Unpacking Your LLC: Tax Considerations in Limited Liability Company Liquidations
Has your LLC lost its luster? Has it outlived its usefulness as an asset management, asset protection, or, dare we say it, wealth transfer vehicle? Are you tired of discussing the company’s operations with the other owners? Are they tired of discussing its operations with you? Do you or the other owners covet the company’s assets? Does it seem time to split things up and let each owner go his or her own way with a share of the LLC’s property? If so, it may be time to dissolve and liquidate the company and distribute its assets to its owners. Some owners may want certain company assets, and other owners may want other company assets.
What, then, is there to think about? Do you have the votes needed under the company’s operating agreement and local LLC law to authorize the LLC’s dissolution and liquidation? Are there third parties whose consents to dissolution, liquidation or the transfer of particular assets will be required? Is there company debt to be satisfied or assumed by the owners in connection with the transfer of assets to the owners in the liquidation process?
And what about taxes? Yes, taxes. No problem, you say. Our LLC, like most, is a partnership for tax purposes, and we, the owners, are partners for tax purposes. When assets are distributed by a partnership to its partners, a partner must recognize taxable gain for income tax purposes only to the extent that any money distributed exceeds the partner’s adjusted basis in his or her partnership interest immediately before the distribution. We have very little money in our LLC, you say, so the liquidating distribution should not result in any taxable gain for our owners, or at least no significant taxable gain.
Not so fast. There are still a few tax questions to consider:
- Are any of the company’s assets “marketable securities”? Marketable securities are generally treated like money when it comes to the taxation of partnership distributions.
- Has any property been contributed to the company by an owner, or former owner, within the last seven years? If so, when that property was contributed did its value exceed the contributing owner’s basis in the property? This built-in gain may be taxable when the property, or even other property, is distributed.
- Has any property been contributed to the company by an owner within the last two years? If within a two year period a partner transfers property to a partnership and the partnership transfers money or other property to the partner, the transfers are presumed for tax purposes to be a sale of the property to the partnership.
- Does the company have unrealized receivables or substantially appreciated inventory (so-called “hot assets”)? If so, will such hot assets be distributed to the owners in proportion to their interests in the company’s hot assets? If hot assets are not distributed to the owners proportionately, the distributions may be treated as taxable exchanges between the company and the owners.
- Here is more on the tax rules behind these questions.
MARKETABLE SECURITIES TREATED AS MONEY
The tax law does provide generally that, when assets are distributed by a partnership to its partners, a partner must recognize gain only to the extent that any money distributed to him or her exceeds the partner’s adjusted basis in his or her partnership interest immediately before the distribution. The tax law also provides, however, that for purposes of applying that general rule the term “money” includes marketable securities, and any such marketable securities are taken into account at their fair market value as of the date of the distribution.
Example: A, B, and C form equal partnership ABC. After some years of operation ABC liquidates. At the time of liquidation, the partnership has assets of $3,000 including $2,000 worth of property (other than money) and $1,000 worth of marketable securities. At the time of liquidation each partner has a basis in his or her partnership interest of $250. ABC has a basis of $1,000 in the marketable securities. ABC distributes the $1,000 of marketable securities to C in complete liquidation of her partnership interest.
The distribution of the $1,000 of marketable securities to C is treated as a distribution of money. As a result, C recognizes $750 of gain on the distribution.
What, then, are “marketable securities”? Well, they are what you think they are and more. Actively traded financial instruments, such as stocks and other equity interests, bonds, and other debt instruments, options, derivatives, and actively traded foreign currencies are marketable securities. (Here, “actively traded” means that an established financial market exists for such property.) Interests in common trust funds or regulated investment companies (that is, mutual funds) are marketable securities. Financial instruments convertible into money or marketable securities are also marketable securities, as are financial instruments the values of which are determined by reference to marketable securities. Marketable securities may also include actively traded interests in precious metals and interests in an entity if substantially all of the assets of the entity consist of marketable securities or money.
Fortunately, there are a number of exceptions to the tax rule that marketable securities are treated as money in partnership distributions. One exception is for a marketable security contributed to the partnership by the partner receiving the marketable security in the distribution. Another is for marketable securities acquired by the partnership in certain non-recognition transactions (that is, transactions when an exchange results in no gain or loss for tax purposes). Another is for marketable securities that were not marketable securities when acquired by the partnership. Yet another is for distributions from certain “investment partnerships” to “eligible partners.” There are particular limitations on each of these exceptions as well as detailed requirements for investment partnerships and eligible partners.
In addition, there is a helpful limitation on the gain a partner must recognize upon receiving a distribution of a marketable security. The partner’s gain is reduced to the extent the distribution results in a decrease in the partner’s share of the net gain inherent in all of the partnership’s marketable securities. This limitation should cover most pro rata liquidating distributions of the partnership’s marketable securities. It should not be expected to cover, at least not completely, the disproportionate distributions of marketable securities that may occur when a pick and choose approach is taken to distributing LLC assets to the owners in liquidation.
DISTRIBUTIONS OF CONTRIBUTED PROPERTY
An LLC’s owners may contribute property as well as money or services to the LLC. Under partnership tax law if a partner contributes property to a partnership and if, at the time of the contribution, the fair market value of the property exceeds the partner’s basis in the property, the partnership must note and keep up with this “built-in gain.” There are several reasons for this.
Fundamentally, the tax law requires that any gain realized by the partnership on the disposition of the contributed property, for example, if the partnership sells the contributed property, must be allocated to the contributing partner to the extent of the property’s built-in gain.
Example: A, B, and C form equal partnership ABC. A contributes a parcel of land, property P. At the time of contribution, A has a basis of $500 in property P, and property P has a value of $800. B and C each contribute $800 in cash. ABC’s initial basis in property P is $500, the same as A’s basis in property P. After some years ABC sells property P for $1,100. At the time of the sale ABC’s basis in property P is still $500.
A’s built-in gain with respect to property P is $300 ($800 value at contribution less A’s $500 basis). ABC’s gain on the sale of property P is $600 ($1,100 sale price less ABC’s $500 basis). A’s share of ABC’s gain is $400 (A’s $300 built-in gain plus $100 (1/3 of ABC’s gain after allocation of A’s built-in gain to A)).
This concept of taxing the contributing partner on the built-in gain extends to certain otherwise non-taxable dispositions of contributed property.
If a partnership distributes property with built-in gain to a partner other than the partner who contributed the property and such distribution takes place within seven years of when the property was contributed, the contributing partner must recognize gain determined as if the contributed property had been sold to the other partner at fair market value on the date of the distribution. The contributing partner must recognize such gain to the extent of the built-in gain in the property.
Example: A, B, and C form equal partnership ABC. A contributes a parcel of land, property P. At the time of contribution, A has a basis of $500 in property P, and property P has a value of $800. B and C each contribute $800 in cash. ABC’s initial basis in property P is $500, the same as A’s basis in property P. Four years later ABC distributes property P, then valued at $1,100, to C in complete liquidation of C’s interest in ABC. At the time of the distribution ABC’s basis in property P is still $500.
A’s built-in gain with respect to property P is $300 ($800 value at contribution less A’s $500 basis).
A has taxable gain of $300 on the distribution of property P to C because if ABC had sold property P to C all of A’s $300 built-in gain would have been allocated to A.
As a result, if property has been contributed to the LLC within seven years of the planned liquidation, the owners should take care to identify any built-in gain and to consider distributing any such contributed property in the liquidation to the contributing owner.
In the alternative, the owners should consider the limited exception available for liquidating distributions in which the contributing owner receives an interest in the contributed property (and no other property). The exception will apply if (i) the contributing owner receives an interest in the contributed property, for example, a one-half interest, in the liquidation and no other property and (ii) the built-in gain in the interest received by the contributing owner (determined immediately after the distribution) will be at least equal to the built-in gain in the contributed property that would have been allocated to the contributing owner under the general rule. Under such circumstances, it will not matter that the other interest in the contributed property, for example, the other one-half, is distributed to other owners.
But what if the contributing owner has transferred his or her interest in the LLC to a successor? Such transfers are common in family LLCs and not uncommon in other LLCs. Does the successor stand in the contributing owner’s shoes when the LLC distributes the contributed property? The answer is yes. The successor, like the contributing owner, is liable for tax on the built-in gain in the contributed property. However, and this is helpful, the successor is also treated as the contributor for purposes of applying the exception for distributions of contributed property to the contributor.
DISTRIBUTIONS TO THE CONTRIBUTING OWNER
The concept of taxing the contributing owner on the built-in gain in contributed property also extends to distributions of other property to the owner who contributed the property with the built-in gain. Here the key factor is also the contribution of appreciated property within seven years of the distribution, but the calculation is more complicated.
A partner who receives a distribution of property (other than money) must recognize gain in an amount equal to the lesser of (i) the excess distribution or (ii) the partner’s net precontribution gain. The “excess distribution” is the amount by which the fair market value of the distributed property exceeds the partner’s adjusted basis in his or her partnership interest immediately before the distribution reduced by the amount of any money received in the distribution. The partner’s “net precontribution gain” is a familiar concept. It is the gain that the partner would have recognized under the rule described above for distributions of contributed property with built-in gain to other partners, and in application it assumes that all the property contributed by the partner in the last seven years and held by the partnership immediately before the distribution has been distributed to another partner.
Example: A, B, and C form equal partnership ABC. A contributes a parcel of land, property P. At the time of contribution, A has a basis of $500 in property P, and property P has a value of $800. B contributes a parcel of land, property Q. At the time of contribution, B has a basis of $800 in property Q, and property Q has a value of $800. C contributes $800 in cash. A’s initial basis in A’s interest in ABC is $500, the same as A’s basis in property P. ABC’s initial basis in property P is $500, the same as A’s basis in property P. ABC’s initial basis in property Q is $800, the same as B’s basis in property Q.
Four years later ABC distributes property Q, then valued at $1,100, to A in complete liquidation of A’s interest in ABC. At the time of the distribution, A’s basis in A’s interest in ABC is still $500, ABC’s basis in property P is still $500, and the value of property P is $1,200.
A’s excess distribution is $600 ($1,100 value of property Q received in the distribution less A’s $500 basis in A’s interest in ABC). A’s net precontribution gain (with respect to property P) is $300 ($800 value at contribution less A’s $500 basis).
A has taxable gain of $300 (the lesser of A’s $600 excess distribution or A’s $300 net precontribution gain) on the distribution of property Q to A.
What this means is that any owner who has contributed property with a built-in gain within the last seven years may be taxed on that built-in gain if the LLC still has the contributed property at liquidation and distributes other property to the contributing owner.
An exception to the general rule prevents contributed property being returned to the contributing partner from being taken into account for purposes of this tax calculation.
But what if the contributing owner has transferred his or her interest in the LLC to a successor? Does the successor stand in the contributing owner’s shoes when the LLC distributes property to the successor? The answer is not completely clear. It is clear that the successor must take the contributing owner’s net precontribution gain into account when determining whether the successor has gain on the receipt of other distributed property. However, it is not clear that the successor is also treated as the contributor for purposes of applying the exception for distributions of contributed property to the contributor.
DISGUISED SALES
Distributions by a partnership of property to a partner within two years of such partner’s contribution of other property to the partnership must be carefully considered. If within a two-year period a partner transfers property to a partnership and the partnership transfers money or other property to the partner, the transfers are presumed for tax purposes to be a sale of the property to the partnership by the transferring partner (on the date the partnership becomes the owner of the property).
When this disguised sale rule applies, it overrides the regular rules concerning distributions of partnership property in liquidation of the partnership. The federal income tax regulations governing disguised sales are complex, but the determination of whether a disguised sale has occurred is based on all the facts and circumstances. There are two basic questions. Would the transfer of money or other property have been made but for the partner’s transfer of the property? If the transfers were not simultaneous, was the later transfer (by the partnership) “dependent on the entrepreneurial risks of partnership operations,”? The regulations elaborate on these questions and provide special rules preventing certain distributions not deemed to be abusive from being taken into account for disguised sale purposes. The regulations also provide special rules for dealing with liabilities incurred in connection with the contributed property.
If the LLC must be liquidated within two years of the contribution of property by an owner, consideration should be given to the income tax consequences to the contributing owner (and the company) of a recharacterization of the contribution as a sale. If the tax consequences would be unacceptable, consideration should be given to returning the property to the contributor in the liquidation distribution.
DISTRIBUTIONS OF UNREALIZED RECEIVABLES AND SUBSTANTIALLY APPRECIATED INVENTORY
Disproportionate distributions of the LLC’s hot assets may result in partners realizing income or loss in the company’s liquidation. The owners should first ask if the company has any hot assets, that is, unrealized receivables or substantially appreciated inventory. The terms “unrealized receivables” and “substantially appreciated inventory” have meanings for tax purposes that are broader than you might expect. In general, unrealized receivables are assets representing not only unrealized receivables in the usual sense, but also the ordinary income recapture element of depreciable property. Inventory is substantially appreciated if its value is more than 120% of its adjusted basis.
If the LLC has hot assets, the owners should next ask if the hot assets will be distributed to the owners in proportion to their interests in the company’s hot assets. Answering this question requires applying the federal income tax regulations’ methods for determining a partner’s interest in the partnership’s hot assets.
If hot assets are not distributed to the owners proportionately, the distributions may be treated as taxable exchanges between the LLC and the owners. If an owner receives less than his or her proportionate share of the company’s hot assets, the owner may have ordinary income as a result of the distribution in liquidation. If an owner receives more than his or her proportionate share of the company’s hot assets, the owner may have taxable gain or loss as result of the distribution.
If there are hot assets, the key to avoiding these problems when liquidating the company is to distribute the hot assets proportionately, that is, in proportion to the owners’ interests in the company’s hot assets as determined under the tax regulations. Also, there is an exclusion for purposes of these calculations for a distribution of property to the owner who contributed the property.
Partnership tax law is complex, and any proposed LLC liquidation deserves a thorough, specific tax analysis. This analysis should include consideration of marketable securities, built-in gain, disguised sales, and disproportionate distributions of the company’s hot assets.
For more information about Unpacking Your LLC, contact a member of Smith Anderson’s Tax Group, business lawyers who understand taxation.
