLC) or the reverse.

CPAs are often brought in after the fact, but ideally, they should be involved early to help explain what a transaction really means from a tax perspective. This includes gain or loss calculations, basis adjustments and holding period rules.

Partnership to SMLLC

Example 1: Partner A sells his share of the partnership to Partner B in Partnership AB. Partnership AB will terminate since it will have only one partner left. Even though this may seem like a simple buyout, it’s treated quite differently depending on whether you’re looking at it from the seller’s or the buyer’s perspective.

Partner A’s interest in the partnership will be treated as a sale of the partnership interest potentially with capital gain or loss. But CPAs need to provide additional guidance in relation to Internal Revenue Code (IRC) Section 751, particularly with the ordinary portion of the gain and the unrecaptured section 1250 gain going to Partner A.

Interesting here is what happens to Partner B. The partnership will be deemed to distribute in liquidation its assets to A and B, and B will be deemed to buy A’s assets after this distribution. The portion of the assets that B bought from A will have basis equal to the purchase price, and the holding period of these assets will start on the day after the sale date. 

Partner B may have a gain or a loss for the portion of assets that got distributed to him based on the liquidation rules of IRC Section 731, which recognizes a gain or loss, in some cases. In other cases, his gain may be deferred through an adjustment to the basis of distributed assets. The holding period for this deemed distributed assets will be tacked and will include the holding period of the partnership. If there’s a basis deficit, the CPA will have to carefully consider how that gets allocated among the distributed assets.

Example 2: CD Partnership sells their interest to E. In this situation, according to revenue ruling 99-6, Partner C and Partner D will have deemed liquidation distribution from their partnership with a potential gain or loss as discussed in example 1 above, and then E is deemed to acquire these assets. The holding period for these assets for E will start on the day following the date of sale.

SMLLC to Partnership

Now let’s flip it. When a single-member LLC adds another owner, it’s no longer disregarded — it becomes a partnership for tax purposes. This is governed by Revenue Ruling 99-5 and happens in a couple of common ways.

Example 1: The disregarded entity owned by Individual A becomes a partner­ship, when A sells a percent of her interest to Individual B. This will be treated as a sale of the same percentage of assets to B. Under IRC §1001, which provides rules for gains or losses, A will recognize a gain or loss on this transaction. The basis in A’s partnership interest is the basis of the remaining assets she contributed. B’s basis is what he paid for his share.

The partnership’s basis in the assets is a mix of both: A’s carryover basis and B’s cost basis. A’s holding period is tacked from before; B’s starts the day after the sale.

Example 2: Individual B contributes money to the partnership itself to be a partner in Partnership AB. B will be treated as contributing money in exchange for his partnership interest. A will be treated as contributing all of her assets in exchange for partnership interest, and A’s basis in partnership interest will be the basis in assets she contributed. A holding period for partnership interest will include A’s holding period in capital and section 1231 assets she contributed. B’s holding period will start on the date following his cash contribution.

Whether you’re looking at a partner buyout or adding a new member to an LLC, these transactions can bring significant tax consequences that are often misunder­stood or missed entirely. CPAs need to be proactive, not reactive. Educating clients before they make these changes can help avoid surprises and even create opportunities for tax planning.

Understanding the nuances of Revenue Rulings 99-5 and 99-6, along with the related sections of the Code, is critical. These aren’t just dry technicalities, they’re practical tools that let CPAs bring real value to clients by helping them structure deals more intelligently and avoid costly mistakes.