Upon complete liquidation of a limited liability company (LLC) classified as a partnership, a distributee member generally does not recognize gain unless the cash and the fair market value (FMV) of marketable securities distributed exceed the outside basis in his or her LLC interest (Secs. 731(a) and (c)(2)). (Note that this column addresses the complete liquidation of an LLC as opposed to liquidation payments made to a retiring member or a deceased member's successor in interest.) Likewise, no gain or loss is recognized by the LLC on a liquidating distribution (Sec. 731(b)).
These general rules regarding gain or loss on liquidation are a major reason for formation as an LLC rather than as a corporation. While both entities provide owners with protection from liability, a corporation and its shareholders generally must both recognize gain or loss on liquidation. Upon distribution of property in complete liquidation, the corporation is treated as if the distributed property is sold at FMV to the distributee (Sec. 336(a)). The distributee shareholder generally must recognize gain or loss equal to the difference between the FMV of the property received and his or her basis in the corporation's stock (Sec. 331(a)).Tax Effects of LLC Liquidation
Gain is recognized by a member in an LLC classified as a partnership on the receipt of a liquidating distribution to the extent money is distributed in excess of the distributee member's basis in his or her LLC interest (see Sec. 731(a)(1)). Gain is also recognized under Sec. 731(a)(1) when a member receives marketable securities that are treated as money in excess of the member's basis in his or her LLC interest (see Sec. 731(c)(2)). In addition, gain may be recognized if (1) distributions of Sec. 751 hot assets (unrealized receivables and substantially appreciated inventory) are not proportionate (see Sec. 751(b)); (2) property that had an FMV different from basis on the date of contribution is distributed to a member other than the contributing member within seven years of contribution (see Sec. 704(c)(1)(B)); (3) the distribution is within seven years after a contribution of appreciated property (see Sec. 737); or (4) the distribution is part of a disguised sale (see Sec. 707(a)(2)).
A loss may be recognized upon a distribution in liquidation of a member's interest if no property other than cash, unrealized receivables, and inventory is received. The loss recognized is the excess of the member's adjusted basis in the LLC over the sum of the cash distributed and the member's basis in the unrealized receivables and inventory received (Sec. 731(a)(2)).
Example 1. Nontaxable liquidating distribution of cash and property: Z LLC is liquidating. Z is classified as a partnership. R's basis in his Z interest is $52,000. He has never contributed property other than cash to the LLC. To liquidate his interest, Z distributes to R $15,000 cash plus real property with a $50,000 FMV. Z's adjusted basis in the real property is $30,000. The LLC has no unrealized receivables or appreciated inventory, so Sec. 751 does not apply. The LLC acquired the real property by purchase.
R recognizes no gain or loss on the liquidation. R first reduces his $52,000 outside basis by the $15,000 cash distribution. His remaining $37,000 of basis in his LLC interest becomes his basis in the distributed real property (Sec. 732(b)). Z does not recognize any gain on the distribution although the FMV of the property R receives ($50,000) exceeds its $30,000 basis.
Example 2. Recognizing a loss on a liquidating distribution: V has a $20,000 basis in L LLC, which is classified as a partnership. L distributes $10,000 cash and inventory worth $12,000 to V in complete liquidation of her LLC interest. The inventory has an adjusted basis of $6,000 to L. V receives only her proportionate share of the inventory, and L has no unrealized receivables. Because the distribution is proportionate, the hot asset rules of Sec. 751(b) do not apply. V has a $4,000 capital loss on the liquidating distribution, computed as shown in the exhibit below.
Under the general distribution rules, V can allocate only $6,000 of basis to the distributed inventory—its adjusted basis to the LLC (Sec. 732(c)(1)). This leaves V with $4,000 of remaining basis in her interest but with no other distributed assets to absorb the additional basis. Consequently, she is allowed a $4,000 capital loss on the liquidation of L (Sec. 731(a)(2)).
Note: Gain or loss recognized on a liquidation may also affect the calculation of the member's net gain for purposes of the 3.8% net investment income tax. If any property besides cash, marketable securities, receivables, and inventory is distributed in the liquidating transaction, all loss recognition is deferred until the distributed property is actually sold or exchanged.
Tax Basis of Property Received
If no gain or loss is recognized on a liquidating distribution, the member's aggregate basis in the property received equals the member's basis in his or her LLC interest just before the distribution, reduced by the cash and marketable securities distributed (Sec. 732(b)). Special rules apply where multiple properties are distributed in a liquidating distribution or where the total carryover basis of distributed properties exceeds the member's basis in the LLC. Basis is assigned to the distributed properties as follows:
Step 1: Subtract the amount of cash and marketable securities received from the member's predistribution basis in his or her LLC interest.
Step 2: Any remaining basis is allocated first to distributed unrealized receivables and inventories in amounts equal to the LLC's basis in those assets.
Step 3: Remaining basis is then allocated to the other distributed assets (other than unrealized receivables and inventory) in amounts equal to the LLC's adjusted basis.
Step 4: Any basis increase (i.e., the distributee member's basis over and above the LLC's basis in the distributed assets) is then allocated to appreciated assets (other than unrealized receivables and inventory) in proportion to each asset's respective amount of any unrealized appreciation. However, basis should not be allocated in excess of FMV.
Step 5: If there is remaining basis increase to be allocated, it is allocated to assets (other than unrealized receivables and inventory) in proportion to their FMVs.
Note: Proposed regulations issued in January 2014, which will become effective when issued as final regulations, provide special rules that result in a "Section 704(c)(1)(C) basis adjustment" when built-in loss property is contributed to an LLC classified as a partnership (Prop. Regs. Sec. 1.704-3(f)(2)). The proposed regulations provide that if a member with a Sec. 704(c)(1)(C) basis adjustment (the Sec. 704(c)(1)(C) member) receives a distribution of property (whether or not the property is Sec. 704(c)(1)(C) property) in liquidation of its interest in the LLC, the LLC's adjusted basis in the distributed property immediately before the distribution includes the Sec. 704(c)(1)(C) member's Sec. 704(c)(1)(C) basis adjustment for the property in which the member relinquished an interest, if any, by reason of the liquidation. The LLC reallocates any Sec. 704(c)(1)(C) basis adjustment from Sec. 704(c)(1)(C) property retained by the LLC to distributed properties of like character under the principles of Regs. Sec. 1.755-1(c)(i), after applying Secs. 704(c)(1)(B) and 737.
If Sec. 704(c)(1)(C) property is retained by the LLC, and no property of like character is distributed, then that property's Sec. 704(c)(1)(C) basis adjustment is not reallocated to the distributed property, and the remainder is treated as a positive Sec. 734(b) adjustment. If the distribution also gives rise to a negative Sec. 734(b) adjustment, then the negative adjustment and the Sec. 704(c)(1)(C) basis adjustment reallocation are netted, and the net amount is allocated under Regs. Sec. 1.755-1(c). If the LLC does not have a Sec. 754 election in effect at the time of the liquidating distribution, it is treated as having made a Sec. 754 election solely for purposes of computing any negative Sec. 734(b) adjustment that would arise from the distribution.
Depreciation Methods Available After Liquidating Distribution
A member who receives a liquidating distribution of depreciable property acquires a depreciable basis in the property. To the extent the transferee member's basis does not exceed the LLC's predistribution basis, the member assumes the LLC's role and continues to depreciate the property using the remaining life and method used by the LLC (Sec. 168(i)(7)). If the member's basis exceeds the LLC's predistribution basis, the excess is treated as newly acquired property that is placed in service by the distributee at the time of distribution. This excess basis is subject to the depreciation rules, lives, and methods in effect at the time of the distribution (Sec. 168(i)(6)).
Holding Period for Distributed Assets
A member's holding period for property received in a nontaxable distribution includes the holding period of the LLC (Secs. 735(b) and 1223(2)). This rule applies whether the member receives the property in a current distribution or a liquidating distribution.
If an LLC distributes assets to a member in a liquidating distribution and those assets have been used in a passive activity, the member continues to carry over any suspended passive activity losses (PALs) with respect to that activity. The suspended PAL is allowed without limitation if the member disposes of substantially all of the passive activity (or his or her interest in the activity) in a taxable disposition to an unrelated third party (Sec. 469(g)). Accordingly, if a member receives only cash in complete liquidation of his or her LLC interest, it appears any suspended PALs generated by the LLC's activities should be fully deductible in the year of the liquidating distribution.
Any gain recognized by a member on an LLC's liquidation is treated as income from the LLC's at-risk activity (Prop. Regs. Sec. 1.465-66(a)). Accordingly, suspended at-risk losses can be used to offset the gain, if any, upon liquidation. However, if there is no gain on the liquidating distribution and the member continues the at-risk activity, it appears the member should be able to continue to carry over the suspended losses to offset future income or until the member has additional at-risk basis. These suspended at-risk losses can be applied only against future income or other future at-risk basis from the same activity (Sec. 465(b)(5)).
Any losses suspended because of lack of basis under Sec. 704(d) are not carried over by the member after the LLC's liquidation. Because the losses have not reduced the member's basis in his or her LLC interest, the suspended losses effectively constitute additional basis to the member when (1) determining gain or loss, if any, on the liquidating distribution, or (2) determining the basis of distributed assets.
Planning the Type of Property to Distribute
A member wishing to prevent gain recognition on a distribution should make sure the LLC does not distribute cash and marketable securities in excess of his or her basis in the LLC. The LLC can make a liquidating distribution of cash and marketable securities up to the retiring member's basis and then distribute other property for the balance of the required amount.
Warning: The IRS recharacterized as a taxable distribution of cash the distribution of a personal residence to a partner in liquidation of his interest. In Chief Counsel Advice 200650014, the IRS addressed a situation where a partnership formed an LLC to acquire a house for distribution to the retiring partner under the terms of a redemption agreement. Under the terms of the agreement, a substantial portion of the purchase price of the house was provided by a loan from a related party that was immediately repaid by the retiring partner.
The IRS attacked the purported distribution based on the fact that (1) the distribution was not a distribution of partnership property since the house was acquired and held for the account of the retiring partner, (2) the distribution should be recast in accordance with the anti-abuse rule of Regs. Sec. 1.701-2 as a distribution of cash to the taxpayer, which the taxpayer then used to acquire the house, (3) under the step-transaction doctrine the acquisition of the house by the partnership and its distribution to the retiring partner should be disregarded, and (4) the acquisition of the house by the partnership and its distribution to the retiring partner lacked economic substance and were unnecessary steps taken solely to achieve tax benefits.
A member can recognize a loss on the liquidation of his or her LLC interest if the distribution consists solely of money, unrealized receivables, and inventory and the LLC's basis in those assets is less than the member's basis in the liquidated LLC interest. In such situations, the loss recognized by the member is generally a capital loss. However, if the LLC holds Sec. 1231 property, a liquidating distribution of all or a portion of that property may convert the retiring member's capital loss to an ordinary loss.
Example 3. Converting capital loss on a liquidating distribution to ordinary loss: J, A, and B are equal members in BC LLC, which owns several small commercial buildings in White Fish, Mont. J has decided to leave the LLC, and A and B have agreed that the FMV of his interest is $500,000. The LLC has enough cash to make one or a series of liquidation payments to J for the full value of his interest. J's basis in his BC interest is $600,000.
If the LLC distributes $500,000 cash to J, he will recognize a capital loss of $100,000. J has no current or planned capital gains, so his ability to use the $100,000 loss will be limited.
Suppose, instead, that BC distributes to J $100,000 cash and one of the small office buildings that has a FMV of $400,000 and a tax basis to BC of $300,000. J will recognize no gain or loss on the distribution and will have a basis in the distributed office building of $500,000, the basis of his LLC interest after reduction for the $100,000 of cash received. (Note that the distribution of property with related depreciation recapture may result in the recognition of gain if the distribution is a disproportionate distribution of hot assets.) If the building continues to be Sec. 1231 property to J and he sells the building for its $400,000 FMV, he will realize a Sec. 1231 loss of $100,000, which will be ordinary, assuming he has no other Sec. 1231 gains.
The liquidation of an LLC may have a number of legal implications. Under state law, there may be questions regarding who remains liable for LLC liabilities distributed to members, required notifications to creditors of the LLC's intent to liquidate, required changes in legal title to distributed assets, required notification to the state of the LLC's intent to liquidate, compliance with applicable bulk sales acts (if the LLC's assets are to be sold prior to liquidation), etc. In addition, there may be legal issues surrounding the application of the operating agreement or other LLC governing documents to the liquidation transaction. For example, the operating agreement may be unclear regarding what methods should be used to value distributed property when members will not receive pro rata distributions of all LLC assets. Clients should seek legal advice before undertaking the liquidation of an LLC.
This case study has been adapted from PPC's Guide to Limited Liability Companies, 21st edition, by Michael E. Mares, Sara S. McMurrian, Stephen E. Pascarella II, and Gregory A. Porcaro. Published by Thomson Reuters/Tax & Accounting, Carrollton, Texas, 2015 (800-431-9025; tax.thomsonreuters.com).
Albert Ellentuck is of counsel with King & Nordlinger LLP in Arlington, Va.