Selling Partnership Interest With Negative Capital Account In Virginia
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A negative capital account refers to a situation where a partner or investor's share of equity in a partnership or limited liability company (LLC) is less than zero. This typically occurs when the individual's share of liabilities exceeds their share of the company's assets.
Follow these steps to correct each partner's ending capital: Add up the ending capital for all the partners' Schedule K-1s. Determine the increase and decrease to enter to zero out the capital. Go to the Input Return tab. From the left of the screen, select Balance Sheet, M-1, M-2 and choose Sch M-2 (Capital Account).
However, a partner's capital account can be negative. This generally happens when the partnership allocates losses or receives a distribution funded by debt incurred by the partnership. These actions can result in a taxable event for partners, so proactive steps need to be taken to avoid a negative balance.
If any members of a partnership have a negative capital account, that partner is legally obligated to restore their deficit, also known as a DRO (deficit restoration obligation).
The general rule is the selling partner treats the gain or loss on the sale of the partnership interest as the sale of a capital asset (see IRC 741). An exception to the general rule exists when the partnership entity holds certain types of assets.
A DRO requires a partner to restore any negative balance (deficit) in their capital account upon the liquidation of the partnership. The DRO demonstrates the partner's willingness to assume the economic risk of loss in the partnership.
A Deficit Restoration Obligation is an obligation by a partner in a partnership (or a member in an LLC taxed as a partnership) to restore the negative balance in its capital account when the partnership liquidates.
Per Internal Revenue Code Sections 704(a)(2) and 1367(a)(2), basis can never fall below zero. If there has been a distribution in excess of basis, then gain has to be recognized on the distribution. This gain is not reported on Schedule K-1. The partner/shareholder reports the gain on their tax return.
