Editor: Albert B. Ellentuck, Esq.
Although the legal termination of an LLC classified as a partnership is determined under state law, termination for tax purposes is determined under the specific provisions of Sec. 708. LLCs terminate under the tax law either because the LLC’s business ceases or because 50% or more of the LLC’s profits and capital interests are transferred within a 12-month period. The mechanical nature of these rules allows the practitioner to determine with a great degree of certainty whether the LLC has terminated for tax purposes. Sec. 708 can also cause the unintended termination of an LLC under the “technical termination” provisions (50% or more ownership change in 12 months), along with the related tax ramifications. In fact, many partnerships and LLCs have been terminated without the partners’ or members’ knowledge.
The general rule for determining whether an event triggers the termination of an LLC classified as a partnership is found in Sec. 708(b)(1). The rule identifies the following two events as those that cause an LLC termination for tax purposes:
- No part of any business, financial operation, or venture of the LLC continues to be carried on by any of its members in an LLC or partnership (including when the LLC has fewer than two members). Conversion of a partnership to an LLC (and vice versa) does not terminate the converting entity.
- The sale or exchange of a 50% or more interest in LLC capital and profits within a 12-month period (which can include parts of two tax years).
Caution: The provisions of Sec. 708 are the only criteria used to determine whether an LLC classified as a partnership is terminated for tax purposes. The legal dissolution of an LLC under state law because of the death, withdrawal, bankruptcy, or incompetence of a member does not result in an LLC termination for tax purposes if the event does not trigger one of the two events previously described.
In certain situations, it may be advisable for an LLC to terminate for tax reasons. For example, if a Sec. 754 basis adjustment election has been missed and the IRS has rejected the LLC’s request for relief, a termination may be the only way to achieve a basis step-up. In other cases, it may be desirable to continue the legal existence of an LLC, even when the LLC has terminated for tax purposes and distributed all its operating assets. This may be the case, for example, if there is an issue about who the tax management partner would be on a subsequent audit of the LLC, where the LLC has contingent assets or liabilities (perhaps pertaining to an ongoing lawsuit), or where it holds title to intangible assets (trade names, licenses, etc.) that it wants to make unavailable to other entities.
Discontinuation of Business
An LLC classified as a partnership is terminated for tax purposes if its business is discontinued and its assets are distributed to its members. In addition, if an LLC’s business is continued in a new form such as a corporation or sole proprietorship, the LLC is terminated for tax purposes (Sec. 708(b)(1)). Presumably, if the LLC’s business continues to be carried on in a partnership form, there is no termination for federal income tax purposes.
Cessation of Business Activities
Determining whether an LLC’s business activities have ceased is not always a straightforward task. To prevent unintended terminations, the regulations and the courts have provided great latitude in the definition of what constitutes a continuation of the LLC’s business activities. As a general rule, the cessation of business activities and the termination of the LLC are considered to occur at the time of the final distribution of assets to the members. The courts have held (in the context of partnerships) that the process of winding up a partnership is considered part of the partnership’s business ( Sargent , T.C. Memo. 1970-214).
Example 1: B and C are members in TC LLC, a cattle company, and each owns a 25% interest in its profits and capital. Q owns the remaining 50% interest. TC is classified as a partnership for federal taxes. The members have decided that due to the depressed cattle market, they want to get out of the business. On July 1, 2008, they agree to dissolve TC , sell its assets, pay off its debts, and distribute the remaining cash to the members. From July 1, 2008, through April 12, 2010, the members proceed through an orderly disposition of TC ’s assets and a windup of its business operations. On March 15, 2010, the members receive a final distribution of the remaining cash. TC does not terminate for tax purposes until March 15, 2010, when the final cash distribution is made. The winding up phase (from the date of the decision to cease business operations through final disposition of the business’s assets, payment of liabilities, and distribution to the members) is considered a continuation of TC ’s business activities.
Most state LLC acts contain provisions that stipulate who can wind up the LLC’s business affairs and how distributions will be made to creditors and members. LLCs generally must distribute their assets first to creditors, then to members according to the provisions of the state act or the LLC’s operating agreement, if the state act permits. When an LLC is dissolved, it generally must file articles of dissolution with the secretary of state of the state of organization.
In determining if no part of any business, financial operations, or venture of the LLC is carried on by any of its members in an LLC, the courts have focused on the beginning phrase “no part.” Interpreting this literally, they have stated that a partnership is not terminated even though its sole assets are notes receivable arising from the sale of the partnership’s assets ( Foxman , 41 T.C. 535 (1964)). When the partnership’s books are left open, holding the notes is considered part of the partnership’s trade or business, and therefore the partnership is not terminated ( Baker Commodities, Inc. , 48 T.C. 374 (1967)).
Example 2: The facts are the same as in Example 1, except that in the process of selling its assets, TC agrees to accept a note for the sale of half its assets. The note has a term of three years and matures on December 15, 2011. TC will retain the note and distribute the interest and principal to the members as it receives the payments. In this situation, the courts have held that holding a note results in the continuation of the LLC because not all the LLC’s assets have been distributed to the members. TC is not terminated for tax purposes until December 15, 2011.
An LLC classified as a partnership can also change its business purpose without causing a termination. For example, a partnership does not terminate when it changes its business purpose from developing property to holding the property for investment purposes ( Ginsburg , 396 F.2d 983 (Ct. Cl. 1968)). But LLC articles of organization that are not broadly stated may need to be amended to reflect the change in business purpose.
Observation: The rules for determining the date on which LLC business activities cease allow the members to manipulate the termination date. For example, if the members in Example 2 want to terminate TC before the date on which the final note payment is collected, they can easily distribute an interest in the note to each member. If the members want to extend TC ’s life, they can do so by leaving notes payable on its books. However, if the manipulation of the LLC termination rules has an obvious tax avoidance motive, the courts could redetermine the termination date.
Nontax Issues Arising from Discontinuing Business
The date on which an LLC is considered terminated because of the discontinuation of business under the tax rules does not govern when the LLC terminates under state law. To legally dissolve an LLC, a certificate of dissolution should be filed with the state of formation. The state will generally not issue the certificate until the LLC can provide documentation that the company is current on all its state tax liabilities. Most state laws provide that if an LLC notifies its known creditors in writing of the dissolution, it will be relieved of liability to those creditors after a short period of time. State law frequently also provides that if an LLC publishes a notice of dissolution, its liability to unknown creditors is relieved after a slightly longer period—usually two years.
Practitioners frequently recommend that an LLC be maintained for some period of time after discontinuation of a business to provide some continuing degree of liability protection. Because the statute of limitation is generally 2–3 years for negligence and tort, 3–4 years for oral contracts, and 5 years for written contracts, it may be advisable to maintain the LLC for at least 5 years.
Administrative Issues on Dissolution
An LLC that is legally dissolving must address many administrative issues, including the following:
- Close accounts with any state agencies, including sales tax collection, worker’s compensation, state employment tax, etc.
- File final federal and state income, excise, sales tax, or other required returns.
- Cancel any business license registrations with a city or other entity.
- Notify states in which the LLC is registered to do business.
- Close all bank accounts.
- Notify creditors.
- Pay use tax on any assets converted to personal use.
- Pay transfer taxes, if any, on distributed assets and retitle assets.
- Cancel or renegotiate a transfer or substitution of the contracting party for contracts and leases into which the LLC entered.
- Pay off or renegotiate a substitution of the debtor for LLC loans.
- Notify customers and vendors.
In some situations, a member may pay off an LLC debt (regardless of whether the member guaranteed the debt) as part of the winding up process or at some point after the LLC’s termination. The tax treatment of this payment depends on several factors. A payment at the time of winding up may be treated as a contribution to the LLC, increasing the contributing member’s basis and reducing his or her gain on termination of the LLC. Payment of an LLC debt subsequent to the year of termination will generally give rise to business or nonbusiness bad debt.
This case study has been adapted from PPC’s Guide to Limited Liability Companies, 15th 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, 2009 ((800) 323-8724; ppc.thomson.com).
Albert Ellentuck is of counsel with King & Nordlinger, L.L.P., in Arlington, VA.