Suppose a partnership (such as an LLC with pass-through taxation) has three members. Each owns an equal share of the business, which has a net liquidation value of $300,000. One partner abandons his capital interest (valued at $100,000). What are the tax consequences for the remaining members? For example, is the $50,000 increase in the value of the capital interest of each remaining member taxed as income, as capital gains, as a gift, or not at all?
Additional simplifying assumptions (if helpful):
- The partnership has an operating agreement that permits abandonment under the same three conditions as IRC section 165 abandonment (imperfectly summarized here).
- The partners' capital interests are fully vested, the LLC has no liabilities, and its assets are liquid.
- One of the remaining partners provides all LLC services and therefore pays income tax on profits, while the other remaining partner is inactive and therefore pays capital gains on profits.
