Outside basis of an LLC interest acquired by purchase, gift, or bequest

When an interest in a limited liabilitycompany (LLC) classified as a partnership is acquired in exchange for a direct contribution to the LLC and no liabilities are contributed or assumed, the member’s initial outside basis (under Sec. 722) equals:

• The amount of money contributed, plus
• The adjusted basis of property contributed, plus
• Any Sec. 721(b) gain recognized when the member contributes to an LLC that is an investment company (generally, more than 80% of the LLC’s assets are securities held for investment).

Members sometimes acquire an LLC interest in exchange for services rendered to the LLC, or a partnership or corporation may be converted into an LLC. Outside basis in these situations is beyond the scope of this item.

Example 1. Members contribute cash and property: P and L form an LLC classified as a partnership to operate a souvenir shop. P contributes $10,000 cash to the LLC, and L contributes a cash register, shelving, and other equipment that has a $10,000 fair market value (FMV) and an adjusted tax basis of $4,000. P’s basis in her LLC interest is $10,000 while L’s is $4,000 — her adjusted basis in the contributed property.

When an LLC interest is purchased from an existing member, the transferee member’s purchase price is initial outside basis (Secs. 742 and 1012). When an LLC interest is acquired by gift, the transferee member’s basis generally equals the donor’s basis (Secs. 742 and 1015). However, if the carryover basis is greater than the FMV of the interest at the time of the gift, then for purposes of determining loss, the donee’s basis is the FMV. If federal gift tax is paid by the donor, the donee’s basis is increased by the amount of tax paid that is attributable to the net appreciation on the transferred interest, but the basis may not exceed the interest’s FMV (Sec. 1015(d); Regs. Sec. 1.1015-5(a)). Net appreciation is the amount by which the FMV of the transferred interest immediately before the gift exceeds the donor’s basis. The donee increases the basis of the interest by the amount of gift tax paid multiplied by the fraction obtained by dividing the amount of net appreciation by the gift’s FMV.

When property is transferred at the owner’s death, Sec. 1014 allows the federal income tax basis of inherited capital gain assets to be stepped up to FMV on the date of death or alternate valuation date.

Note: Even if the value of an inherited interest is zero, an heir can still have positive outside basis if the heir is allocated a share of LLC liabilities (Regs. Sec. 1.742-1).

When an LLC interest is acquired in another type of nonrecognition transaction, the transferee’s basis is determined under the nonrecognition provisions that apply. For example, an LLC interest can be acquired in a distribution from a corporation or another partnership or LLC. The transferee’s basis in an interest distributed from an LLC classified as a partnership is determined under the rules of Sec. 732, which generally provides that the interest’s basis is its adjusted basis to the LLC immediately before the distribution.

Example 2. Determining outside basis when member purchases interest from another member: B owns a 25% interest in T Investors LLC, which is classified as a partnership. T has no liabilities. B sells his interest in T to R for $50,000. At that time, B’s outside basis in his interest is $40,000, and the LLC’s basis in its assets is $160,000. The FMV of T’s assets is $200,000. R’s initial outside basis in the LLC interest is $50,000 — his purchase price. His initial basis is determined without reference to the LLC’s basis in its assets. Because the transaction creates an imbalance between R’s share of the inside basis of LLC assets (25% × $160,000 = $40,000) and R’s outside basis ($50,000), the LLC must adjust the basis of its assets if a Sec. 754 election is made or is in effect.

Example 3. Determining outside basis when member acquires LLC interest by gift: Assume the same facts as Example 2, except B decides to gift his interest in T to his daughter, E. Her initial outside basis in the LLC interest is $40,000 — a carryover of B’s basis. After the transaction, the LLC’s inside basis in its assets and the members’ aggregate outside bases in their LLC interests are equal.

Example 4. Determining outside basis when member inherits LLC interest: Assume the same facts as Example 3, except E inherits B’s interest in T. If the alternate valuation date is not elected, E’s initial outside basis in the LLC interest is $50,000 — the FMV of the interest on B’s date of death. The transfer of the interest to E creates an imbalance between E’s share of the inside basis of LLC assets (25% × $160,000 = $40,000) and E’s outside basis. If T does not have a Sec. 754 election in effect, E may want the LLC to make the election to adjust the basis of its assets in order to reflect the step-up of B’s interest in T to FMV on the date of his death.

Practice tip: Determining the value of an LLC interest requires some professional judgment. For example, a valuation discount may apply if the interest represents a minority interest or there are restrictions on its transferability. If the value of a decedent member’s estate is less than the applicable exclusion amount, the LLC interest should be included in the estate at its highest reasonable value, which maximizes the heirs’ basis in the interest without any estate tax cost.

How subscription notes affect outside basis

Members sometimes make contributions to an LLC in installments or pursuant to a subscription note payable to the LLC. This arrangement is sometimes called a staged or multiyear pay-in. If such a contribution is made to an LLC classified as a partnership, the member’s outside basis generally is increased only as the contribution obligation is retired (i.e., as contributions are made) (Rev. Rul. 80-235; Oden, T.C. Memo. 1981-184).

Example 5. Deferred member contributions (staged pay-ins): M and J form an LLC classified as a partnership that has no liabilities. M contributes $150,000 cash, and J contributes $40,000 cash and a personal note for $110,000. The note bears a market interest rate but does not have fixed payment dates. J intends to retire the note within 10 years. During year 2, J contributes $20,000, reducing his contribution obligation by that amount.

M’s initial outside basis is $150,000. J’s initial outside basis is only $40,000 — his cash contribution. J has no additional basis as a result of his note. His basis increased by $20,000 when he actually made a payment to reduce the note’s principal balance.

Practice tip: If the LLC wants to keep track of a subscription note balance, the note can be booked as an asset with an offsetting entry to a deferred capital contribution account. This allows for the disclosure of the asset on the books but, for tax purposes, makes it clear that J’s capital account does not include the deferred contributions. Also, the note must be recorded in the LLC’s book capital accounts at FMV to comply with the capital account maintenance provisions under the substantial economic effect safe harbor.

This case study has been adapted from Checkpoint Tax Planning and Advisory Guide‘s Limited Liability Companies topic. Published by Thomson Reuters, Carrollton, Texas, 2022 (800-431-9025; tax.thomsonreuters.com).