Intangible property contributions to an LLC

The federal income tax treatment of a contribution of property, including money, to a limited liability company (LLC) depends on whether the LLC is classified as a partnership, a disregarded entity, or a corporation for federal income tax purposes. A contribution to an LLC classified as a C or S corporation is subject to the tax rules governing corporations. Generally, contributions are nontaxable if the transfer of property to the corporation is solely for stock (other than nonqualified preferred stock) and immediately after the exchange the transferors control the corporation. A contribution by the owner to a disregarded single–member LLC has no tax consequences because the LLC is not considered an entity separate from its owner. Contributions to an LLC classified as a partnership are governed by the partnership tax rules, which are the subject of the remainder of this discussion.

Applying the general nonrecognition rule

Generally,  provides that a member’s transfer of property (including money) to an LLC classified as a partnership does not result in taxable income or loss to the member or the LLC. The LLC steps into the shoes of the contributing member with respect to the holding period and adjusted tax basis of the contributed property (Secs. 1223 and 723). The member’s basis in an LLC interest (outside basis) that is acquired in exchange for a property contribution is the member’s adjusted tax basis in the contributed property (Sec. 722). The general nonrecognition rule under Sec. 721 applies both to contributions made upon the formation of the LLC and to subsequent contributions by new or existing members. Note that in some situations, contributions of property may result in the LLC interest having a split holding period.

The general nonrecognition rule under Sec. 721 for LLCs classified as partnerships applies only to contributions of property. While there usually is little difficulty in determining whether a contribution consists of property, questions can arise when a contribution could be characterized as either (1) property created by a person’s services or (2) services that create property for the LLC’s benefit. This issue also arises if a member’s capital account is credited with an amount that clearly exceeds the fair market value (FMV) of the contributed property. In these situations, the adverse consequences of a misstep can be significant.

Determining whether the member is contributing property or services

Money, fee title to real estate, and ownership of equipment are examples of contributions that clearly constitute property.

There is no requirement that the contributed property be tangible (e.g., see 71-564 (trade secret as property for purposes of Sec. 351) and Ambrose, T.C. Memo. 1956–125 (contract rights as property)). Contract rights, goodwill, technical knowledge, and trade secrets all may constitute intangible property eligible for nonrecognition treatment. Also, a letter of intent may constitute property (Stafford, 727 F.2d 1043 (11th Cir. 1984)). The court in that case held that the letter of intent had value in a manner similar to goodwill. For that reason, although it was not binding, it constituted property. The property had been created by the partner’s efforts for his own account, and the partner owned the property prior to when he contributed it to the partnership. As a result, the contribution of the letter of intent was a nonrecognition transaction. When transferring intangible property to an LLC, the transaction should address any rights to licenses or other items that are related to the property.

Example 1. Ensuring that a member’s contribution consists of property:A, a real estate developer, wished to construct an office building on Block R. To this end, A negotiated a letter of intent by which an investor agreed in principle (1) to provide a first mortgage loan for the project and (2) to enter into a long–term lease for the completed building. The letter of intent was not legally binding on either party.

After the letter of intent was executed, A decided to form an LLC with B and F to develop the project. Pursuant to an operating agreement drafted without the help of a tax practitioner, A contributed the letter of intent he had negotiated. B, an architect, agreed to design the building and prepare architectural drawings for the LLC. F contributed $75,000 cash. Each member received an initial capital account equal to the agreed–upon FMV of their contribution and a one–third interest in LLC profits and losses.

F’s cash contribution is a property contribution. Based on the preceding discussion, A’s contribution of the letter of intent should also be treated as a contribution of property.

B’s services in designing the building are performed for the LLC’s account. Although his services create property, namely, architectural drawings, B agreed from the start to create this property for the LLC. He never owned the property he created. As a result, B’s contribution does not qualify for nonrecognition treatment, and he is taxed on the receipt of his LLC interest in capital. The FMV of that interest is treated as compensation for services. If B had created the designs and drawings before an LLC had been formed (either formally or informally), so that he owned them with no obligation to contribute them to the LLC, a contribution of this service–created property would qualify for nonrecognition treatment (Frazell, 335 F.2d 487 (5th Cir. 1964)). Also, B could have contributed his services for a profits–only interest in a transaction that was structured to be tax free.

Contributed self-created intangibles are not capital assets in the LLC’s hands

Certain self–created intangible assets contributed by a member do not qualify as capital assets. While these assets can qualify as property (i.e., be subject to the nonrecognition rules under Sec. 721 when they are contributed to an LLC), they will not be capital assets in the LLC’s hands. Therefore, a taxable gain on the LLC’s eventual sale or disposition of these intangible assets is treated as ordinary income. Specifically, the following types of property, if contributed by a taxpayer whose personal efforts created the property (or, with respect to a letter, memorandum, or similar property, a taxpayer for whom the property was prepared or produced), are not capital assets in the hands of the LLC (Sec. 1221(a)(3)):

• Patents;
• Inventions;
• Models or designs (whether or not patented);
• Secret formulas or processes;
• Copyrights;
• Literary, musical, or artistic compositions;
• Letters or memoranda; or
• Similar property.

Note: Taxpayers can elect to treat musical compositions or copyrights in musical works as capital assets (Sec. 1221(b)(3)).

Generally, gain on the LLC’s sale of property described above produces ordinary income. This rule also applies to a taxpayer in whose hands the property’s basis is determined in whole or in part by reference to the basis of the person who created it (or for whom it was prepared or produced) (Sec. 1221(a)(3)(C)). This means that when such an asset is contributed to an LLC in exchange for an LLC interest, its sale by the LLC will produce ordinary income (or loss).

Exception for certain contributed patents

Even though patents are excluded from the definition of a capital asset under Sec. 1221(a)(3), under an exception in Sec. 1235, certain transfers by patent holders are treated as a sale or exchange of a capital asset held for more than one year. A holder generally is an individual whose efforts created the patent property or who has acquired an interest in the patent property in exchange for consideration paid to the inventor in money or money’s worth prior to the actual reduction of the invention covered by the patent to practice. IRS Letter Rulings 200506008, 200506009, and 200506019 concluded that individual patent holders who transferred patents to an LLC classified as a partnership in exchange for membership interests retained their status as patent holders under Sec. 1235. So, the individuals’ shares of any gain on the LLC’s subsequent sale of the patents could qualify under Sec. 1235 as long-term capital gain.

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, 2026 (800-431-9025; tax.thomsonreuters.com).