Death of an LLC member: Basic tax considerations

Editor: Shaun M. Hunley, J.D., LL.M.

An LLC taxed as a partnership will likely face one or more tax issues upon the death of a member. These will include determining the best method of allocating the deceased member’s share of LLC income for the portion of the LLC’s tax year before the date of death. In some cases, the tax year or even the continuity of the LLC itself may be affected.

Closing the LLC’s tax year with respect to a deceased member

The LLC’s tax year closes with respect to a deceased member on the date of death. Deceased members are allocated their ratable share of the LLC’s income for the portion of the tax year occurring before that date. Either the annual proration or the interim closing–of–the–books method can be used to determine the amount of income required to be reported on the decedent’s final Form 1040, U.S. Individual Income Tax Return. The member’s estate (or successor member) receives a Schedule K–1, Partner’s Share of Income, Deductions, Credits, etc., reporting its share of LLC income or loss earned from the date of death through the end of the LLC’s tax year.

Allocating income when an LLC interest is distributed from the decedent member’s estate 

An LLC’s tax year closes if the decedent’s estate or other successor sells or exchanges the entire interest in the LLC or if the entire interest is liquidated. However, when an estate distributes an interest in an LLC that is classified as a partnership to a beneficiary to satisfy a specific bequest, the transfer from the estate to the beneficiary is not considered a sale or exchange (Regs. Sec. 1.706–1(c)(2)(i)). So, in that instance, the LLC’s tax year does not close. Instead, the beneficiary includes the LLC’s income or loss for the part of the year the estate held the LLC interest as well as the part of the year the beneficiary held the interest. However, if the estate distributes the LLC interest to the beneficiary to satisfy a specific bequest in the same year that the member dies, the LLC’s income or loss for that year is allocated between the decedent (through the date of death) and the beneficiary (for the rest of the year).

Caution: When an estate distributes an LLC interest to a beneficiary to satisfy a pecuniary (monetary) bequest, the transaction is considered a sale or exchange that closes the LLC’s tax year with respect to the estate (Regs. Sec. 1.706–1(c)(1)). As a result, the LLC must allocate the year’s taxable income or loss between the estate and the beneficiary.

Example 1. Allocating income when an LLC interest is distributed by an estate to a beneficiary: L was a 50% member of P LLC (which is classified as a partnership for federal income tax purposes) when she died on Feb. 15 of Year 1. P uses the calendar year for tax purposes. At her death, L’s interest in P was transferred to her estate. P’s tax year closes with respect to L on Feb. 15, Year 1. L will report her share of P’s Year 1 income through Feb. 15 on her final Form 1040, and her estate will report its share of P’s Year 1 income from Feb. 16–Dec. 31.

L‘s estate held its interest in P until March 31 of Year 2, when it was transferred to W to satisfy a specific bequest. None of the LLC’s income for Year 2 is reported by the estate. Instead, W reports the income for the entire year. Both the estate and W should receive a Schedule K–1 for Year 2. The estate’s Schedule K–1 will not reflect any income or loss for the year, and its capital account should be zeroed out.

Variation 1: If, instead, the estate’s transfer to W satisfies a pecuniary (monetary) bequest, the transfer from the estate to W is treated as a sale or exchange. Then, the LLC’s tax year closes with respect to the estate on March 31 of Year 2. So, the estate reports its share of LLC income or loss allocable to the period from Jan. 1 through March 31 of Year 2, and W reports his share of income or loss allocable to the period from April 1 through the end of the year.

Variation 2: Assuming the same facts as the original example, with the exception that on July ٣١ of Year 1, the estate of L transferred the partnership interest to W. In this scenario, no income is allocated to the estate of L. Like the original example, L will report her share of partnership income through Feb. 15 on her final Form 1040. W will report his share of partnership income from Feb. 16 through Dec. 31 (Regs. Sec. 1.706–1(c)(2)(ii)).

Buy/sell agreement

Service LLCs, such as law firms and accounting firms, often prohibit the interests of deceased members from being transferred to anyone except 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 the member’s 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 upon at some earlier point in time (see Owen, ed., “Case Study: Using a Buy/Sell Agreement to Establish the Value of a Business Interest,” 51 The Tax Adviser 136 (February 2020)).

Note: Because the value of the LLC interest must be included in the decedent’s gross estate at FMV for federal estate tax purposes, 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., the deceased member’s estate) to pay estate tax on LLC interest value that is never received.

Death of a member in a two-person LLC

A two–person LLC that is classified as a partnership generally terminates for tax purposes under Sec. 708(b)(1) at either of the members’ deaths (since a partnership requires at least two partners). Although terminated for tax purposes, the LLC may continue in legal existence as a single-member LLC (SMLLC). However, there are two exceptions to the rule that an LLC immediately terminates for tax purposes upon the death of a member in a two–person LLC.

Estate or beneficiary continues as member: A two–member LLC does not terminate as a partnership for tax purposes upon the death of a member if the deceased member’s successor–in–interest (i.e., the estate or a beneficiary) continues to share in the LLC’s profits or losses (Regs. Sec. 1.708–1(b)(1)(i)). However, if the estate is not closed in a timely fashion, the IRS might question the reason for its remaining open.

Example 2. Estate has a continuing interest in LLC profits and losses: S, M.D., and R, M.D., are 50/50 members in a medical practice professional LLC that is classified as a partnership for federal tax purposes. The LLC operating agreement provides that, upon the death of one of the members, the surviving member has the first right of refusal to buy the deceased member’s interest at a price calculated pursuant to a specified formula. Accordingly, the LLC will not terminate for federal income tax purposes upon the death of one of the members, since the deceased member’s estate (or other successor–in–interest) will have a continuing interest in the LLC’s profits and losses unless and until a purchase price is agreed upon and paid, thus resulting in only one owner.

Liquidating payments made under Sec. 736: A second exception to the general rule governing the termination of a two–member LLC classified as a partnership applies when an LLC continues to make payments to a retiring member or a deceased member’s successor–in–interest under the provisions of Sec. 736 (Regs. Sec. 1.708–1(b)(1)(ii)). The retired member or deceased member’s successor–in–interest will be treated as a member until the interest in the LLC has been completely liquidated (Regs. Sec. 1.736–1(a)(1)(ii)). Accordingly, the LLC does not terminate as a partnership for tax purposes until such time. Under this provision, if the LLC buys out a member through a series of liquidating payments made under Sec. 736, the LLC will not terminate as a partnership for tax purposes until the final payment is made.

Planning tip: Some state LLC statutes prohibit a nonlicensed person from holding an interest in a professional LLC. A professional LLC may want to enter into a buy/sell agreement to avoid a situation in which liquidating payments are made to a nonlicensed successor–in–interest.

LLC ceases to do business on date of death

An LLC is terminated for tax purposes if all of its business activities are discontinued (Sec. 708(b)(1)). It is possible that a member’s death could cause business activities of an LLC to cease, thereby causing the LLC’s termination for tax purposes. For example, assume an LLC is in the business of providing a service and has one member who provides the service and a number of members who do not participate in providing services but are investors. If the service provider dies, the business activities of the LLC could cease on the date of the service provider’s death. In that case, the LLC’s tax year would close for all members, and the decedent’s distributive share of LLC income or loss through the date of death (which would also be the date the LLC terminates) would be reported on the decedent’s final Form 1040.

Contributor

Shaun M. Hunley, J.D., LL.M., is an executive editor with Thomson Reuters Checkpoint. For more information about this column, contact thetaxadviser@aicpa.org. This case study has been adapted from Checkpoint Tax Planning and Advisory Guide‘s Limited Liability Companies topic. Published by Thomson Reuters, Frisco, Texas, 2025 (800-431-9025; tax.thomsonreuters.com).