Sample Answer to Question 1
The LLC is classified for tax purposes as a partnership, unless it elects to be taxed as an "association" (corporation).
Edna
Edna's amount realized on the sale: $30,000 cash received plus her $20,000 share of the partnership debt.
Under IRC § 751(a), Edna recognizes $10,000 of ordinary income attributable to her share of the account receivable, and $5,000 attributable to her share of the inventory. Under IRC § 741, she recognizes an additional $10,000 of capital gain.
Pearl
Pearl's outside basis is $50,000 (including her $20,000 share of the partnership liability).
CDE
The partnership has no gain or loss. Under IRC § 743(a), there is no change in the basis of CDE's assets.
However, if an election under IRC § 754 is made, the inside basis of the assets can be increased by $25,000, for the benefit of Pearl only.
Under IRC § 755, the basis increase is allocated to two classes of assets in proportion to the relative appreciation on each. The two classes are the "hot" assets (receivable and inventory) and the "nonhot" assets (everything else, here the stock). There is $60,000 of appreciation in the hot assets and $40,000 of appreciation on the nonhot assets. Thus, the $25,000 basis increase is allocated $15,000 (60%) to the hot assets and $10,000 (40%) to the stock. The $15,000 increase to the hot assets' basis is in turn allocated based on their relative appreciation. Since the receivable is appreciated by $40,000 and the inventory by only $20,000, two thirds of the $15,000 increase ($10,000) is allocated to the receivable, and one third ($5,000) is allocated to the stock.
There are no tax consequences to Chris or Davis.