Dale F Jensen for Tax Insights / HHCPA writes: Taxpayers love utilizing the lower capital gains tax rates when they can. Not widely known, however, is the Capital Gains Look-Through Rule (IRS Reg 1.1(h)-1). This rule says that certain types of gain from the sale or exchange of an interest in a partnership (including an LLC taxed as a partnership), stock in an S-corporation, or an interest in a trust are taxed as if the sale of all the assets in the pass-through entity had occurred.
Because different types of assets are deemed to be sold in these entities, various tax rates may apply. For example, a selling partner (including a member in an LLC treated as a partnership) may be subject to a 25% maximum rate from unrecaptured Section 1250 gain (generally dealing with depreciation recapture), or they could get hit with a 28% maximum rate on the sale of collectables. Another example is when the entity has what IRS terms “Hot Assets” which are generally things like unrealized receivables or inventory which generate ordinary (not capital gain) income.
Or, say you’re a shareholder selling S-corporation stock or a beneficiary selling an interest in a trust. Along with the items mentioned above, another example is if the entity has capital assets held short term, ordinary income rates can then apply.
It is important to note that while the taxpayer needs to determine the type of asset, its fair market value, its tax basis, and its holding period, the regulation does not require or provide pass-through entities with any specific reporting rules to follow. It is also important to note that the capital gains look-through rule does not apply to liquidations or redemptions.
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