A limited liability company (LLC) transfers cash and property to its members by making distributions. A distribution of cash or property from an LLC classified as a disregarded entity has no tax ramifications because the assets transferred are already deemed the owner’s assets for federal taxes (although legal ownership is vested in the disregarded entity).
A distribution of cash or property from an LLC classified as a C corporation may represent a salary payment, a dividend, a return of capital, or a distribution made in partial or complete liquidation. (Unless the distribution is specifically classified by the entity as a salary, the IRS will argue that any corporate distribution is a dividend.) Each of these types of payments has different tax consequences for the LLC and the owner.
A distribution from an LLC classified as a partnership may represent a guaranteed payment, a return of capital, a distribution of operating profits, or a disguised sale of property. A distribution to a member in an LLC classified as a partnership may be a liquidating distribution or a current distribution. A liquidating distribution is a distribution (or a series of distributions that may extend beyond one year) that completely liquidates a member’s interest in the LLC. Under the general rule of Sec. 731(a), current distributions of cash or property are not taxable to the distributee member if the amount of cash received does not exceed the member’s tax basis in the LLC. The basis of the distributed property in the hands of the distributee member is equal to the LLC’s basis in the distributed property immediately before the distribution, limited to the total amount of the member’s basis in his or her LLC interest.
Observation: Special rules apply in determining the basis of distributed property when multiple properties are distributed in a liquidating distribution or when multiple properties are distributed and the total carryover basis of the distributed properties exceeds the member’s basis in the LLC.
Generally, a distribution to a member has no effect on the LLC. However, the LLC may recognize gain or loss on a distribution of so-called hot assets (generally, unrealized receivables and substantially appreciated inventory).
Loans from LLCs to members are not taxable, but if the transfer of money from an LLC to a member is treated as a loan, a subsequent cancellation of the debt will result in a deemed distribution of money to the member at the time of cancellation (Regs. Sec. 1.731-1(c)(2)). Because loans to LLC members are not taxable, but certain cash distributions are, a member may be tempted to recategorize an excess cash distribution as a loan from the LLC to the member. For the transaction to be treated as a loan, there must be an unconditional and legally enforceable obligation to repay a sum certain at a determinable date (Rev. Rul. 73-301).
Tax Planning Using LLC Distributions
LLC distributions most frequently occur when an LLC distributes operating cashflow or refinancing proceeds or liquidates a member’s interests. But distributions can also be used to accomplish the LLC’s tax planning goals. Following are several tax planning situations in which an LLC may want to distribute property to a member:
Alternative to sale of property: Some-times an LLC considering the sale of property finds it is more beneficial to distribute the property to a member, who then sells the property. This is particularly attractive when the LLC is liquidating a member’s interest and the member will have a higher basis in the distributed property than the LLC, or when a member has expiring carryforwards that will offset the gain on sale of the property.
However, see Court Holding Co., 324 US 331 (1945), where, in a corporate context, the IRS successfully argued that where a corporation negotiated the sale of property and then distributed the property to shareholders who consummated the sale, the sale of the property was taxable to the corporation and not the shareholders. To avoid this outcome, an LLC considering the distribution of property to a member for sale should not enter into negotiations with potential purchasers.
Alternative to like-kind exchange: If the LLC holds property that some members want to transfer in a Sec. 1031 exchange but other members do not, the LLC might consider distributing the exchange property to the interested parties. This may be a partial liquidation of the distributee members’ interests, or other property may be distributed to the other members.
Observation: Due to several recent IRS attacks on Sec. 1031 exchanges of property distributed by an LLC or partnership, practitioners should be careful when structuring Sec. 1031 exchanges where (1) property is contributed to an LLC in anticipation of the LLC exchanging the property in a like-kind exchange, (2) the property received in the exchange is contributed to an LLC by a member subsequent to the member’s receipt of the property in a like-kind exchange, (3) the property to be exchanged is distributed to the members in anticipation of the exchange, or (4) the property received by an LLC in a like-kind exchange is distributed to the members immediately after the exchange. In such cases, at a minimum, practitioners should consider having the client transfer the property before entering into a binding agreement to exchange the property. The longer the property is held between the date of transfer and the date of exchange, the better.
Alternative to special allocation of gain or loss: When a member will be specially allocated the gain or loss from the sale of a specific property under the terms of the LLC operating agreement, a distribution of the property is a viable alternative. This is beneficial when the special allocation of gain to the distributee member is not “substantial” under the substantial economic effect rules (see Regs. Sec. 1.704-1(b)(2)).
Nontax Issues When Planning Current Distributions
Distributions to LLC members must be made within the constraints of the provisions in the applicable state LLC statute and the LLC’s operating agreement. Practitioners advising LLC clients on making a current distribution should carefully review the operating agreement and applicable state statute for provisions that limit or restrict the LLC’s rights and obligations to make distributions.
Making Prohibited Distributions
Most state statutes contain a provision that prohibits an LLC from making a distribution that results in its insolvency. Some states specifically prohibit distributions that result in the LLC’s liabilities (including its obligation to make preferential distributions to members on dissolution) exceeding its assets. However, the statutes generally allow an LLC to make distributions that impair its ability to make preferential distributions to members on dissolution if the organizing documents so provide. Members and managers that receive or approve prohibited distributions are usually liable for the amount of the excess distribution. In addition, the terms of the LLC’s bank loans may restrict the LLC from making distributions. Any planned distributions should not violate the terms of the loan, which could cause the loan to be called.
Amount and Timing of Distributions
An LLC generally is not required under state law to make distributions to members prior to the withdrawal of the members or dissolution of the LLC. Requirements to make interim distributions usually must be included in the LLC’s organizing documents. State LLC statutes normally provide a default method for allocating distributions among the members (the default usually is based on capital contributions or on a per capita allocation). This default can usually be overridden by provisions in the articles of organization or operating agreement.
Distributions in Kind
Most state LLC statutes provide that an LLC is not compelled to make a distribution of property other than cash. Likewise, members generally are not compelled to receive a distribution of property other than cash (except to the extent of the member’s percentage interest in LLC property). This prohibition usually can be overridden by provisions in the articles of organization or operating agreement. If property contributions are going to be allowed, the LLC’s operating agreement should address how such contributions will be valued.
Tax Issues When Planning Current Distributions
Current distributions from an LLC classified as a partnership to its members are common, and most practitioners are familiar with how such distributions are treated. However, distributions sometimes can have unintended results if the LLC does not properly plan for when and how such distributions will be made. The following list addresses some tax issues to consider when an LLC classified as a partnership plans a current distribution:
1. Because a distribution of cash in excess of the member’s basis can result in the recognition of gain, careful consideration must be given to the order in which cash and property distributions are made and also to the distribution of encumbered property or debt, which can result in a deemed distribution of cash.
2. The application of Sec. 731(c) can result in a distribution of marketable securities being taxed as a distribution of cash.
3. A disproportionate distribution of the LLC’s “hot assets” may result in recognition of ordinary income instead of capital gain by the distributee member or a recognition of gain or loss by the distributor LLC when no gain or loss would otherwise have been recognized. The hot asset rules apply if the member receives more or less than his or her share of the LLC’s hot assets, so the property distributed need not be unrealized receivables or substantially appreciated inventory for the hot asset rules to cause ordinary income recognition. As a general rule, any disproportionate distribution of LLC assets may result in a Sec. 751 problem if the LLC holds unrealized receivables or appreciated inventory items.
4. A current distribution to a member may be part of a disguised sale of property or an LLC interest between the member and the LLC or between two members. A distribution that is part of a disguised sale may cause the selling party to recognize taxable gain on what would otherwise have been a nontaxable distribution, under Sec. 707(a)(2)(B).
5. A distribution of previously contributed property to a member other than the contributing member may result in the recognition of gain or loss by the contributing member (Sec. 704(c)(1)(B)).
6. Distributions to members who previously contributed appreciated property may result in the recognition of gain by the members on an otherwise nontaxable distribution under Sec. 737.
If a transaction treated as a distribution is, in substance, a sale or other transaction, the partnership anti-abuse regulations may be used to recharacterize the transaction. In TAM 9645005, the IRS ruled that where a two-member partnership held property that was to be sold in a condemnation sale, the distribution of the property one day before the sale to the partners to allow one to take advantage of the Sec. 1033 reinvestment provisions while allowing the other to keep the proceeds was not, in substance, a distribution. Instead, the partnership was deemed to be the selling entity, and the distributions to the partners were deemed to be sales proceeds and not property.
This case study has been adapted from PPC’s Guide to Limited Liability Companies, 12th Edition, by Michael E. Mares, Sara S. McMurrian, Stephen E. Pascarella II, Gregory A. Porcaro, Virginia R. Bergman, William R. Bischoff, and Linda A. Markwood, published by Thomson Tax & Accounting, Ft. Worth, TX, 2007 ((800) 323-8724; ppc.thomson.com ).