The tax treatment of a contribution to a limited liability company (LLC) depends on whether the LLC is taxed as a partnership, a disregarded entity, or a corporation. A contribution to an LLC taxed as a corporation is subject to the rules governing corporations. Generally, the contributions are nontaxable if the transfer of cash and property to the corporation is solely for stock (other than nonqualified preferred stock) and immediately after the exchange the transferors control the corporation. A contribution to an LLC taxed as a disregarded entity has no tax consequences because the entity is not considered an entity separate from its owner. Contributions to an LLC taxed as a partnership are governed by the partnership rules. These rules will be the subject of the remainder of this discussion.
Note: An LLC taxed as a corporation with different classes of membership could be deemed to have nonqualified preferred stock, even if the membership units are not called that anywhere in the LLC agreement.
General Nonrecognition Rule
Generally, Sec. 721 provides that a member’s transfer of property to an LLC taxed as a partnership does not result in income or loss to the member or the LLC. The LLC steps into the shoes of the contributing member with respect to the holding period and adjusted tax basis of the contributed property (Secs. 1223 and 723). This general nonrecognition rule applies both to contributions made upon the formation of the LLC and to subsequent contributions by new or existing members.
Example 1: A, B, and C form ABC LLC, which provides accounting services and is classified as a partnership. Each member practiced accounting as a sole proprietor prior to the formation of ABC. A contributes $10,000 cash. B contributes $5,000 cash and a tax library with a $5,000 FMV and a $3,000 tax basis. C contributes $1,000 cash and computer equipment with a $9,000 FMV and an $8,000 tax basis.
A, B, and C recognize no gain or loss on the contributions made to the new LLC. Likewise, the LLC recognizes no gain or loss on receipt of the contributions. Under Sec. 723, the LLC’s basis in the contributed assets is the same as each contributing member’s basis in the assets prior to the contribution. Therefore, ABC has a tax basis balance sheet reflecting $16,000 cash, a tax library with a $3,000 tax basis, and computer equipment with an $8,000 tax basis.
Example 2: Assume now that in the year after formation, A contributes an additional $5,000 cash to ABC. A new member, D, is admitted to the LLC. D contributes office equipment with a $10,000 FMV and a $4,000 tax basis. The LLC has no outstanding debt at the time of A’s and D’s contributions. Neither A nor D recognizes taxable income or loss on the contribution of the cash or property. ABC has a tax basis of $5,000 in the contributed cash and $4,000 in the contributed office equipment.
The general nonrecognition rule that applies to contributions by members to LLCs is not the same as the corporate rule that conditions nonrecognition treatment on the contributing shareholders being in control immediately after the exchange (Sec. 351). There is no control requirement for nonrecognition treatment under the rules applicable to LLCs taxed as partnerships. Since there is no control requirement, there is no requirement that the contributions be part of a systematic plan or that the contributions meet any of the other requirements of Sec. 351.
Exceptions to the Nonrecognition Rule
The general nonrecognition rule does not apply to the following:
- Certain contributions that result in a reduction in a member’s share of liabilities, if the deemed distribution of cash resulting from the reduction exceeds the member’s tax basis in his or her LLC interest. For example, this exception applies to certain contributions of encumbered property.
- Contributions that are more properly characterized as part of a disguised sale transaction.
- Contributions to an investment company as defined in Sec. 721(b).
- Contributions that are not considered contributions of “property.” For example, a contribution of services in exchange for an interest in the profits and capital of an LLC is not considered property.
- Contributions that are deemed gifts. A 1999 IRS field service advisory (FSA 199950014) provided that a couple made taxable gifts when they took back partnership interests with a value less than the value of the assets transferred. Presumably, this same argument would apply to members in LLCs taxed as partnerships.
Note: Sec. 721(c) provides Treasury with regulatory authority to prevent the general nonrecognition rule from applying to gain realized on the transfer of property to a partnership (or an LLC taxed as a partnership) if such gain, when recognized, will be includible in the gross income of a person other than a U.S. person.
Timing and Valuation of Property Contributions
It is frequently difficult to determine the timing and valuation of a capital contribution. Accordingly, the members of an LLC may want to address the timing and valuation of capital contributions in the operating agreement or in a separate contribution agreement. While it is normally easy to determine the timing of a property contribution because some legal documentation of the transfer is usually required, the value of the contribution is not always readily ascertainable.
To prevent the IRS from questioning the valuation of a contribution, the members should specify a reasonable method they have agreed to for valuing the contribution. Providing a reasonable method can also head off challenges by creditors concerning the value of contributed property. The valuation method may be, but does not have to be, based on an appraisal.
Documentation of Contributions
Documentation of capital contributions is also important. Most state statutes enforce only written contribution obligations. Accordingly, the terms of each capital contribution should be in writing, signed by both the LLC and the member/ contributor, and should include the following:
- Name, address, and EIN of the member and the LLC;
- Description of the property, services, etc., to be contributed;
- The value of the property and the method used to determine the value;
- The date of the contribution;
- The percentage interest in the LLC received for the contribution;
- Any liabilities assumed in connection with the contribution;
- Any other conditions or terms agreed to by the parties;
- A written transfer document, where appropriate (for example, an assignment of title);
- The acceptance of the contribution by the LLC;
- The adjusted basis of the property (including any accumulated depreciation subject to recapture under Sec. 1245 or 1250);
- Whether the contributor or the LLC will be responsible for payment of transfer fees and other costs related to the contribution;
- Any warranties and representations required to be made by the contributor regarding the contributed property; and
- Whether the LLC requires an inspection of the contributed property.
This case study has been adapted from PPC’s Guide to Limited Liability Companies, 14th Edition, by Michael E. Mares, Sara S. McMurrian, Stephen E. Pascarella II, Gregory A. Porcaro, Virginia R. Bergman, William R. Bischoff, James A. Keller, and Linda A. Markwood, published by Thomson Tax & Accounting, Ft. Worth, TX, 2008 ((800) 323-8724; ppc.thomson.com ).
Albert Ellentuck is of counsel with King & Nordlinger, L.L.P., in Arlington, VA.