LLC distributions that liquidate a member’s interest

The termination of a limited liability company (LLC) classified as a partnership for federal income tax purposes typically involves distributing all the LLC’s assets to its members in liquidation of their interests, although a partnership sometimes is terminated for tax purposes even if it continues to hold some assets.

Note: The rules for distributions that liquidate a member’s interest generally apply both to distributions that result in all the members’ interests being liquidated (generally in connection with terminating the LLC) as well as to distributions that liquidate one or more members’ interests, after which the LLC remains in existence because there are still at least two members. Certain payments made to liquidate a retiring (withdrawing) member’s interest (or the interest of a deceased member’s successor in interest) are classified as Sec. 736(a) payments, in which case they are treated either as guaranteed payments or distributive shares of LLC income. To the extent that liquidating distributions are not classified as Sec. 736(a) payments, they are taxed under the rules for distributions under Secs. 731 and 732, discussed next.

Exceptions to general nonrecognition rule

Generally, members of an LLC classified as a partnership for tax purposes do not recognize taxable gain or loss on a distribution unless the cash and the fair market value (FMV) of marketable securities distributed exceed their outside basis in the LLC interest (Sec. 731(a)). Likewise, the LLC generally does not recognize taxable gain or loss on distributions made to members (Sec. 731(b)). However, the following exceptions apply:

• Members recognize gain on distributions to the extent money is distributed in excess of their basis in their LLC interest (outside basis). For this purpose, marketable securities are treated as money.
• Ordinary income may be recognized on a disproportionate distribution of Sec. 751 “hot assets.”
• A member that contributed Sec. 704(c) property (i.e., with an FMV different from its basis on the contribution date) to the LLC may have to recognize gain or loss if such property is distributed to another member within seven years of its contribution.
• A member that contributed appreciated property to the LLC may have to recognize gain on a distribution (other than money) received within seven years of the appreciated property’s contribution.
• Gain or loss may have to be recognized if the distribution is deemed to be part of a disguised sale (Sec. 707(a)(2)(B)).
• 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 basis in the LLC interest (outside basis) over the sum of the cash distributed and the member’s basis in the unrealized receivables and inventory received in the distribution (Sec. 731(a)(2)).

Note: The preceding bulleted rules apply equally to distributions that liquidate a member’s interest and to those that do not, with the exception of the final one allowing members to recognize a loss on a liquidating distribution if only cash, unrealized receivables, and inventory are received.

Example 1. Nontaxable liquidating distribution: Z LLC, classified as a partnership, is liquidating. An individual member, R, has basis in his Z interest of $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. He 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, even though the $50,000 FMV of the property R receives exceeds its $30,000 basis.

Example 2. Recognizing a loss on a liquidating distribution: V has a $20,000 basis in A LLC, which is classified as a partnership. A distributes $10,000 cash and inventory worth $12,000 to V in complete liquidation of his LLC interest. The inventory has an adjusted basis of $6,000 to A. V receives only his proportionate share of the inventory, and A 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 table “Liquidating Distribution With a Capital Loss,” 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 his interest after considering the cash and inventory distributions. Consequently, he is allowed a $4,000 capital loss on the liquidation of A (Sec. 731(a)(2)). Note, however, that if V sells the inventory at its FMV ($12,000), he will recognize $6,000 of gain ($12,000 – $6,000). So, his overall gain is $2,000 ($6,000 gain on inventory sale and $4,000 loss on the liquidating distribution). That mirrors the economics of the transaction, as he received $22,000 worth of cash and inventory in exchange for his interest, which had an adjusted basis of $20,000.

If any property besides cash, receivables, and inventory is distributed in the liquidating transaction, all loss recognition is deferred until the distributed property is actually sold or exchanged.

Example 3. No gain or loss recognized on liquidation: Assume the same facts as in Example 2, except that V also received a parcel of real estate that the LLC held for investment. The LLC’s adjusted basis in the real estate was $4,000. Its FMV was $7,000. The result of the liquidating distribution is shown in the table “Liquidating Distribution With No Gain or Loss,” below.

As in Example 2, V has a $6,000 built-in gain with respect to the inventory. He also has a $3,000 builtin gain in the real estate he receives ($7,000 FMV – $4,000 basis), for a total built-in gain of $9,000. This makes sense because he had a $20,000 basis in the LLC and received cash and property with an FMV of $29,000 ($10,000 cash, inventory worth $12,000, and real property worth $7,000).

Members’ tax basis in property received in liquidation

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:

1. Subtract the amount of cash and marketable securities received from the member’s predistribution basis in his or her LLC interest.
2. Any remaining basis is allocated first to distributed unrealized receivables and inventories in amounts equal to the LLC’s basis in those assets.
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.
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.
5. Any remaining basis increase is allocated to assets (other than unrealized receivables and inventory) in proportion to their FMVs.

Note: Proposed regulations issued in 2014, which would become effective if and when finalized, provide special rules that result in a Sec. 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)).

Depreciating property received in a liquidating distribution

A member that receives a liquidating distribution of depreciable property acquires a depreciable basis in the property determined under the rules discussed above. To the extent a member’s basis does not exceed the LLC’s basis, the member steps into the LLC’s shoes 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 basis, the excess is treated as newly acquired property that is placed in service by the member 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)).

Note: Special rules apply to claiming bonus depreciation on a qualifying asset that is acquired and distributed to a member in the same tax year.

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.

Suspended losses

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 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 an LLC interest, any suspended PALs generated by the LLC’s activities should be fully deductible in the year of the liquidating distribution, as long as the member does not own any interests in the same activities outside the LLC.

Any taxable 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 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 under Sec. 704(d) due to a lack of basis in the member’s LLC interest (outside basis) are not carried over by the member after the LLC’s liquidation. Because the suspended losses have not reduced the member’s basis in the 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.

Members may be allocated excess business interest expense from an LLC that reduced their basis in the LLC but that they have not yet treated as paid or accrued (and, therefore, not yet deducted at the member level). When such a member disposes of the LLC interest, this remaining excess business interest expense increases the member’s basis in the LLC (outside basis) immediately before the disposition. Following the disposition, the member is not entitled to any deduction for the excess business interest expense that increased the member’s outside basis (Sec. 163(j)(4)(B)(iii)(II)).

Nontax considerations

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, legal issues may surround 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 liquidating an LLC.

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.