In general, distributions of property other than cash from an LLC taxed as a partnership are tax-free to the members. This feature of an LLC is one reason why a business operating as an LLC may choose to be taxed as a partnership rather than a corporation.

However, there are five circumstances in which a distribution of property other than cash to a member can trigger gain recognition to a member or LLC. This article examines the concept of ‘hot assets’ which are assets that can trigger one of the five circumstances where member or LLC must recognize gain on a distribution of assets to a member.

Hot assets are a particular type of asset held by an LLC taxed as a partnership. They consist of items other than cash and labeled for accounting purposes as an ‘unrealized receivable’ or as ‘inventory’. Hot assets are assets that have been sold by the LLC for an ordinary loss rather than a capital loss. The partnership tax rules require a member’s gain or loss from the sale of hot assets to equal the gain or loss from the sale of assets that are not hot assets.

The application of IRC Section 751(b) to the distribution of property other than cash can trigger income or loss that the member receiving the distribution has to recognize. Section 751(b) applies if a distribution of property other than cash to a member would cause a member’s share of income and loss from assets that produce capital gain and loss to differ from the member’s share of income and loss from hot assets. Section 751(b) essentially requires a distribution of non-cash property to change the percentage share a member has in capital gain or loss property compared with hot assets resulting in LLC and member gain recognition on the distribution.

The SECURE Act, effective January 1, 2020, makes significant changes to the previous rules governing payout of distributions to beneficiaries of an inherited retirement account, including IRAs.

Previously, beneficiaries were in general entitled to “stretch” the required minimum distributions from the inherited account over the life expectancy of the beneficiary. The “stretch” option allowed the beneficiary to continue to benefit from the tax-deferred investment returns of the inherited retirement account over the beneficiary’s lifetime.

The SECURE Act eliminates the “stretch” option for most beneficiaries of inherited retirement accounts, and requires them to distribute the funds in the account in full within 10 years of the plan participant’s death.

Going forward, the “stretch” option will only be available to 5 classes of beneficiaries:

1. The surviving spouse of the plan participant
2. Minor children of the plan participant
3. Disabled beneficiaries
4. Chronically ill beneficiaries
5. Beneficiaries less than 10 years younger than the plan participant

Generally, all income received from any source is included in a taxpayer’s gross income. Income is taxed as ordinary income unless the income is received from the sale or exchange of property characterized as a capital asset or from property used in a trade or business. When a debt for which a taxpayer is legally responsible is forgiven, the amount discharged is included in the gross income of the taxpayer. This is the case whenever any amount of debt is forgiven and is no longer the obligation of the taxpayer.

Unless an exception applies, the taxpayer must pay taxes on the amount of discharged debt even though they received nothing tangible to pay the tax with.

Exceptions include bankruptcy or insolvency of the taxpayer. If the forgiven debt is a business debt, the taxpayer’s tax attributes (net operating loss, general business carryover or basis in property) are reduced by any amount excluded from gross income. This prevents strategic use of a bankruptcy or insolvency to deduct both forgiven debt and net losses.

Another important exception is for ‘qualified principal residence’ indebtedness. Such indebtedness is limited to a mortgage secured by the taxpayer’s principal residence used to buy, build or substantially improve the home. This exception does not include home equity line of credit indebtedness.