IRS Rules on Consequences of Sale of LLC Interest Treated as Sale of Real Estate

The IRS has ruled that an individual’s sale of a limited liability company (LLC) interest, treated as a sale of an undivided interest in the underlying real property owned by the LLC, is subject to neither the Sec. 453(e) related-party rules nor the Sec. 453(g) installment method disallowance rule. However, the individual must recognize all unrecaptured Sec. 1250 gain to the extent of Sec. 1231 gain in each tax year attributable to the sale (Letter Ruling 200937007).

Facts

The taxpayer for whom the letter ruling was issued is an individual who owns improved residential and commercial real estate but has not sold any real estate in several years. A trust was formed to invest in real estate and elected to be treated as a corporation for federal income tax purposes. The trust does not currently have any assets. A licensed realtor owns all the beneficial interest of the trust and serves as the trustee.

The trustee and the taxpayer are not related by blood or legally, but each owns a 50% interest in three partnerships: partnerships 1, 2, and 3. The trustee, the taxpayer, and individuals 1 and 2 each own 25% of partnership 4. The trustee and individual 1 are brothers.

Partnership 4 is an LLC and a disregarded entity under Sec. 761(a) for purposes of subchapter K. Partnership 4 owns one commercial real estate building from which it receives rental income. Partnership 4 depreciates the building using the straight-line method.

The taxpayer intends to sell his 25% interest in partnership 4 to the trust, reporting the gain using the installment method under Sec. 453. The trust will issue a promissory note, make monthly interest payments, and make a balloon payment for the principal at the end of the note term. The taxpayer will retain a security interest in the assets of the trust, including the membership shares of partnership 4. The trust is not and will not become a creditor of the taxpayer. The sale will be treated for federal income tax purposes as a sale of the taxpayer’s 25% interest in the commercial building. The trust may sell its 25% interest in partnership 4 or the undivided interest in the real property within two years after the installment purchase.

Issue 1—Related Parties

Under Sec. 453(e), if a taxpayer (the first seller) sells property to a related person and reports the gain under the installment method, and the related buyer later sells the property in a second disposition before the first seller reports all gain from the first sale, the first seller must include in his or her taxable income, in the year of the second disposition, the remaining deferred gain from the first sale to the extent of the total amount realized by the second seller from the second sale. A “related person” is defined for this purpose under Sec. 453(f)(1) as a person whose stock would be attributed to the first seller under Sec. 318(a) (other than paragraph (4)) or who has a relationship to the first seller as described in Sec. 267(b).

Sec. 267(b)(2) includes in the definition of related persons an individual and a corporation if the individual directly or indirectly owns more than 50% of the corporation’s outstanding stock. Stock held by a corporation, partnership, estate, or trust is considered proportionally held by its shareholders, partners, or beneficiaries under Sec. 267(c)(1). An individual is also deemed to own the stock of his or her partner under Sec. 267(c)(3) if the partner actually or constructively owns stock of the same corporation under Regs. Sec. 1.267(c)-1(a)(2).

The IRS ruled that the taxpayer and the trust are not related persons under Sec. 267(b) or Sec. 318(a). Accordingly, the taxpayer is not required to recognize gain on the second disposition of the taxpayer’s 25% interest in partnership ₄.

Issue 2—Controlled Entities

Sec. 453(g)(1)(A) precludes use of the installment method under Sec. 453(a) for sales of depreciable property between related persons. Sec. 453(g)(3) defines related persons for this purpose as a person and all entities controlled by that person (as stated in Sec. 1239(b)) and two or more partnerships that are related under Sec. 707(b)(1)(B). A controlled entity is a corporation of which more than 50% of the outstanding stock is owned directly or indirectly by one person, a partnership of which more than 50% of the capital or profits interest is owned directly or indirectly by one person, or an entity that is a related person under Secs. 267(b)(3), (10), (11), or (12). Sec. 1239(c)(2) also imposes the constructive ownership rules of Sec. 267(c) (other than paragraph (3)).

The IRS ruled that the taxpayer and the trust are not related parties under Sec. 1239(b) or Sec. 707(b)(1)(B). Accordingly, Sec. 453(g) does not preclude the taxpayer from using the installment sale method.

Issue 3—Depreciation Recapture

Sec. 453(i) requires any recapture income from installment sale property that would be treated as ordinary under Secs. 1245 or 1250 to be recognized in the year of disposition and any gain in excess of the recapture amount to be taken into account under the installment method.

Sec. 1250 requires the recapture of any depreciation in excess of the straight-line method upon the disposition of any Sec. 1250 property. This recapture is treated as ordinary income and is required to be recognized in the year of disposition.

The portion of capital gain treated as unrecaptured Sec. 1250 gain is subject to a special 25% maximum federal income tax rate for noncorporate taxpayers. Sec. 1(h)(6) defines unrecaptured Sec. 1250 gain as the excess of long-term capital gain that would be treated as ordinary income if Sec. 1250(b) included all depreciation and the applicable percentage under Sec. 1250(a) were 100% reduced by any net loss in the 28% tax rate category.

The IRS determined that partnership 4 calculated depreciation using the straightline method and accordingly ruled that there is no ordinary income recapture under Sec. 1250 upon the sale. However, the taxpayer must recognize any unrecaptured Sec. 1250 gain, equal to the amount of the straight-line depreciation allowed for the property, limited by the amount of net Sec. 1231 gain in each tax year. The taxpayer must take the unrecaptured Sec. 1250 gain into account before the adjusted net capital gain.

Implications

Consistent with prior guidance, the ruling confirms that for an individual to be considered as owning the stock of a corporation by or for his or her partner under Sec. 267(c), the individual must own or constructively own stock of the corporation. In the present case, the fact that the taxpayer and the trustee were equal partners in partnerships 1, 2, and 3 did not cause the taxpayer to be related to the trust (which had elected to be treated as a corporation for federal tax purposes) because the taxpayer did not own or constructively own any of the beneficial interests in the trust. As long as this is the case, it would appear that one is not precluded from using the installment sale method under Sec. 453(a).

The facts do not explain why the IRS considers partnership 4 to be a disregarded entity for federal income tax purposes under Sec. 761(a). It is possible that the disregarded status of partnership 4 is based on an analysis under Rev. Rul. 2004-86, Rev. Rul. 55-39, or Rev. Proc. 2002-22. However, the letter ruling does not specifically identify the partners of partnership 4 as co-owners of the property (see Regs. Sec. 1.761-2(a)(2)). Further, while Sec. 761 permits an election out of subchapter K, that election is not technically an entity classification.

EditorNotes

David Kautter retired from Ernst & Young LLP in Washington, DC, in December 2009.