Partner Buyout Journal Entry: LLC, S Corp, Sale or Redemption

How do you record a partner buyout in the books?

The entry depends on who pays the departing owner. When another owner or a new owner pays, the company is not a party, so its books only move a capital account from seller to buyer. When the company pays, it uses its own cash or signs its own note, and the departing owner's capital account is cleared against that payment.

Two numbers are easy to mix up. The price almost never equals the capital account. And the capital account in the books is not the seller's tax basis: the K-1 instructions say the capital account on the K-1 (item L) comes from the partnership's books and cannot be used to figure the partner's adjusted basis.

The sale entry works under either capital account method: the tax-basis method that item L reports, or the fair-market-value method in the regulations. A goodwill write-up exists only in the second, and it does not raise the tax-basis account that item L reports. Keep both sets of numbers and have the preparer reconcile them; see partner capital accounts. Tax on each side of the deal is in buying out a partner.

Gather before booking: the signed buyout agreement and its effective date, the operating or shareholder agreement, each owner's capital account on the exit date, a balance sheet on that date, the departing owner's loans to or from the company and any unpaid guaranteed payments, the depreciation schedule, and the latest K-1s.

Before any entry, close the books through the exit date: post profit or loss through that date to each owner under the agreement, along with their draws and contributions. A partnership's tax year closes for a partner whose entire interest ends (26 CFR 1.706-1), so the capital account that moves or is cleared is the account after that step.

The case is not simple when the price differs from the capital account, is paid over time, includes receivables, depreciated equipment or goodwill, or leaves one owner. The section "Which buyouts need a tax preparer before the entry is final?" lists them.

How do you record a sale to another partner or a new partner?

Debit the seller's capital account and credit the buyer's by the same amount: the capital account that goes with the interest sold. The price does not appear in the company's books, because the company neither pays nor receives it.

The Form 1065 instructions for item L say a partner who buys an interest starts with an "other increase" equal to the seller's ending capital account for the interest transferred, and the seller's account drops by the same amount. The capital account regulation also treats the seller's account as carrying over to the buyer.

• Part of an interest: move only the matching part of the capital account.
• Several buyers: split the seller's capital account among them in the proportion each buys.
• Buyer is new to the company: open a new capital account for the buyer with the amount moved.
• Cash, assets, liabilities and profit: unchanged. Update the owner list and sharing percentages from the agreement as of the exit date.
• The seller's gain or loss: reported on the seller's own return, generally as capital gain or loss except for the part tied to receivables and inventory (section 741). The company books nothing for it.

If the company pays or promises any part of the price, that part is likely a redemption, not a sale between owners; see "How do you record the LLC redeeming a partner's interest?" below. Who is bound to pay under the agreement decides it, so a preparer confirms.

How do you record the LLC redeeming a partner's interest?

Debit the departing partner's capital account and credit cash for what the LLC pays now, or a note payable for what it owes later. In the simple case, the other partners' capital accounts do not move; their ownership percentages rise because the departing partner's share is gone.

Book the departing owner's loans to or from the company and any unpaid guaranteed payments on their own lines, settled as the agreement says; do not net them into the capital account entry. See owner contribution or loan to your LLC and shareholder loans to an S corporation.

If the LLC redeems only part of an interest and the partner stays in, make the same entry for the part redeemed. Section 736 covers payments in liquidation of a retiring partner's interest, so a preparer decides how a partial payout is treated.

Do not expense the price on your own. Payments made to liquidate a retiring partner's interest in partnership property are a distribution, not an expense (section 736; Publication 541). Payments for the partner's share of unrealized receivables or goodwill can instead be a distributive share or a guaranteed payment, which can change the profit and loss statement and the K-1s. Which rule applies depends on whether the retiring partner was a general partner, whether capital is a material income-producing factor, and, for goodwill, whether the agreement itself provides a reasonable payment for it. Capital is generally material when a substantial part of income comes from inventory, plant or equipment, and generally not when income is mainly fees for personal services (Publication 541; 26 CFR 1.704-1(e)(1)(iv)). A preparer decides it before the entry is final.

What if the price is more or less than the capital account?

The difference needs its own entry, and no single entry is required. The operating agreement usually picks the method. Both methods below are accounting practice, not tax law, and neither changes anyone's tax basis; the preparer reconciles the book entry to item L.

If the price is below the capital account, the bonus method credits the difference to the remaining partners' accounts. Revalue first runs the other way: write the assets down, so every account falls first, including the remaining partners', then redeem at the lower account.

The capital account regulation allows an agreement to revalue property, including goodwill, when a partner retires or a new partner contributes, if, among other conditions, the revaluation rests on fair market value and has a substantial non-tax business purpose.

The label in the books does not set the tax result. Section 736 sorts payments to a retiring partner by what they are for, and a payment for receivables or goodwill can be taxed differently from the rest. Unrealized receivables include the accounts receivable of a cash-method partnership and payment rights for work begun but not finished (Publication 541). In a sale they also include potential ordinary income from depreciated equipment and buildings; that part does not count for section 736 payments (section 751(c)). A cash-basis ledger shows none of these on the balance sheet, so list unpaid invoices, unfinished jobs and the depreciation schedule separately for the preparer.

How do you book buyout payments over time: a note, installments, interest?

When the agreement fixes the amount and dates, book the unpaid price as a liability on the exit date. Each payment then splits into principal, which reduces the note, and interest, which gets its own line.

That is the usual book entry. Under the regulation method, a partnership's own note generally reduces the departing partner's capital as principal is paid, not when the note is signed; a readily tradable note and a negotiable note given in liquidation are treated differently (26 CFR 1.704-1(b)(2)(iv)(e)(2)). Confirm which entry your agreement and books call for.

Split the part due within a year from the rest, as with any loan (recording a business loan). Interest is booked apart from principal; whether it is deductible and how the former partner reports it depend on the terms, so the preparer decides.

Two traps:

• The former partner can stay a partner for tax. A retiring partner is treated as a partner for income tax until the interest is completely liquidated (Publication 541), so K-1s can keep coming while the note is paid. Item L reports cash and property distributed during the year (Form 1065 instructions), so an account cleared on the day the note is signed can differ from item L until the note is paid. Keep a note schedule for the preparer.
• A payout that depends on profit is not a fixed note. Payments that are not for the partner's share of property are a distributive share if the amount depends on partnership income, and a guaranteed payment if it does not, however long the payments run (section 736; Publication 541). Decide that before booking.

What does the departing partner's final K-1 and capital account show?

A partner who sells the whole interest, or is redeemed in full at once, receives a K-1 for the part of the year they were a partner, and the ending capital account is zero. The K-1 form has a Final K-1 box for the year the interest ends.

If the LLC redeems the interest and pays over time, the partner stays a partner for tax until the last payment (Publication 541), so the K-1 is not final until then and item L can differ from the books; see the section on buyout payments over time, above.

Item L, the capital account box, follows the Form 1065 instructions:

• Seller, after a sale: an other decrease equal to the account for the interest transferred.
• Departing partner, after a redemption: withdrawals and distributions for the cash and property paid.
• Buyer: a beginning account of zero if joining by contribution, or an other increase equal to the seller's account if buying.

The seller's total gain is not a K-1 amount; the seller works it out from their own tax basis, and the K-1 reports only certain parts of it, such as the ordinary-income part tied to receivables and inventory. That gain, and which income belongs to the departing partner for the year of exit, are in buying out a partner.

What changes when a two-owner LLC becomes one owner?

When one owner buys the other's interest in a two-owner LLC taxed as a partnership, the partnership ends. The LLC files a final Form 1065 and, unless it elects to be taxed as a corporation, becomes part of the remaining owner's own return (Revenue Ruling 99-6; IRS: LLC classification). If the LLC redeems the other owner instead, the ruling does not cover it: the payout follows the retiring-partner rules in section 736, and the remaining owner's asset basis can differ from a purchase.

• Final return: a partnership's tax year ends when it terminates, and the final Form 1065 is due the 15th day of the 3rd month after the month the partnership ends (Form 1065 instructions; Publication 541). In a purchase, the partnership terminates when the other owner buys the entire interest (Revenue Ruling 99-6). In a redemption paid over time, the retiring partner stays a partner for tax until fully paid, so a preparer sets the end date.
• Books: the two partner capital accounts are replaced by one owner's equity account, and later withdrawals become owner draws. See LLC equity accounts.
• Tax basis of assets, if the other owner bought the interest: Revenue Ruling 99-6 treats the buyer as buying the assets behind the seller's share. In the ruling's simple facts (no debt, no receivables or inventory), the buyer's tax basis in them starts at the price paid and a new holding period begins. Debt and receivables change that, and the result can differ from book values, so the depreciation records need a preparer's review.
• An LLC taxed as an S corporation: it is not affected this way, because a corporation can have one shareholder (section 1361). See "How does an S corporation record a shareholder leaving?" below.

How does an S corporation record a shareholder leaving?

A sale of shares to a co-owner or an outsider changes only the stock records. A redemption by the corporation uses company cash or a note, so it needs an entry.

Sale of shares. Make no entry for the price, because the corporation is not a party. Update the stock ledger and shareholder list as of the sale date.

Check that the buyer can be a shareholder. An S corporation cannot have a shareholder that is not an individual (apart from certain estates, trusts and exempt organizations), a nonresident alien shareholder, more than 100 shareholders, or more than one class of stock (section 1361). An ineligible buyer ends the S election as of the day the corporation stops qualifying (section 1362; Form 1120-S instructions). Relief for an inadvertent termination exists but is not automatic (section 1362(f)), so check the buyer before the sale closes.

Redemption. Debit a treasury stock account (a negative equity account) or the stock accounts, and credit cash or a note payable. The price is not an expense. Whether the shares are cancelled or held in treasury depends on the company's records and its state's corporate law, so confirm that before booking.

A redemption is treated as a sale of the stock only if it meets a test in section 302(b), such as a complete redemption of all the shareholder's stock. Otherwise it is a distribution. Stock owned by a spouse, children, grandchildren or parents can count toward the test (section 318), with a narrow exception for a seller who leaves the company entirely, claimed by attaching a statement to the seller's first return for the year of the redemption (section 302(c)(2); 26 CFR 1.302-4). A preparer decides which applies; the shareholder's tax is in buying out a partner.

Accumulated adjustments account. The AAA on Schedule M-2 of Form 1120-S is a tax-return account, not a book account. When a redemption is treated as an exchange, the AAA is adjusted by the ratable share attributable to the redeemed stock (26 CFR 1.1368-2(d); Form 1120-S instructions). Keep retained earnings and distributions clean so the preparer can compute it. See S corporation bookkeeping.

Closing the books. Without an election, income is allocated to shareholders by day. When a shareholder's whole interest ends, the corporation can elect under section 1377(a)(2), with every affected shareholder's consent, to treat the year as two years. A qualifying disposition allows a separate, irrevocable election under 26 CFR 1.1368-1(g)(2): one shareholder's disposition, such as a sale, of at least 20% of the stock, or a redemption treated as an exchange of that much, within 30 days. It needs the consent of every shareholder who held stock during the year. Closing the books does not make either election; the corporation attaches a statement to a timely original or amended Form 1120-S (Form 1120-S instructions). Both split the year on the exit date, so if either may be made, close the books as of that date. A shareholder's own basis is in S corporation shareholder basis.

Can you add a member to an existing LLC, and how do you record it?

Yes, if the operating agreement and state law allow it. The new member either buys part of an existing member's interest, which moves a capital account as in the sale section above, or contributes money or property, which is new capital: debit cash or the asset, and credit a new capital account for the new member. The operating agreement sets the terms of admission; where it is silent, local law is treated as part of the agreement (Publication 541).

• A new member's capital account need not match their ownership percentage. See partner capital accounts and splitting ownership between LLC partners.
• Property contributed: the books may carry it at fair market value while item L uses its adjusted tax basis. Keep both (Publication 541).
• Price versus value: if the new member pays more or less than their share of the company's value, handle the difference with the revalue-first or bonus method described above; the regulation cited there allows a revaluation when a new partner contributes.
• Contribution or loan: money a member puts in as a loan is not capital. See owner contribution or loan.

An LLC with one owner is disregarded as separate from its owner for income tax unless it has elected corporate treatment. Adding a second member generally turns a disregarded LLC into a partnership that files Form 1065, and the owner's equity splits into two capital accounts (IRS: LLC classification). An LLC already taxed as a corporation keeps that treatment; for an S corporation, check the new shareholder's eligibility instead. How the owner is taxed depends on whether the new member buys or contributes; see changing your business structure. Have a preparer confirm the opening capital accounts and the first return.

Which buyouts need a tax preparer before the entry is final?

Get a review from your CPA or tax preparer before booking when any row below applies. Each can change the entry, the K-1s or a filing.

If one of these applies, settle the entry and the filings together before booking: bookkeeping help. If capital accounts were never kept, rebuild them first. See rebuilding partnership capital accounts.

Example

These examples are illustrative. All figures are in US dollars.

A partner sells to the other partner

Two partners share profit equally in an LLC taxed as a partnership. Partner A's capital account is US$60,000 and Partner B's is US$60,000. B pays A US$80,000 personally for A's entire interest.

The US$80,000 never enters the LLC's books. A's US$20,000 over the capital account is part of A's own gain calculation, which starts from A's tax basis. B's account is now US$120,000.

The LLC has one owner, so the partnership ends. It files a final Form 1065, and B's US$120,000 becomes the owner's equity account. For tax, if the LLC has no debt, receivables or inventory, Revenue Ruling 99-6 treats B as buying the assets behind A's half for US$80,000.

The LLC redeems a partner with a note

Three partners share profit equally, and each has a US$50,000 capital account. Partner C leaves. The LLC agrees to pay C US$50,000 in two yearly payments of US$25,000. Interest is left out to keep the numbers round. The entries clear C's account when the note is signed, the usual book treatment; capital kept under the regulation method may instead fall as principal is paid.

A and B keep their US$50,000 accounts and now share profit equally between them.

Suppose the agreed price is US$70,000 instead. Under the bonus method, C is paid out at US$70,000 and A and B each absorb US$10,000.

Under revalue first, a book-capital entry only, the LLC writes up goodwill by US$60,000, which adds US$20,000 to each of the three accounts. Then C's account, now US$70,000, is cleared against the note.

Bonus leaves A and B at US$40,000 each. Revalue first leaves them at US$70,000 each, with goodwill of US$60,000 on the balance sheet. Either way C is cleared and the note is US$70,000. How the payment is taxed is a separate question.

An S corporation shareholder leaves

An S corporation has 1,000 shares. One shareholder owns 300, which is 30%, and the price is US$90,000.

If a co-owner buys the shares, the corporation makes no entry for the price. It updates the stock ledger on the sale date.

If the corporation redeems the shares for cash, it debits Treasury stock US$90,000 and credits Cash US$90,000. If the redemption is treated as an exchange and the accumulated adjustments account is US$100,000, the AAA falls by the ratable share for the redeemed stock, about US$30,000. In that case, 30% is also large enough for the corporation to consider the election to split the year.

Different for you?

• The price differs from the capital account, or includes receivables, inventory or goodwill: how each payment is taxed is in buying out a partner. To settle the entry and the capital accounts on the exit date, get bookkeeping help.
• The payout runs over time or depends on profit, the LLC drops to one owner, or an S corporation gets a new shareholder: the exit date, the final K-1 and capital account, and the returns and elections that follow depend on the agreement. Have them settled with bookkeeping help.
• Capital accounts were never kept and the Form 1065 is late: see rebuilding partnership capital accounts and late partnership return penalty relief.
• You need to set up or check each partner's account: see partner capital accounts.
• The departing partner was paid by guaranteed payment or draw: see guaranteed payments versus partner draws.
• You are an S corporation shareholder who needs basis: see S corporation shareholder basis.
• A member put money in as a contribution or loan: see owner contribution or loan to your LLC.
• The seller is not a US person: the buyer, or the LLC if it redeems, may have to withhold on the amount realized (the price plus debt relief), and extra forms may apply. See foreign partners and withholding and cross-border tax help.
• You want the general rules for how a partnership is taxed and files: see how partnerships are taxed.