Regs. Sec. 1.708-1(d) provides the federal income tax rules that apply to the division of a limited liability company (LLC) classified as a partnership. To understand this regulation, one must first understand the terminology it uses.
Prior LLC: A prior LLC is one that exists under applicable jurisdictional law that is subsequently divided into two or more LLCs (Regs. Sec. 1.708-1(d)(4)(ii)).
Resulting LLC: A resulting LLC is one that (1) results from the division of a prior LLC and exists under applicable jurisdictional law after the division and (2) has at least two members that were members in the prior LLC. In other words, a resulting LLC is a post-division LLC that results from the division (Regs. Sec. 1.708-1(d)(4)(iv)).
Continuing LLC: A continuing LLC is a resulting LLC in which the members owned more than 50% of the capital and profits interests of the prior LLC. There can potentially be several continuing LLCs. For example, if the prior LLC divides into two new LLCs and both have exactly the same members as the prior LLC, there are two continuing LLCs. Note that a continuing LLC will not necessarily meet the definition (below) of a divided LLC. It is also possible that none of the resulting LLCs will qualify as a continuing LLC if none of the resulting LLCs have members that owned more than 50% of the capital and profits of the prior LLC (Regs. Sec. 1.708-1(d)(1)).
Note: Any resulting LLC that does not meet the definition of a continuing LLC is treated as a new LLC for federal income tax purposes. As such, it must obtain a new taxpayer identification number (TIN), establish its own tax year, select its own accounting methods, and make its own tax elections.
If an LLC division is undertaken simply to place assets into separate legal entities, and the members’ interests in the recipient LLCs are identical to their interests in the prior LLC, each of the recipient LLCs is considered a continuation of the prior LLC (see IRS Letter Ruling 8605047).
Example: The members of M LLC, a medical practice, decide to divide into two LLCs — one to continue its family medical practice (“new” M LLC) and the other to continue the radiology practice (N LLC). M and N are both classified as partnerships for federal taxes. The ownership of the LLC’s capital and profits interests before and after the division is as shown in the table, “Determining Which LLC Continues for Tax Purposes” (below).
The new M is deemed a continuation of the old M LLC (the prior LLC) because more than 50% of the capital and profits interests of the prior LLC are owned by members of the new M. (Collectively, A and B owned 60% of old M.)
Divided LLC
A divided LLC is a continuing LLC that is treated for federal income tax purposes as a continuation of the prior LLC (Regs. Sec. 1.708-1(d)(4)(i)). As such, the divided LLC retains the prior LLC’s TIN, tax year, tax accounting methods, and tax elections. If only one resulting LLC meets the definition of a continuing LLC, that LLC will be the divided LLC. If there are several continuing LLCs, the continuing LLC with assets having the greatest fair market value (net of liabilities) is the divided LLC. Only one resulting LLC can possibly qualify as the divided LLC. However, it is also possible that none of the resulting LLCs will qualify as the divided LLC. For example, if none of the resulting LLCs have members that owned more than 50% of the capital and profits of the prior LLC, none of the resulting LLCs will qualify as the divided LLC.
Recipient LLC
A recipient LLC is an LLC that is treated for federal income tax purposes as receiving assets and liabilities from the divided LLC, either directly under the assets-over form or indirectly under the assets-up form (Regs. Sec. 1.708-1(d)(4)(iii)).
50% rule determines treatment of post-division LLC
Again, upon the division of an LLC into two or more LLCs, any resulting LLC is considered a continuing LLC if the members of the resulting LLC owned more than 50% of the capital and profits of the prior LLC.
As mentioned above, under this 50% rule, there can potentially be several continuing LLCs. For example, an LLC could split into two resulting LLCs with the same partners. Both resulting LLCs would be continuing LLCs. However, only one of the continuing LLCs can be treated as the divided LLC. That LLC retains the prior LLC’s identity for federal income tax purposes. In other words, the divided LLC is effectively treated as a continuation of the prior LLC.
Reporting requirements
A resulting LLC treated as the divided LLC must file a Form 1065, U.S. Return of Partnership Income, for the tax year of the prior LLC and retain the prior LLC’s employer identification number (EIN). The return must include a statement that the divided LLC is a continuation of the prior LLC. (This should also be written across the top of the first page of the return.) The statement must list the distributive shares of the members for the period up to and including the date of the division and for the period after that date. The statement must also include the names, addresses, and EINs of all LLCs that are treated as resulting LLCs (if any). The divided LLC also remains subject to the prior LLC’s accounting methods and elections (Regs. Sec. 1.708-1(d)(2)(ii)).
All other resulting LLCs (whether or not treated as continuing LLCs) must obtain new EINs. These LLCs must file Forms 1065 for the period beginning on the day after the date of the division. However, resulting LLCs that are regarded as continuing LLCs but not as the divided LLC still remain subject to the prior LLC’s accounting methods and tax elections (Regs. Sec. 1.708-1(d)(2)(ii)). These continuing LLCs must also include a tax return statement disclosing the name, address, and EIN of the prior LLC. All resulting LLCs regarded as new LLCs must obtain EINs and adopt their own accounting methods and make their own elections. When there is no divided LLC, the prior LLC is deemed to terminate and liquidate as of the division date. A final return for the prior LLC for the short period ending on the division date must be filed.
Tax results of division
The form of an LLC division will be respected for federal income tax purposes if it is either an assetsover transaction or an assets-up transaction (Regs. Sec. 1.708-1(d)(3)). In a division under the assets-over form, the momentary ownership of all interests in the recipient LLCs by the prior LLC does not prevent the classification of the recipient LLCs as partnerships. LLC members should also consider any legal filings required by state law and review the LLCs’ articles of organization and operating agreements to ensure they meet the resulting LLCs’ needs.
If an LLC division occurs under a state law that does not require a form to be implemented or is implemented using any form that is not an assets-up transaction, the division is treated as an assets-over transaction (Regs. Sec. 1.708-1(d)(3)(i)).
In an assets-over division where at least one resulting LLC is a continuation of the prior LLC, the LLC that is considered the divided LLC contributes certain assets and liabilities to a recipient LLC or LLCs in exchange for interests in the recipient LLC or LLCs. Immediately thereafter, the divided LLC distributes the interests it receives to some or all of its members in partial or complete liquidation of their interests in the divided LLC. In an assets-over division where none of the resulting LLCs is a continuation of the prior LLC, the divided LLC is treated as contributing all of its assets and liabilities to new resulting LLCs in exchange for interests in the recipient LLCs. Immediately thereafter, the prior LLC is treated as liquidating by distributing the interests in the resulting LLCs to its members (Regs. Sec. 1.708-1(d)(3)(i)(A)).
In an assets-up division, the prior LLC transfers assets to its members, who then transfer those assets to a recipient LLC. In an assets-up division where the LLC distributing assets is a continuation of the prior LLC, the divided LLC (which must be a continuing LLC) distributes certain assets to some or all of its members in partial or complete liquidation of their interests. Immediately thereafter, the members contribute the distributed assets to a recipient LLC in exchange for interests in that LLC. In an assets-up division where none of the recipient LLCs are a continuation of the prior LLC, the prior LLC distributes certain assets to some or all of its members in partial or complete liquidation of their interests in the prior LLC. Immediately thereafter, the members contribute the distributed assets to a resulting LLC or LLCs. If the prior LLC does not liquidate under applicable state law, then, with respect to the assets and liabilities that in form are not transferred to a new resulting LLC, the prior LLC will be treated as transferring those assets and liabilities to a new resulting LLC in an assets-over transaction. Under either type of assets-up division, the distribution must result in the members’ being treated under applicable state and local law as the owners of the distributed assets. Additionally, for the form of this transaction to be respected, all assets held by the prior LLC that are transferred to the resulting LLC must be distributed to and then contributed by the members of the resulting LLC (Regs. Sec. 1.708-1(d)(3)(ii)).
If any division is part of a larger series of transactions and the substance of the larger series of transactions is inconsistent with the form of the transaction, the IRS may disregard the form and may recast the larger series of transactions in accordance with their substance (Regs. Sec. 1.708-1(d)(6)).
The regulations clarify that for a division to occur, at least two members of the prior LLC must be members of each resulting LLC that exists after the transaction (Regs. Sec. 1.708-1(d)(4) (iv)).
This case study has been adapted from Checkpoint Tax Planning and Advisory Guide’s Limited Liability Companies topic. Published by Thomson Reuters, Carrollton, Texas, 2023 (800-431-9025; tax.thomsonreuters.com).
Contributor
Shaun M. Hunley, J.D., LL.M., is an executive editor with Thomson Reuters Checkpoint. For more information about this column, contact thetaxadviser@aicpa.org.
