Distributions by LLCs
The Rules Are Complex
By Norman J. Mangina, Elizabeth Plummer, and Paul J. Streern
Wyoming became the first state to enact a limited liability company (LLC) statute. Florida followed in 1982. Until 1988, however, there continued to be uncertainty about whether an LLC would be taxed as a partnership or corporation for Federal tax purposes. In 1988, the IRS settled this uncertainty by issuing a ruling stating that properly structured LLCs would be taxed as partnerships. Thus began a business-entity revolution. Since then, 47 other states and the District of Columbia have enacted LLC statutes. (Hawaii's LLC act is awaiting signature and is scheduled to become effective April 1, 1997.) LLCs can be used effectively by many types of businesses and will be used more frequently as they are more highly publicized and understood. Recent "check the box" regulations, which allow the LLC to select whether to be taxed as a partnership or corporation, have removed the uncertainty that previously existed as to whether all the appropriate criteria had been met.
Advantages of LLCs
LLCs are a popular choice of business form for both tax and nontax reasons. LLCs have few ownership and operating restrictions, provide their owners with limited liability, and may be taxed as partnerships.
An LLC is a separate legal entity that provides its members, the owners of the company, with limited liability. The LLC's debt is generally nonrecourse unless a member specifically guarantees payment. Therefore, members are liable for debts only to the extent of their investment in the company--much like corporate shareholders. This absence of liability stands in stark contrast with the situation faced by general partners of a limited partnership who take on full debt-paying responsibility.
In contrast to regular corporations, however, LLCs can provide limited liability to their owners while still being taxed like a partnership. Under corporate tax rules, income is taxed at both the corporate and shareholder levels and special allocations among shareholders are not allowed.
Distributions
The treatment of LLCs as partnerships for Federal tax purposes makes LLCs an attractive choice for a business' organizational form. The partnership tax provisions, however, can be quite complex, especially the provisions dealing with distributions of LLC assets to the LLC's members. The rules governing these distributions should be understood by all LLC members to prevent unexpected and often undesirable tax consequences.
An actual distribution of cash or other property to an LLC member will fall under the partnership distribution rules. A decrease in a member's share of liabilities, however, can also trigger a distribution. In this case, the LLC is deemed to have distributed cash to the member whose share of liabilities is reduced even though he or she did not actually receive a distribution. The amount of the deemed distribution is measured by the dollar amount of the decrease in the member's share of liabilities.
The treatment of the distribution to the LLC and any member will depend on the type of distribution made. Distributions may be classified as either current or liquidating and either proportionate or disproportionate. A liquidating distribution is one made to a member who is terminating his or her entire interest in the LLC. All other distributions are considered current. A disproportionate distribution is one which changes a member's proportionate share of LLC ordinary income assets, specifically unrealized receivables and substantially appreciated inventory. Unrealized receivables include the zero basis receivables of a cash basis taxpayer along with certain ordinary income recapture items (e.g., depreciation recapture). When these receivables are collected, ordinary income will be recognized by the recipient.
Substantially appreciated inventory is defined as inventory or any other property not classified as a capital or IRC section 1231 asset and whose total fair market value is greater than 120% of the basis of those assets to the LLC. Accounts receivables are included in this definition of "inventory." In applying the 120% test, inventory acquired for the principal purpose of avoiding the provisions of IRC section 751 is excluded. All distributions that are not disproportionate are considered to be proportionate.
Current Proportionate Distributions. In a current proportionate distribution, the member's basis in his or her LLC interest is reduced by the basis of the property distributed. The member's basis cannot be reduced below zero. Thus, a gain may be recognized by the member to the extent cash distributed exceeds the basis of the member's LLC interest. Because a reduction in liabilities is treated as a constructive cash distribution, a comparable reduction in the member's share of liabilities can also produce a taxable gain. Losses are never recognized to the distributee member in a current proportionate distribution. The member's basis in the distributed property is generally a carryover basis from the LLC, limited to the member's basis for his or her LLC interest. The following examples demonstrate the effects of a current proportionate distribution.
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Example. Assume XYZ is an LLC and has the year-end balance sheet depicted in Exhibit 1. Each member's basis in his or her LLC interest is $85,000. Assume the LLC distributes capital asset A to member X and capital assets C and D to members Y and Z, respectively. Member X's basis in his interest will be reduced by $15,000 to $70,000. His basis in the distributed asset will be $15,000, and he will recognize no gain or loss. XYZ will also recognize no gain or loss as a result of the distribution to member X. The distribution to member Y would have a similar effect. After the distribution, member Y would have a basis in his interest of $55,000, a basis in the distributed asset of $30,000, and XYZ would recognize no gain or loss. In contrast, because a member's tax basis in his or her LLC interest can never be negative, member Z's basis in his interest can only be reduced to zero. Member Z's basis in the asset is $85,000, and the remaining $5,000 of LLC basis in asset D is lost and not recoverable. (This $5,000 of basis loss can only be prevented by use of an IRC section 754 election that may or may not be feasible. See the discussion later in this article.) A more favorable tax result can be obtained by having the LLC sell the asset (if feasible), recognize the $40,000 loss, and distribute the cash to member Z. No basis would be lost if this approach were used, and the $40,000 loss would flow-through to the three owners.
Liquidating Proportionate Distributions. Unlike a current distribution, a member may recognize a gain or loss in a liquidating proportionate distribution. As in the case of current distributions, gains are only recognized when cash received exceeds the member's basis in the LLC. The basis of the distributed property in the hands of the member is equal to his or her LLC basis less any cash distributed to the member. A loss may be recognized in liquidating distributions only under limited circumstances. If cash, inventory, and unrealized receivables (or any combination thereof) are the only property distributed, and if the basis of this property to the LLC is less than the basis of the member's interest, the member will recognize a loss to the extent of this difference. In this loss case, the basis of the cash, inventory, and unrealized receivables in the hands of the member is equal to the property's basis in the hands of the LLC (that is, a carryover basis). No gain or loss will be recognized by the LLC in a liquidating proportionate distribution.
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Again, assume XYZ has the balance sheet depicted in Exhibit 1. Assume there is a liquidating distribution in which X receives $100,000 of cash, Y receives capital assets A and B, and Z receives capital assets C and D. Member X must recognize a capital gain of $15,000 ($100,000 cash distributed less X's $85,000 LLC basis). Member Y recognizes no gain or loss and allocates his $85,000 LLC basis to assets A and B in proportion to their basis to the LLC ($36,429 to asset A, and $48,571 to asset B). Member Z also recognizes no gain or loss, and allocates his LLC basis to assets C and D in proportion to their basis to the LLC ($21,250 to asset C, and $63,750 to asset D). Because the total basis of assets C and D cannot be stepped-up to an amount greater than member Z's $85,000 basis in his interest, the remaining $35,000 of LLC basis in assets C and D is lost and not recoverable. Again, this basis loss can be overcome by an IRC section 754 election discussed later in this article.
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Example. Consider a liquidating distribution where the LLC has the balance sheet depicted in Exhibit 2. If XYZ distributes all the inventory and $45,000 cash to member X in complete liquidation of member X's interest, X has received a disproportionate distribution. Both the receivables and the inventory are categorized as substantially appreciated inventory since their total fair market value of $70,000 exceeds 120% of their basis to the LLC, or $48,000. The $55,000 of inventory distributed to member X exceeds his one-third share of the $70,000 of ordinary income property by $23,333. Therefore, member X is deemed to have received one-third of each asset ($33,333 cash, $5,000 receivables, $18,333 inventory, $20,000 capital asset A, and $23,333 capital asset B). He is then deemed to have exchanged some of these assets ($5,000 receivables, $20,000 capital asset A, and $23,333 capital asset B) for additional cash and inventory ($11,666 cash and $36,667 inventory). Both the member and the LLC must recognize gain on the exchange. Member X recognizes $3,654 capital gain. The LLC recognizes $8,636 ordinary income.
As was noted earlier, both current and liquidating distributions can cause a loss of asset basis when a distribution is made to a member whose LLC interest basis is less than the basis of the distributed property in the hands of the LLC. To prevent such a loss of basis, the LLC can make an IRC section 754 election. If the LLC has an IRC section 754 election in effect, the excess of the basis of the distributed property in the hands of the LLC over the basis of the property in the member's hands is allocated to similar-type assets still owned by the LLC. The allocation effectively recoups the lost basis and adds it to that of the LLC's remaining assets.
An IRC section 754 election, however, can also have adverse effects on the LLC. Such negative consequences could occur, for example, in a liquidating distribution where the distributed property has a basis to the LLC that is less than the member's basis in his or her LLC interest. The member still substitutes his LLC basis for the asset (or assets) received, but the LLC must then reduce the basis of its remaining assets by the difference between the asset's basis to the member and its basis to the LLC.
An IRC section 754 election affects not only distributions, but also sales and exchanges of LLC interests. When a member sells or exchanges an LLC interest, the basis of the new member's share of LLC property is increased by the excess of his or her basis in his or her LLC interest over the basis of his or her proportionate share of LLC property. This adjustment effectively makes the basis of his or her share of LLC property equal to the total basis. The adjustment can also have the opposite effect, reducing the basis of his or her share of LLC property when the basis of that property exceeds the overall LLC basis. These adjustments affect only the new member.
To be effective for the current year, the LLC must file the IRC section 754 election by the due date of the tax return that includes the distribution. Once the election is made, it is binding on all future distributions unless it is revoked with the consent of the IRS. Accordingly, LLC members should understand all the implications of an IRC section 754 election before making such an election.
Subsequent Sale of
Distributed Property
The character of the gain or loss realized by the distributee member when he or she sells distributed property is governed by IRC section 735. Any gain on the sale of unrealized receivables will be ordinary income regardless of how long the member held the receivables. This rule assures that the potential income retains its ordinary character and prevents its conversion to capital gain. A gain or loss on the subsequent sale of inventory will be characterized as ordinary income if the sale takes place within five years of the distribution. Otherwise, the gain or loss will be capital in nature. For any other property sold by the distributee member, the character of the gain or loss depends on the holding period and the character of the property in the hands of the member. The holding period of the member includes the period of time the LLC held the asset.
Terminations
It is obvious that IRC sections dealing with distributions should be invoked when an LLC actually distributes property. However, what may be less apparent is that these sections also apply when an LLC terminates. An LLC will terminate for tax purposes when either 1) it ceases to actively conduct any part of its trade or business, or 2) 50% or more of the total interest in the capital and profits of the LLC is sold or exchanged within a twelve month period. This latter case is referred to as a technical termination. The sale or exchange may be to a new or an existing member. The consequences of a technical termination have recently been changed by proposed regulations outlined in Notice PS-5-96.
Prior Regulations. Under the prior regulations, a technical termination results in a deemed distribution of LLC property to its members followed by the recontribution of that property back to a new LLC. The rules of proportionate liquidating distributions apply, and the LLC and its members may recognize gains or losses upon the deemed distributions. The property may then be contributed to the new LLC in a tax-free transaction.
Another consequence of a termination under the prior regulations is the loss of the LLC tax year and the loss of all prior elections. The new LLC must establish a new tax year and file new elections. The loss of the tax year may cause LLC income for a period of greater than twelve months to be bunched into a member's single tax year. The following example illustrates the effect of a termination under the prior regulations.
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Example. Assume X and Y of the XYZ LLC (Exhibit 1) sell their entire interests in the LLC to M and N for $100,000 each. These sales cause a technical termination of the LLC since more than half of the total interest in the LLC was sold within twelve months. The income or loss of the LLC as of the date of termination will be allocated to the members X, Y, and Z, and will be treated as received on the date of termination. If an LLC whose tax year ends on March 31 terminates on August 31, both the March 31 year-end income and the income or the subsequent five-month period between March 31 and August 31 will be taxable in the member's tax year ending December 31, assuming the member is a calendar year taxpayer. The assets are then deemed to be distributed in a proportionate liquidating distribution to members Z, M, and N. Each member takes a substituted basis in the property deemed to have been received. Member Z has an $85,000 basis in his distributed assets. He recognizes no gain since the cash he is deemed to receive does not exceed his basis, and he recognizes no loss since he receives assets other than cash, inventory, and unrealized receivables. Members M and N each have a $100,000 basis in the assets they are deemed to receive and likewise recognize no gain or loss. Finally, the new members are deemed to contribute their property to a new LLC in a tax-free transaction. The basis of the property to the new LLC is a carryover basis from the members.
Under the proposed regulations, when members X and Y sell their interests in the XYZ LLC (Exhibit 1) to M and N, the LLC terminates but makes no deemed distribution. Instead, XYZ contributes its assets and liabilities to the new ZMN LLC in exchange for a 100% interest in the new LLC in a nontaxable transaction. The basis of XYZ's interest in ZMN is the same as its basis in the assets it contributed to the new LLC. Thus, upon distribution of this interest to Z, M, and N, no gain or loss will be recognized, and the members' basis in the new LLC will be the same as their basis in the old LLC.
Finalization of this proposed regulation appears very likely in the near future. It will become effective when it is published in the Federal Register and will apply to terminations occurring on or after May 13, 1996. In general, these new regulations should have a positive impact on the taxation of LLC terminations. LLCs and their members no longer will need to be concerned about recognizing gains or losses or losing basis when 50% or more of the LLC's total interests are sold or exchanged within a 12-month period.
Planning Through the Operating Agreement
When considering the formation of an LLC, care should be taken to ensure distribution issues are thoroughly discussed and the operating agreement contains provisions governing distributions and sales of member interests. Close attention must be paid to all distributions by an LLC to avoid unfortunate tax results such as unnecessary income recognition and loss of tax basis. Additionally, the operating agreement should specifically empower the LLC to make all appropriate tax elections. This foresight will go a long way toward ensuring the tax liability of LLC members is minimized. *
Norman J. Mangina, is a tax accountant with Gross, Collins + Cress, P.C., Atlanta, GA. Elizabeth Plummer, PhD, CPA, is an assistant professor and Paul J. Streer, PhD, CPA, a professor, at the J.M. Tull School of Accounting, University of Georgia.