Distributions of Sec. 704(c) property by an LLC

A member that contributes Sec. 704(c) property (property with a basis different than fair market value (FMV) when contributed) to a limited liability company (LLC) classified as a partnership may be required to recognize gain or loss if that property is later distributed to another member. Under Sec. 704(c)(1)(B), a distribution of Sec. 704(c) property within seven years of the date of contribution requires the contributing member to recognize any remaining precontribution gain or loss on the date of such distribution. The amount and character of the gain or loss is determined as if the LLC had sold the property to the distributee member for its FMV on the date of distribution. The precontribution gain or loss recognized is the difference between the property’s FMV and tax basis on the date of contribution, reduced by any portion of that amount already taken into account under the Sec. 704(c) rules. (These rules require special allocations of depreciation or amortization expense with regard to depreciable or amortizable Sec. 704(c) property. See Prop. Regs. Sec. 1.704–3(f)(3)(ii)(D).)

Note: Proposed regulations, which would be 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. 1.704–4(a)(4)). For example, if a member contributes Sec. 704(c) property to an LLC classified as a partnership on May 15, 2018, the seven–year period with respect to the property ends on and includes May 14, 2025.

An installment obligation received by an LLC classified as a partnership and property acquired pursuant to a contributed contract are treated as Sec. 704(c) property under the rules for distributions of contributed property to the extent that the installment obligation or the acquired property is Sec. 704(c) property under the substituted–basis rules of Regs. Sec. 1.704–3(a)(8). As a result, if the installment obligation or property acquired pursuant to a contributed contract is distributed by an LLC to a member other than the contributing member within seven years of the contribution, the contributing member may recognize gain or loss under Sec. 704(c)(1)(B) (Regs. Secs. 1.704–3(a) and 1.704–4(d)).

It appears the contributor must recognize gain or loss as if they sold the contributed property and realized the gain or loss directly. As a consequence, the contributor recognizes the gain or loss for the year that includes the date of the triggering distribution rather than the year that includes the last day of the LLC’s tax year in which it makes the distribution.

Distributions of built-in loss property

In general, Sec. 704(c)(1)(B) requires the recognition of any built–in gain or loss. However, built–in loss triggered by a distribution of property contributed by a member who holds more than a 50% interest in the LLC is disallowed due to the application ofSec. 707(b)(1)(A). Though not specifically mentioned in the Sec. 704 regulations, this issue is addressed in the preamble to the regulations (T.D. 8642; 60 Fed. Reg. 66727, Dec. 26, 1995).

Note: Proposed regulations on the application of Sec. 704(c)(1)(C) were issued in ٢٠١٤ and generally would become effective if and when finalized (REG–144468–05, 79 Fed. Reg. 3041). The proposed regulations create the concept of a Sec. 704(c)(1)(C) basis adjustment. The Sec. 704(c)(1)(C) basis adjustment is initially equal to the built–in loss associated with the Sec. 704(c)(1)(C) property at the time of contribution and then is adjusted in accordance with the proposed regulations (Prop. Regs. Sec. 1.704–3(f)). If Sec. 704(c)(1)(B) treats the Sec. 704(c)(1)(C) member as recognizing loss on the sale of the distributed property, the Sec. 704(c)(1)(C) basis adjustment is taken into account in determining the amount of the loss (Prop. Regs. Sec. 1.704–3(f)(3)(v)(B)). Accordingly, when Sec. 704(c)(1)(C) property is distributed to a member other than the contributing member within seven years of its contribution to the LLC, the loss will be taken into account by the contributing member.

Required basis adjustments

If a member recognizes gain or loss under the Sec. 704(c)(1)(B) rules, the distributee member’s basis in the distributed property is the LLC’s basis in the property immediately before the distribution, increased by any gain and decreased by any loss that the contributing member recognizes. The contributing member’s basis in their LLC interest (outside basis) is also increased or decreased to reflect the recognized gain or loss (Regs. Sec. 1.704–4(e)).

Example. Distribution of Sec. 704(c) property: J and K form a real estate development company, B, which is classified as a partnership. J contributes two parcels of land, each with a basis of $25,000 and an FMV of $50,000. K contributes $100,000 cash. Three years later, B distributes one parcel of the land contributed by J to K. At the time of the distribution, the FMV of the parcel is $75,000. J recognizes a gain of $25,000 on the date of distribution, the difference between the land’s FMV and its tax basis on the date of contribution. K’s basis in the distributed parcel is $50,000 — the LLC’s $25,000 basis before the distribution plus the $25,000 gain recognized by J. J’s basis in his LLC interest is $75,000 — the $50,000 basis of the contributed properties plus the $25,000 gain he recognizes on the distribution. If the real estate was held by the LLC as inventory, the character of J’s gain would be ordinary.

Successors to the contributing member

A successor to a contributing member is exposed to the potential for gain or loss on a subsequent distribution of Sec. 704(c) property in the same manner as the original contributor (Regs. Sec. 1.704–4(d)(2)). Consequently, when a member who previously contributed appreciated or depreciated property transfers all or a portion of their LLC interest, whether by sale, gift, or otherwise, a proportionate share of the Sec. 704(c) exposure carries over to the transferee member. If, within seven years of the contribution, the contributed property is distributed to a member other than the transferee–successor, the transferee will recognize the precontribution gain or loss attributable to the interest.

A successor member’s exposure to this potential gain increases the importance of the available basis adjustment when an election under  is in effect. If a purchaser pays for unrealized appreciation attributable to contributed property, the election may help them avoid recognition of some or all precontribution gain should a triggering distribution occur.

Exceptions to gain recognition when Sec. 704(c) property is distributed years.

Distributions of like-kind property

A member who contributed Sec. 704(c) property to an LLC does not recognize gain or loss upon distribution of that property to another member if the contributor receives a qualifying distribution of like–kind property (Regs. Sec. 1.704–4(d)(3)). In such cases, to the extent of the value of the like–kind property received by the member, the property received is treated as if it were the contributed property. The property received by the contributor must be of a like kind to the contributed property such that it would qualify for nonrecognition treatment under Sec. 1031 if it were directly exchanged for the contributed property.

Note: For exchanges where both the relinquished and the replacement property are transferred after 2017, only real property (other than property held primarily for sale) can qualify for Sec. 1031 like–kind exchange treatment.

A qualifying like–kind distribution to the contributor must be made by the earlier of the 180th day after the distribution of the contributed property or the due date (including extensions) of the contributing member’s tax return for the year the distribution of the contributed property occurred (Regs. Sec. 1.704–4(d)(3)).

Regs. Sec. 1.704–4(d)(3) provides that the gain or loss the contributing member would have recognized because of the distribution of contributed property is reduced by the amount of built–in gain or loss in the distributed like–kind property in the hands of the contributing member immediately after the distribution. The built–in gain depends on the FMV of the distributed property compared with its basis in the hands of the contributing member immediately after the distribution.

Other exceptions to the Sec. 704(c) gain recognition rule

Regs. Sec. 1.704–4(c) contains additional exceptions to the general rule requiring the recognition of built–in gains and losses under Sec. 704(c)(1)(B) for the following types of distributions:

• Distributions of property contributed to the LLC before Oct. 4, 1989 (Regs. Sec. 1.704-4(c)(1)).
• Certain distributions in complete liquidation of a member’s interest (Regs. Sec. 1.704-4(c)(2)). Distributions qualify for the exception if the contributing member receives an interest in the Sec. 704(c) property contributed by that member (and no other property) and the built-in gain or loss in the interest distributed to the contributing member, determined immediately after the distribution, is equal to or greater than the built-in gain or loss on the property that would have been allocated to the contributing member on a sale of the contributed property to an unrelated party immediately before the distribution.
• Complete transfers of all LLC assets and liabilities to a newly formed LLC, followed by a distribution of the interest in the transferee LLC in liquidation of the transferor LLC as part of the same plan or arrangement (Regs. Sec. 1.704-4(c)(4)).
• The incorporation of an LLC by any method, provided there are not actual distributions to members and the LLC is liquidated (Regs. Sec. 1.704-4(c)(5)).
• Distributions of undivided interests in property previously contributed by the distributee member to the extent of the undivided interest originally contributed (Regs. Sec. 1.704-4(c)(6)).

Anti-abuse regulations

An anti–abuse provisionRegs. Sec. 1.704–4(f)(1)) gives the IRS the power to recast transactions structured with the principal purpose to avoid the ramifications of  Sec. 704(c)(1)(B), based on all the facts and circumstances. Examples of abusive situations include those under Regs. Sec. 1.704–4(f)(which refers to the seven–year period as five years because it has not been updated for that extension, which was enacted by Section 1063 of the Taxpayer Relief Act of 1997, P.L. 105–34):

• Postponement of actual distributions of property past seven years after contribution while increasing the economic risks and benefits derived from the property relative to the distributee member.
• LLCs formed to minimize the time a potential purchaser would need to be a member of the LLC to avoid the seven-year holding period. The example in the regulations is based on the distribution of property held for seven years to an individual who has been a member for more than two years.

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).