Sec. 721 generally provides that a member’s transfer of property to a limited liability company (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.
However, the nonrecognition rule applies only to contributions of property. While there usually is little difficulty in determining whether a contribution consists of property, questions can arise when a contribution could be characterized as property created by a person’s services or services that create property for the LLC’s benefit. This issue also arises if a member’s capital account is credited with an amount that clearly exceeds the fair market value (FMV) of the contributed property. In these situations, the adverse consequences of a misstep can be significant.
What Constitutes Property?
In most instances, determining whether a member’s contribution is property is a simple task. Money, fee title to real estate, and ownership of equipment are examples of contributions that clearly constitute property. When the property was created by the personal efforts of a member, however, there may be a question of whether the interest was received for the product (property) or the effort (services).
There is no requirement that the contributed property be tangible (see, e.g., Rev. Rul. 71-564 and Ambrose, T.C. Memo. 1956-125). Contract rights, goodwill, technical knowledge, and trade secrets all constitute property eligible for nonrecognition treatment. Also, a federal appeals court overturned a district court ruling that a letter of intent could constitute property only if it had value and was legally enforceable (Stafford, 727 F.2d 1043 (11th Cir. 1984)). The appeals court disagreed, determining that enforceability was not an essential condition of property status. The court analogized the letter of intent to goodwill, which is considered to be property even though it is unenforceable. For that reason, although it was not binding, the letter of intent constituted property. The property had been created by the partner’s efforts, for his own account, and the partner owned the property before he contributed it to the partnership. As a result, the contribution of the letter of intent was a nonrecognition transaction.
Example: A wants to construct an office building on block R. To this end, A (who is not an attorney) drafted a letter of intent by which an investor agreed in principle (1) to provide a first mortgage loan for the project and (2) to enter into a long-term lease for the completed building. The letter of intent was not legally binding on either party.
After the letter of intent was executed, A decided to form an LLC with B and C to develop the project. Pursuant to an operating agreement, A contributed the letter of intent he had negotiated. B, an architect, agreed to design the building and prepare architectural drawings for the LLC. C contributed $75,000 cash. Each member received an initial capital account equal to the agreed-upon FMV of their contribution and a one-third interest in LLC profits and losses.
C’s cash contribution is a property contribution. Based on the preceding discussion, A’s contribution of the letter of intent should also be treated as a contribution of property.
B’s services in designing the building are performed for the LLC’s account. Although his services create property, namely architectural drawings, B agreed from the start to create this property for the LLC. He never owned the property he created. As a result, B’s contribution does not qualify for nonrecognition treatment, and the FMV of his LLC interest is treated as compensation for services. If B had created the designs and drawings before an LLC had been formed so that he owned them with no obligation to contribute them to the LLC, a contribution of this service-created property would qualify for nonrecognition treatment (Frazell, 335 F.2d 487 (5th Cir. 1964)).
Contribution of Patents
The contribution of a patent or patents is considered a contribution of property to which the general nonrecognition rule applies. Special treatment is available if a patent is acquired from the patent holder (Sec. 1235). In such cases, in a subsequent sale of the patent by the transferee, the transferor member’s share of the gain recognized by the LLC on disposition of the patent will qualify under Sec. 1235 as long-term capital gain. Letter Rulings 200506008, 200506009, and 200506019 held that where the original patent holders transferred a patent to a wholly owned LLC, the LLC is entitled to long-term capital gain treatment on the subsequent sale of the patent.
Contribution of Debt Guarantees
Many LLCs request that members guarantee loans or make other similar financial guarantees. Often the LLC will treat such arrangements as a full or partial capital contribution. This creates some issues of timing and valuation that should be addressed in the operating agreement or other written agreement between the LLC and the member. The LLC should also consider paying members who guarantee loans a guarantee fee.
In Seminole Thriftway, Inc., 42 Fed. Cl. 584 (1999), the court held that the deductibility of guarantor payments was generally dependent on (1) the reasonableness of the fees; (2) whether businesses of the same type and size customarily paid guarantor fees to their owners; (3) whether the owners demanded compensation for signing as guarantors; (4) the absence of equity distributions to the owners, even though the payer’s profitability permitted such distributions; and (5) the proportional relationship between the amount of the guarantor payment and the owner’s share of equity.
Valuing the Contribution
Valuing the contribution of a financial guarantee can be problematic since there is no ready market for such instruments. To avoid having the value of the contribution questioned, the members should agree in writing on its value before the contribution is made. The guarantee can be valued using any reasonable method, including basing the value on a percentage of the guaranteed amount or using a fixed amount. The method used for determining the value should be specified in the LLC’s operating agreement or a separate capital contribution agreement. The agreement should also contain a provision for future increases in the guarantee. The LLC may also want to limit the dollar value of debt guarantees that can be contributed to capital to avoid the dilution of voting control.
The contribution agreement may also need to address the situation where the amount guaranteed is reduced because the guarantor loses financial strength. In that case, the agreement should provide for a reduction in interest, perhaps using a percentage range. For example, if the guarantee is reduced by no more than 10%, there is no reduction; if it is reduced by between 10% and 25%, there is a 5% reduction, etc.
An alternative to a traditional debt guarantee is to issue a second class of LLC interest to the guarantor. These LLC interests have a liquidation preference but have limited (or no) voting rights unless there is a default on the guaranteed debt.
Timing of Contribution
The timing of the contribution of a guarantee, and the right of the member/guarantor to vote and exercise the rights of ownership resulting from the contribution should be determined before the contribution is made. Since the receipt of an unrestricted LLC interest results in income to the guarantor, timing may be important to minimize income taxes as well. Normally, the execution of a guarantee establishes the responsibility of the guarantor for the debt. Accordingly, the authors believe the guarantor/member should be credited with a capital contribution at that time.
This case study has been adapted from PPC’s Guide to Limited Liability Companies, 19th 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, Fort Worth, Texas, 2013 (800-323-8724; ppc.thomson.com).
Albert Ellentuck is of counsel with King & Nordlinger LLP in Arlington, Va.