Mandatory basis adjustments for certain LLC transfers

Regardless of whether a limited liability company (LLC) has a Sec. 754 election in effect, a partnership-level tax basis adjustment is required when an LLC interest is transferred (including a transfer upon the member’s death) if the LLC has a substantial built-in loss immediately after the transfer, unless the LLC is considered an electing investment partnership (EIP) or a securitization partnership (both discussed below). An LLC has a substantial built-in loss if (1) its adjusted basis in LLC property exceeds the fair market value (FMV) of such property by more than $250,000 or (2) if, immediately after the transfer, the transferee member would be allocated a loss in excess of $250,000 if the LLC’s assets were sold for cash equal to the FMV of the assets (Secs. 743(a) and (d)). Notice 2005-32 addresses the reporting requirements for LLCs that must make basis adjustments when there is a transfer of an interest in an LLC with a substantial built-in loss.

Example 1. Mandatory basis adjustment on transfer of interest: AR is an LLC classified as a partnership. AR has no liabilities and does not have a Sec. 754 election in effect. AR’s assets have an FMV of $1 million and an adjusted basis of $1.4 million. AR has a substantial built-in loss because the adjusted basis of LLC property exceeds its FMV by more than $250,000. H, a member of AR, sells his 25% interest to G for its $250,000 FMV.

AR must make a negative adjustment of $100,000 to its assets (25% × $400,000), all of which is allocable to G. G must provide the written notice described in Regs. Sec. 1.743-1(k)(2) to AR within 30 days after the sale, and AR must attach the statement described in Regs. Sec. 1.743-1(k)(1) to the LLC’s Form 1065, U.S. Return of Partnership Income, for the year of the transfer.

Note:  In some cases, a required basis adjustment due to transferring an LLC interest when the LLC has a substantial built-in loss is a related-party basis adjustment, which is subject to unfavorable tax rules (see Notice 2024-54 and proposed regulations REG-124593-23).

EIPs

As discussed above, an LLC that has elected to be treated as an EIP is not treated as having a substantial built-in loss with respect to a transfer (Sec. 743(e)(1)). Instead, under Sec. 743(e)(2), the transferee member’s distributive share of losses (without regard to gains) from the sale or exchange of LLC property is not allowed except to the extent the losses on the transfer exceed the loss (if any) recognized by the transferor (or any prior transferor to the extent not fully offset by a prior disallowance under Sec. 743(e)(2)). These disallowed losses do not decrease the transferee’s basis in the LLC. If the transferee member’s basis in the distributed property is reduced under Sec. 732(a)(2) (because the LLC’s adjusted basis in the distributed property exceeds the member’s basis in the LLC less money received), the loss recognized by the transferor on the transfer is reduced by the amount of the basis reduction (Sec. 743(e)(4)).

Notice 2005-32 provides that if an EIP allocates losses with a different character from the sale or exchange of property to the transferee (for example, both ordinary or Sec. 1231 losses and capital losses) and the losses allocated to that member are limited by Sec. 743(e)(2), then a proportionate amount of the disallowed losses is deemed to consist of a proportionate amount of each loss of a separate character that is allocated to the transferee member.

An LLC that has a Sec. 754 election in effect cannot elect to be treated as an EIP.

An LLC is an EIP as defined in Sec. 743(e)(5) if:

• The LLC makes an election to have the EIP rules apply;
• The LLC would be an investment company under Section 3(a)(1)(A) of the Investment Company Act of 1940 but for an exemption under Paragraph (1) or (7) of Section 3(c) of the act;
• The LLC has never been engaged in a trade or business;
• Substantially all of the LLC’s assets are held for investment;
• At least 95% of the assets contributed to the LLC consist of money;
• No assets contributed to the LLC had an adjusted basis in excess of FMV at the time of contribution;
• All LLC interests were issued by the LLC pursuant to a private offering before the date that is 24 months after the date of the first capital contribution to the LLC;
• The articles of organization or operating agreement of the LLC has substantive restrictions on each member’s ability to cause a redemption of the member’s interest; and
• The articles of organization or operating agreement provides for a term not in excess of 15 years.

On or before the date the LLC’s income tax return is due each year, an LLC classified as an EIP is required to provide enough information to the members to allow them to compute the amount of losses disallowed under Sec. 743(e). Notice 2005-32 provides that, because the amount of losses disallowed under Sec. 743(e) is determined regardless of gains, an LLC classified as an EIP is required to separately state on Schedules K, Partners’ Distributive Share Items, and K-1, Partner’s Share of Income, Deductions, Credits, etc., all allocations of losses to all of its members, including losses that, in the absence of Sec. 743(e), could be netted against gains at the LLC level.

If an LLC’s election to be treated as an EIP is terminated, it must continue to state such gains and losses separately in future returns relating to any period during which the LLC has one or more transferee members subject to Sec. 743(e)(2).

Example 2. Applying the EIP rules: AO LLC is a domestic LLC classified as a partnership. The LLC wants to elect to be treated as an EIP for year 2 and all succeeding tax years. AO and all of its members have a calendar tax year. The LLC has no liabilities. AO meets all other requirements to be an EIP under Sec. 743(e)(5). AO properly elects to be treated as an EIP for year 2.

On Nov. 30, year 2, E transfers a 10% LLC interest to V. This is the only transfer of an interest in AO during year 2. V’s purchase price for the interest is $300,000. E’s adjusted basis in her LLC interest on Dec. 31, year 1, was also $300,000. E’s share of AO’s year 2 income is $275,000 of long-term capital gain and $183,000 of long-term capital loss. V’s share of AO’s year 2 income is $25,500 of long-term capital gain and $17,000 of long-term capital loss.

The adjusted basis of E’s LLC interest on Nov. 30, year 2, $392,000, equals her adjusted $300,000 basis on Dec. 31, year 1, plus her distributive share of year 2 LLC gain, $275,000, less her distributive share of year 2 LLC loss, $183,000. The $92,000 loss E recognizes on the sale of her LLC interest equals the $392,000 adjusted basis of her LLC interest on the date of the sale, less the $300,000 she realized on the sale. Consequently, the first $92,000 of gross loss allocated to V is disallowed under Sec. 743(e)(2). V’s long-term capital loss of $17,000 in year 2 is disallowed. The first $75,000 of any gross loss allocated to V in future years will also be disallowed, regardless of whether AO is an EIP in those future years.

V’s adjusted basis on Dec. 31, year 2, is $325,500, the sum of her $300,000 purchase price plus her $25,500 share of LLC gain. The $17,000 loss allocated to V, but disallowed under Sec. 743(e)(2), does not reduce the basis of her LLC interest.

AO must provide the required annual statement described below to all of its members. The statement must be attached to each member’s Schedule K-1 for AO’s tax year ending Dec. 31, year 2. Assume that E receives AO’s Schedule K-1 on March 12, year 3. Within 30 days after receiving the Schedule K-1, E must provide statements to V and AO as described in Notice 2005-32.

Electing to be an EIP

Until further guidance is provided, Notice 2005-32 requires an LLC to make the election to be treated as an EIP by attaching a written statement to an original or amended income tax return for the tax year for which the election is effective. The election must include (1) the name, address, and tax identification number (TIN) of the LLC making the election; (2) a representation that the LLC is eligible to make the election; and (3) a declaration that the LLC elects under Sec. 743(e) to be treated as an EIP.

For the election to be valid, the original or amended return must be filed not later than six months after the due date (excluding extensions) for filing the return for the tax year for which the election is effective. Once an election is made, it is effective for all succeeding tax years, unless terminated or revoked. The election is effective for all transfers during the LLC’s tax year and for all subsequent transfers unless the LLC fails to meet the definition of an EIP, files a Sec. 754 election, or revokes the election.

On the date an LLC fails to meet the definition of an EIP, it becomes subject to the mandatory basis adjustment rules on the next transfer of a membership interest and each subsequent transfer. An LLC classified as an EIP also may terminate its election to be treated as an EIP without the IRS’s consent by filing a Sec. 754 election. The LLC will become subject to the mandatory basis adjustment rules on the next transfer of a membership interest after the election is filed. Otherwise, an EIP election can only be revoked with IRS consent. The application for consent to revoke the election must be submitted to the Service in the form of a letter ruling request. If an election to be treated as an EIP is terminated, any losses that are subsequently allocated to members who received their interest while the EIP election was in effect remain subject to disallowance under Sec. 743(e)(2).

Tiered ownership structures

An LLC that is engaged in a trade or business, or that has previously engaged in a trade or business, cannot elect to be treated as an EIP. Notice 2005-32 provides rules that address how the trade or business determination is made where an upper-tier partnership or LLC holds an interest in a lower-tier partnership or LLC. In such cases, the upper-tier entity is not treated as engaged in the trade or business of the lower-tier entity if, at all times during the period in which the upper-tier entity owns an interest in the lower-tier entity, the adjusted basis of its interest in the lower-tier entity is less than 25% of the total capital that is required to be contributed to the upper-tier entity by its partners or members during the entire term of the upper-tier entity. The notice does not address the situation in which the upper-tier entity’s adjusted basis in the lower-tier entity is, at any time, 25% or more of the total capital that is required to be contributed.

Securitization LLCs

A securitization LLC is not treated as having a substantial built-in loss with respect to any transfer (Sec. 743(f)(1)). A securitization LLC is any LLC the sole business activity of which is to issue securities that provide for a fixed principal (or similar) amount and are primarily serviced by the cash flows of a discrete pool (either fixed or revolving) of receivables or other financial assets that by their terms convert into cash in a finite period, but only if the sponsor of the pool reasonably believes that the receivables and other financial assets comprising the pool are not acquired so as to be disposed of (Sec. 743(f)(2)).

Reporting requirements

Notice 2005-32 provides guidance on the reporting requirements for LLCs with mandatory basis adjustments resulting from a Sec. 743 transfer. Such LLCs must comply with Regs. Sec. 1.743-1(k)(1) by attaching a statement to their tax return for the year of transfer as if a Sec. 754 election were in effect at the time of the transfer. The transferee of an interest in an LLC with mandatory basis adjustments resulting from a Sec. 743 transfer must comply with Regs. Sec. 1.743-1(k)(2) by notifying the LLC of the transfer, within the time prescribed, as if a Sec. 754 election were in effect at the time of the transfer. In addition, LLCs required to make a mandatory basis adjustment must comply with Regs. Secs. 1.743-1(k)(3), (4), and (5) as if a Sec. 754 election were in effect at the time of the transfer.

Notice 2005-32 also provides that if an interest in an LLC that is classified as an EIP is transferred in a sale or exchange or upon the death of a member, the transferor (or, in the case of a member who dies, the member’s executor, personal representative, or other successor-in-interest) must notify the transferee and the LLC in writing. The notice must be provided within 30 days after the date on which the transferor (or the executor, personal representative, or other successor-in-interest) receives a Schedule K-1 from the LLC for the LLC’s tax year in which the transfer occurred. The notice must be signed under penalties of perjury and must include (1) the name, address, and TIN of the transferor; (2) the name, address, and TIN of the transferee (if ascertainable); (3) the name of the LLC; (4) the date of the transfer (and, in the case of the death of a member, the member’s date of death); (5) the amount of loss, if any, recognized by the transferor on the transfer of the interest, together with the computation of the loss; (6) the amount of losses, if any, recognized by any prior transferors to the extent the losses were subject to disallowance under Sec. 743(e)(2) in the hands of a prior transferee and have not been offset by prior loss disallowances under Sec. 743(e)(2); and any other information necessary for the transferee to compute the amount of disallowed loss. If the transferor is a nominee (within the meaning of Temp. Regs. Sec. 1.6031(c)-1T), then the nominee, and not the beneficial owner of the transferred interest, must supply the information to the transferee of the interest and to the LLC. The transferee and the LLC must retain the transferor’s notice for as long as the contents of the notice may become material for tax purposes.

If the transferor member, or its legal representative in the case of a transfer by death, fails to provide the transferee member with the required statement, the transferee member must treat all losses allocated from the LLC classified as an EIP as disallowed under Sec. 743(e)(2) unless the transferee member obtains, from the LLC or otherwise, the information necessary to determine the proper amount of disallowed losses. If the transferee does not have the information necessary to determine the proper amount of disallowed losses but does have information sufficient to determine the maximum amount of losses that could be disallowed, then the transferee may treat that amount of losses as disallowed. For example, if the transferee is able to ascertain the adjusted basis that a prior transferor had in its LLC interest but is not able to ascertain the amount realized by that transferor, the transferee may assume, for purposes of calculating the amount of disallowed losses, that the sales price when the prior transferor sold its interest was zero. If, following the filing of a return on this basis, the transferor member or the LLC provides the required information to the transferee member, the transferee member should make appropriate adjustments in an amended return for the year of the loss allocation from the LLC.

Until further guidance is provided, Notice 2005-32 requires an LLC classified as an EIP to provide an annual statement to all of its members. The statement is attached to each member’s Schedule K-1 for any tax year for which an EIP election is in effect (whether or not the election is in effect for the entire tax year).

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, 2025 (800-431-9025; tax.thomsonreuters.com).