Distributions to LLC members that contributed appreciated property

Sec. 737 generally provides that a distribution of property other than cash to a member who previously contributed appreciated property to a limited liability company (LLC) classified as a partnership may be a taxable event. Specifically, if a member contributes appreciated property to an LLC, that member is required to recognize any precontribution gain on the contributed property to the extent that the value of property (other than money) subsequently distributed to that member exceeds the member’s basis in the LLC. Sec. 737 does not apply if the distribution occurs more than seven years after the appreciated property is contributed to the LLC. However, Sec. 737 applies whether or not the distribution causes the member’s interest in the LLC to be reduced. For more on distributions of property by a partnership (including an LLC classified as a partnership for tax purposes) to a partner that has contributed property to the partnership, see Venables, “Partnership Distributions: Rules and Exceptions,” 55-8 The Tax Adviser 26 (August 2024).

Note: Regulations proposed in 2014, which would become effective if and when finalized, address the determination of the seven-year period. The seven-year period begins on and includes the date of contribution and ends on and includes the last date that is within seven years of the contribution (Prop. Regs. Sec. 1.737-1(c)(3)).

An installment obligation received by an LLC in an installment sale of Sec. 704(c) property is treated as contributed property with respect to the contributing member for the Sec. 737 rules to the extent it is treated as Sec. 704(c) property under Regs. Sec. 1.704-3(a)(8). Similar rules apply to property acquired by an LLC pursuant to a contract that is Sec. 704(c) property and to property acquired in a nonrecognition transaction (Regs. Sec. 1.737-2(d)(3)).

Exceptions to the rules requiring gain recognition

The Sec. 737 rules do not apply to cash distributions. Cash distributions are governed by the rules of Sec. 731, which require the recognition of gain when a cash distribution exceeds the member’s basis in the LLC. Any Sec. 737 gain recognized is in addition to gain recognized under Sec. 731. Regs. Sec. 1.737-2 contains additional exceptions to the gain recognition rules under Sec. 737, including:

• A contribution of all existing LLC assets and liabilities to a new LLC in exchange for an interest in the new LLC and, as part of the same plan, the interest in the new LLC is distributed in liquidation of the transferor LLC. Subsequent distributions from the new LLC can be subject to Sec. 737.
• A contribution of all built-in gain property (Sec. 704(c)) to a new LLC and, as part of the same plan, only the interest in the new LLC is distributed to the contributing member in complete liquidation of the member’s interest in the transferor LLC. Subsequent distributions of the Sec. 704(c) property from the new LLC to the contributing member are subject to Sec. 737.
• The incorporation of an LLC by any method, provided there are no actual distributions to the members and the LLC is liquidated.
• Distributions of previously contributed property subject to Sec. 737(d) (1) and Regs. Secs. 1.737-2(d)(1)– (4) (see “Distributions of Previously Contributed Property” below).

The regulations confirm that the like-kind property distribution rules under Sec. 704(c)(2), which reduce or eliminate gain recognition, do not apply to Sec. 737 (see Regs. Sec. 1.704-4(d)(3)).

Gain recognized by distributee member

The gain a member recognizes on a distribution to which Sec. 737 applies is the lesser of (1) the amount by which the fair market value (FMV) of the distributed property (on the date of distribution) exceeds the member’s basis in the LLC, or (2) the net precontribution gain of the contributing member (Sec. 737(a)). A member’s net precontribution gain equals the net amount that would be recognized under Sec. 704(c)(1)(B) if all property contributed by the member within seven years of the distribution (and held by the LLC on the date of distribution) were distributed to another member. Regs. Sec. 1.737-1(d) clarifies that the character of the gain (capital or ordinary) is determined at the LLC level.

Example 1. Distribution to a member who contributed appreciated property: Four years ago, T and J formed an LLC that is classified as a partnership. T contributed undeveloped real estate that had an FMV of $150,000 and a tax basis of $50,000, and J contributed $150,000 cash. The LLC used the cash contributed by J to purchase various patents. During the current year, the LLC distributes a patent with an FMV of $80,000 to T. On the date of distribution, the LLC’s basis in the distributed patent is $40,000, and T’s basis in his LLC interest is $30,000.

T recognizes a $50,000 gain on the distribution — the lesser of (1) T’s net precontribution gain of $100,000 ($150,000 FMV of contributed property – $50,000 basis of contributed property); or (2) the $50,000 by which the FMV of the distributed property exceeds T’s basis in his LLC interest ($80,000 FMV of distributed property – $30,000 basis in LLC interest). The $50,000 gain T recognizes on the distribution is a capital gain, assuming that the real estate was a capital asset in the LLC’s hands.

If facts and circumstances indicate a transaction is a disguised sale under Sec. 707(a)(2)(B), the rules of Sec. 737 do not apply. A distribution that is part of a disguised-sale transaction is considered to be a payment for property or for an LLC interest and not an LLC distribution.

Character of gain: The character of the gain recognized by the distributee member under Sec. 737 is determined by, and is proportionate to, the character of the member’s net precontribution gain. For this purpose, all gains and losses on Sec. 704(c) property taken into account in determining the member’s precontribution gain are netted according to their character. Character is determined at the LLC level. If properties of a particular character net to a built-in loss, they are disregarded (Regs. Sec. 1.737-1(d)).

Basis adjustments resulting from gain recognition

If gain is recognized on a distribution to a contributor of appreciated property, both the LLC and the distributee member make a mandatory basis adjustment equal to the gain recognized by the distributee member. The LLC’s adjusted tax basis in eligible property is increased by the Sec. 737 gain recognized by the distributee member. Eligible property is property that (Regs. Sec. 1.737-3(c)):

• Entered into the calculation of the distributee member’s net precontribution gain;
• Has an adjusted tax basis to the LLC less than the property’s FMV on the date of distribution;
• Would have the same character of gain on a sale by the LLC to an unrelated party as the character of any of the Sec. 737 gain recognized by the distributee member; and
• Was not distributed to another member in a distribution subject to Sec. 704(c)(1)(B) that was part of the Sec. 737 distribution.

For allocating basis among eligible properties, all eligible property of the same character is treated as a single group. Character for this purpose is determined in the same manner as the character of the recognized gain is determined under Regs. Sec. 1.737-1(d). The basis increase is allocated among the separate groups of eligible property in proportion to the character of the gain recognized under Sec. 737. The basis increase is then allocated among property within each group in the order in which the property was contributed to the LLC by the member, starting with the property contributed first, in an amount equal to the difference between the property’s FMV and its adjusted tax basis to the LLC at the time of the distribution. For property that has the same character and was contributed in the same (or a related) transaction, the basis increase is allocated based on the respective amounts of unrealized appreciation in such properties at the time of the distribution (Regs. Sec. 1.737-3(c) (3)). The distributee member increases the basis in their LLC interest by the gain recognized on the distribution. The increase in the basis of the distributee member’s LLC interest is deemed to occur immediately before the distribution (Sec. 737(c)(1)).

Example 2. Basis adjustments to reflect Sec. 737 gain recognized on property distribution: Assume the same facts as in Example 1. The LLC’s basis in the real estate contributed by T will be increased to reflect the $50,000 gain he recognized on the distribution. T will also increase his basis in the LLC by the $50,000 gain recognized. The LLC will have a basis of $100,000 in the contributed real estate ($50,000 original basis + $50,000 adjustment for gain recognized). T will have a basis of $40,000 in the distributed patent (the LLC’s basis in the patent) and a basis of $40,000 in his LLC interest ($30,000 original basis + $50,000 adjustment for gain recognized – $40,000 basis assigned to distributed patent).

Distributions of previously contributed property

Sec. 737 does not apply if the distributed property is property that was previously contributed by the distributee member. However, precontribution gain may be recognized when the distributed property is an interest in an entity and that entity received property contributions after the interest in the entity was contributed to the LLC (Sec. 737(d)(1) and Regs. Sec. 1.737-2(d)).

Example 3. Nonrecognition of gain when previously contributed property is distributed: F and B form an LLC that is classified as a partnership. F contributes Parcels A and B, each having an FMV of $75,000 and a tax basis of $25,000 on the date of contribution. B contributes Parcels X and Y, each having an FMV of $75,000 and a tax basis of $65,000 on the date of contribution. Sixteen months later, when the FMV of Parcels A and X is $125,000 each and the FMV of Parcels B and Y is $100,000 each, the LLC distributes Parcel A to F. Because the distributed property was originally contributed by F, the transaction does not result in a taxable gain. After the distribution, Parcel A will have a tax basis in F’s hands of $25,000.

Example 4. Recognition of gain upon distribution of a previously contributed interest in an entity: Assume the same facts as in Example 3, except F also contributes BR Inc. stock (a C corporation) to the LLC when it is formed. BR Inc. has no assets or liabilities on the date of contribution. Instead of distributing Parcel A to F, the LLC contributes Parcel X (which has a $125,000 FMV) to BR Inc. and then distributes the BR Inc. stock to F. Under the general rule of Sec. 737, F would not recognize gain because the distribution of BR Inc. stock is a distribution of property previously contributed by him. However, under Sec. 737(d) and Regs. Sec. 1.737-2(d), F must recognize precontribution gain to the extent the FMV of the BR Inc. stock (which now includes the value of Parcel X) exceeds the basis of F’s LLC interest. F recognizes gain of $75,000 ($125,000 FMV of BR Inc. stock after contribution of Parcel X – $50,000 basis in F’s LLC interest).

Example 5. Distribution of an undivided interest in previously contributed property: Assume the same facts as in Example 3, except F and B also contribute Property C, in which they each own an undivided half interest, when the LLC is formed. Sixteen months later, the LLC makes a current distribution to F of an undivided half interest in Property C. No gain is recognized under Sec. 737.

Distributions in connection with a termination

Members must recognize Sec. 737 gain on a termination of the LLC under Sec. 708(b)(1) if the termination takes place within seven years of the contribution of appreciated property by a member.

Interaction of Secs. 737 and 704(c)(1)(B)

Sec. 737 requires the recognition of gain by a member who previously contributed appreciated property to the extent the FMV of property distributed to the member (other than money) exceeds the member’s basis in their LLC interest. Sec. 704(c)(1)(B) contains a similar provision requiring that a distribution to a member of contributed property with an FMV different from its basis on the date of contribution will cause the contributing member to recognize any precontribution gain or loss attributable to the distributed property. Both of these provisions apply only to distributions made within seven years of the date of contribution.

In certain situations, both of these Code sections may apply to the same transaction. Regs. Sec. 1.737-1(c)(2)(iv) provides that if both Secs. 737 and 704(c) (1)(B) apply to the same distribution, the member’s LLC basis is increased or decreased by the Sec. 704(c)(1)(B) gain or loss first. This also includes any gain not recognized due to application of the like-kind exception under Sec. 704(c)(2) and Regs. Sec. 1.704-4(d)(3). This will result in a reduction or elimination of gain recognition under Sec. 737.

Planning opportunities for Sec. 737 distributions

Gain recognition under Sec. 737 is a function of the member’s basis in contributed assets and the member’s basis in the LLC. Therefore, the following areas offer some planning potential:

• Structure Sec. 737 distributions to be classified as an advance against the member’s share of LLC income. Regs. Sec. 1.737-1(b) (3)(ii) provides that a member’s basis in the LLC is determined as of the end of the LLC’s tax year if the distribution is considered an advance or draw. As a result, if the LLC earns a profit, the members’ bases will be increased by their share of LLC income, and the potential gain recognition under Sec. 737 will be reduced or eliminated. The reverse strategy would be applied if a net loss was anticipated at year end.
• A Sec. 754 election should be considered when cash and Sec. 704(c) property are distributed or when an interest in the LLC is transferred. To the extent the basis of LLC property is increased, the precontribution gain is reduced.

Anti-abuse rule

Regs. Sec. 1.737-4(a) gives the IRS the power to recast transactions structured with the principal purpose to avoid the ramifications of Sec. 737, based on the facts and circumstances. In the Sec. 737 context, the primary focus of the anti-abuse rules is on contributions to the LLC that temporarily increase basis or on shifts in LLC liabilities that increase basis.

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.  

This case study has been adapted from Checkpoint Tax Planning and Advisory Guide’s Limited Liability Companies topic. Published by Thomson Reuters, Frisco, Texas, 2024 (800-431-9025; tax.thomsonreuters.com).