I (Abby) am the sole member in an LLC. The sole asset of the LLC is a Rental Property with an adjusted basis for tax purposes of $150,000 and a fair market value of $400,000. My friend, Bob, wishes to purchase a 1/2 interest in the LLC for $200,000 in cash. How should we structure this transaction in order to minimize our federal tax liability?
A number of states, including Colorado, allow single-member limited liability companies. As a matter of state law, there is basically no difference between a single-member LLC and a multi-member LLC. Both types of LLCs provide the same type of statutory limited liability to the LLC’s member(s), and both types must conform to the statutory requirements for organization and management of the entity. However, from the perspective of federal taxation, a single-member LLC is viewed and treated somewhat differently than a multi-member LLC.
Under the current IRS regulations, a single-member LLC may choose to be taxed either as a corporation or as a disregarded entity. Since the sole member of an LLC generally desires to have the income of the LLC flow-through to the member’s individual tax return, most single-member LLCs choose to be treated for federal tax purposes as an entity disregarded from its owner. What that means, in the eyes of the Internal Revenue Service, is that the LLC, as an entity, does not exist for federal tax purposes and all of the assets, liabilities, earnings and losses of the LLC are deemed to be the personal assets, liabilities, earnings and losses of the sole member.
Under the same regulations, a multi-member LLC may choose to be taxed either as a corporation or as a “tax partnership”. Again, since the members of most LLCs generally desire to have their distributive share of the income of the LLC flow-through to the members’ individual tax returns, most multi-member LLCs choose to be treated for federal tax purposes as a tax partnership. As a tax partnership, all of the earnings and losses of the LLC flow-through to the individual members, just like in a single-member LLC. However, this is where the similarity ends. While a single-member LLC and its owner are one and the same for federal tax purposes, the Internal Revenue Service treats a multi-member LLC as a tax partnership, a entity separate and apart from its members. Thus, the admittance of a new member into a former single-member LLC creates a new taxable entity in the eyes of the Internal Revenue Service.
The transaction between Abby and Bob represents a typical situation which illustrates the potential tax consequences when a sole-member LLC wishes to convert into a multi-member LLC. Here, Abby’s single-member LLC, which is currently treated by the IRS as a disregarded entity, will become a full-fledged “tax partnership”, a separate entity, upon the admittance of Bob as a member in the LLC. This article discusses the two ways that this transaction can be structured, one which has immediate tax consequences to Abby and one which can defer the potential recognition of gain for all parties.
Option 1: Abby Keeps the $200,000. Under Option 1, Bob pays Abby $200,000 in cash for a 50% membership interest in the LLC. Abby deposits the $200,000 in her personal bank account and does not contribute any portion of the $200,000 to the LLC. Abby and Bob then continue to operate and manage the business of the LLC as co-owners and the LLC is treated as a tax partnership by the Internal Revenue Service.
As a sole-member LLC, Abby’s LLC was disregarded for purposes of federal taxation and Abby was deemed to be the 100% owner of Rental Property. If Abby receives $200,000 cash in exchange for granting Bob a 1/2 interest in the LLC, Abby will be deemed to have sold a 50% ownership interest in Rental Property to Bob. Under § 1001 of the Internal Revenue Code, Abby will be required to recognize gain from the deemed sale of the 50% interest in Rental Property to the extent that the proceeds Abby received are in excess of her adjusted basis in the property sold. Since Abby’s adjusted basis in 50% of Rental Property is $75,000, and the sales price is $200,000, Abby will be required to recognized $125,000 of taxable gain.
However, the tax consequences of the creation of the new LLC are not all bad. Immediately after the deemed sale of the 50% ownership interest in Rental Property, Abby and Bob are then treated as contributing their respective 50% interests in Rental Property to the new LLC in exchange for ownership interests in the LLC. Bob’s basis in the LLC will be equal to $200,000, the amount paid by Bob to Abby for a 50% ownership interest in Real Property. Abby’s basis in the LLC will be $75,000, the amount of Abby’s adjusted basis in Abby’s remaining 50% ownership interest in Real Property. The LLC’s adjusted basis in Real Property will be $275,000, the basis of the property in Abby’s and Bob’s hands immediately after the deemed contribution. And finally, under IRC § 721 and 723, this contribution by Abby and Bob of Rental Property into the LLC will not be a taxable event to either Abby, Bob, or the LLC.
Option 2: The $200,000 is Contributed Directly to the LLC. Under Option 2, Bob contributes all of the $200,000 to the LLC, and the LLC uses all of the contributed cash in its business. Abby and Bob then continue to operate and manage the business of the LLC as co-owners and the LLC is treated as a tax partnership by the Internal Revenue Service.
In this scenario, a new tax partnership LLC will be deemed to have been created. Abby is treated as having contributed all of Real Property to the LLC and Bob is treated has having contributed $200,000 in cash. Because Abby does not receive any cash or other property as a result of this transaction, Abby will not be required to recognize any gain. In addition, pursuant to IRC § 721, neither Abby nor Bob will be required to recognize any gain or loss as a result of their respective capital contributions to the LLC.
Under Option 2, Bob’s basis in the LLC is equal to $200,000, the amount of cash that Bob contributed to the Abby’s basis in the LLC is equal $150,000, the amount of Abby’s adjusted basis in Real Property that Abby contributed to the newly-created LLC. The new LLC’s assets include a $150,000 carry-over basis in Real Property and $200,000 in cash.
Conclusion. When presented with an investor who is willing to buy into a single-member LLC, the sole member of the LLC may be tempted to rationalize that part of the cash being paid by the investor should flow to the sole member as compensation for the sweat equity that the sole member has contributed to the LLC. However, unless the sole member has other tax considerations that would make it advantageous for the sole member to recognize an immediate taxable gain, the sole member would be ill-advised to pocket all or any portion of the cash investment. Instead, just as Abby and Bob are advised to structure their transaction according to Option 2, the sole member of an LLC is advised to allow the incoming member to contribute the cash directly into the multi-member LLC, with such contribution to be used for the operations of the LLC. In this manner, since the former sole member doesn’t receive compensation in exchange for allowing a new member into the LLC, the former sole member will not have to recognize any immediate taxable gain as a result of the transaction.
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