Income Taxation of LLC Income in Year of Death

Editor: Albert B. Ellentuck, Esq.

For a deceased member, a limited liability company’s (LLC’s) tax year ends on his or her date of death (DOD); the member’s distributive share of LLC income earned through the DOD is reported on his or her final return. Termination of the LLC’s tax year also occurs if the LLC terminates on a member’s death or because the LLC’s business is discontinued or the LLC has only one member remaining. Rev. Rul. 99-6 deals with the consequences of changing from a multi-member LLC to a single-member LLC.

Transfer under a Buy-Sell Agreement

Service LLCs, such as law and accounting firms, often prohibit deceased members’ interests from being transferred to anyone but an existing LLC member. To ensure this result, the remaining members (as opposed to the LLC itself) may be required to acquire the interest from the decedent’s estate immediately after death. Similar buy-sell agreements may be entered into by members in LLCs engaged in other types of businesses, to provide a market for a deceased member’s interest or ensure the remaining members can purchase a deceased member’s interest for a price agreed on by the members at some earlier point. In such cases, the LLC’s tax year ends as to the deceased member on the DOD; the member is allocated a ratable share of the LLC’s income for the portion of the tax year occurring prior to that date. The annual proration or interim closing-of-the-books method can be used to determine the amount of such income required to be reported on the decedent’s final tax return.

Note: Because the LLC interest must be included in the decedent’s gross estate at fair market value (FMV), a buy-sell agreement that results in the sale of the LLC interest for less than FMV may cause the deceased member’s successor-in-interest (e.g., his or her estate) to receive an amount less than the estate tax assessed on the transferred interest.

A purchase under a buy-sell agreement can also cause a technical termination of the LLC and a closing of its tax year as to all members. A technical termination occurs if the deceased member owned at least a 50% interest in the LLC’s capital and profits; see Sec. 708(b)(1)(B). A technical termination of the LLC also occurs on the decedent member’s DOD if the purchase of the deceased member’s interest, along with transfers of other interests during the 12 months immediately before the member’s death, add up to 50% or more of total interests in the LLC’s capital and profits.

When a technical termination occurs, the LLC’s tax year closes as to all members on the date the terminating event takes place; see Regs. Sec. 1.708-1(b)(3)(ii). Accordingly, the tax year closes as to all members on the DOD.

Death of Member in Two-Person LLC

The death of a member in a two-person LLC will terminate the LLC’s partnership status for Federal tax purposes if it results in the LLC immediately winding up its business; see Sec. 708(b)(1)(A). If this occurs, the LLC’s tax year closes on the member’s DOD. Similarly, the death of a member in a two-person LLC generally will cause a technical termination of the LLC under Rev. Rul. 99-6. The regulations, however, provide two exceptions to prevent this.

A two-person LLC does not terminate on a member’s death if the deceased member’s successor-in-interest (usually, the estate) continues to share in the LLC’s profits or losses; see Regs. Sec. 1.708-1(b)(1)(ii). The LLC’s tax year does not close and the member’s distributive share of LLC income from the DOD through the end of the LLC’s tax year is reported on the successor-in-interest’s return; see Regs. Sec. 1.706-1(a). Likewise, if an LLC begins or continues to make liquidating payments to a deceased member’s successor-in-interest under Sec. 736, the latter is treated as a member until the deceased member’s interest in the LLC has been completely liquidated; see Regs. Sec. 1.736-1(a)(1)(ii). In a two-person LLC, the LLC does not terminate, nor does the LLC year end (other than the LLC’s normal tax year), until the final liquidating payment is made to the successor-in-interest; see Regs. Sec. 1.736-1(a)(6).

LLC Ceases to Do Business on DOD

According to Sec. 708(b)(1)(A), an LLC terminates for tax purposes if all of its business activities are discontinued. It is possible that a member’s death could cause an LLC’s business activities to cease, thereby causing the LLC’s immediate termination.

Example: An LLC is in the business of providing a service. The LLC has one member who provides the service and a number of members who are merely investors. If the service provider died, the LLC’s business activities would probably cease on his or her DOD. Accordingly, the LLC’s tax year would close; the distributive share of LLC income earned by the decedent through the DOD would be reported on his or her final income tax return.

As a general rule, the cessation of business activities and the termination of an LLC are deemed to occur at the time of the final distribution of assets to members. In Sargent, TC Memo 1970-214, the court held that the process of winding up is considered part of an entity’s business. Consequently, if the LLC continues to pay its creditors or make distributions to the remaining members after the date of the service provider’s death, the LLC would not terminate until such activities were complete.

Deceased Member’s Final Schedule K-1

A deceased member’s final Schedule K-1, Partner’s Share of Income, Deductions, Credits, etc., reflects his or her share of LLC liabilities and his or her profit, loss and capital ownership ratios immediately before death (in the column of the Schedule K-1 labeled “Beginning”). It also reflects the member’s share of LLC income or loss through the DOD and any distributions made to the deceased member through the DOD. The Schedule K-1 should also show a constructive distribution to “zero out” the deceased member’s capital account at the time of death. The box on the K-1 labeled “Final K-1” should be checked.

The deceased member’s final Schedule K-1 should also reflect his or her  share of self-employment (SE) income, if any, through the DOD. The decedent member’s SE income is reported on his or her final K-1, based on his or her distributive share of LLC income through the DOD.

Editor’s note: This case study has been adapted from PPC’s Guide to Limited Liability Companies, 12th Edition, by Michael E. Mares, Sara S. McMurrian, Stephen E. Pascarella II and Gregory A. Porcaro, published by Practitioners Publishing Company, Ft. Worth, TX, 2006 ((800) 323-8724; ppc.thomson.com).