Limited Liability Companies (LLC): Electing Partnership vs. S Corporation Status PART 2

PART 2
Limited Liability Companies: Electing Partnership vs. S
Corporation Status
Chapter 4: Distributions for an LLC
Chapter 5: Sale of Member Interest
Chapter 6: Withdrawal of a Member
Chapter 7: Death of a Member

The following slide deck was used in conjunction with a textbook
entitled Limited Liability Companies: Electing Partnership vs. S
Corporation Status. The following are Chapters 4 – 7; Chapters 1 – 3
are posted in Slideshare as Part 1.
The presentation was given over 2-days at multiple locations across
the state of Illinois. The textbook is available for purchase at
TaxSchool.Illinois.edu.

Chapter 4: Distributions
for an LLC
LLC[P]
p. 155

Distribution of Assets
 Money & marketable securities can be
withdrawn without recognizing gain/loss
to the extent of member’s basis
 Other assets – no gain/loss recognized
unless adjusted basis of asset exceeds
member’s adjusted basis in LLC
p. 156

Alternative Rule
p. 156
Determine the member’s share of the
adjusted basis of the LLC property

Example 4
CAPITAL ACCOUNT
Inside Basis FMV Basis
Beg. Bal. $50,000 $60,000
Basis Equip (400)
FMV Equip _ ( 2,000)
$49,600 $58,000
p. 158

p. 158
Member continues with cost-
recovery method and remaining life
of depreciable assets distributed

Contributing member must
recognize gain/loss on assets
distributed to a member (other
than contributing member) if
distribution occurs within 7 years
of contribution to LLC.
p. 158

Proportionate Distribution
Cash
Unrealized receivables
& inventory (hot assets)
Other assets
Member’s basis is allocated as follows:
p. 159

Proportionate Distribution
p. 159
Allocating increase
1. Properties with unrealized appreciation
2. In proportion to their FMV
Allocating decrease
1. Unrealized depreciation
2. In proportion to their adjusted bases

Example 6
Basis FMV
2005 Pontiac 11,500 12,100
2004 Camaro 13,300 14,200
2002 Lincoln 13,600 15,100
38,400 41,400
p. 160

Example 7
Member A’s outside basis $13,000
Basis of property received $12,800
Excess basis $ 200
p. 160

Example 7 – continued
p. 160

Example 8
Member B’s outside basis $14,900
Excess basis $ 2,100
Unrealized appreciation ($ 1,000)
FMV allocation $ 1,100
p. 161

p. 161

Example 9
Member C’s outside basis $10,500
Decrease in basis $(2,300)
p. 162

p. 162

Disproportionate Distributions
Disproportionate distribution of
unrealized receivables or
substantially appreciated inventory
is considered a sale between a
member and the LLC[P].
p. 163

Unrealized Receivables
Right for payment for noncapital goods
or for services rendered
Depreciation recapture on personal
property
Depreciation recapture on real property
Soil & water conservation recapture
p. 163

Substantially Appreciated
 Congress eliminated “substantially
appreciated” for sale and exchange of
partnership interests
 “Substantially appreciated” NOT
eliminated for partnership distributions
p. 164

Disproportionate Distributions
 Exchange of any interest in LLC[P] §751
property – member must notify LLC[P]
within 30 days.
 LLC[P] must file Form 8308 and give to
each member by Jan. 31 of the
following year.
p. 165

Distribution Of Contributed Property
 Property distributed to any member
(other than contributing member) within
7 years of contribution must have built-
in gain allocated to contributing member
 Property sold by LLC must have built-in
gain allocated to contributing member
any time
p. 168

Contributed Property
Built-in gain/loss transfers to
the transferee member if LLC
interest is sold.
p. 168

§754 Election NOT Made
Member may elect to utilize
§754 if property is distributed
to member within 2 years of
acquiring LLC interest.
p. 168

Situation 5[P] – continued
p. 172

p. 173

p. 174

Types of Distributions
 Redemptions – corporation
purchases stock from a member
 Liquidation – Distributes
remaining property to members
 Nonliquidating – Dividend or
payment during ongoing
business operations
p. 179

Taxation of Distributions
Basis
Accumulated earnings and profits (AEP)
Accumulated adjustments account (AAA)
Other adjustments account (OAA)
p. 179

§301 Trilogy
Dividend
S/H basis
Gain
p. 180

AEP
 General Concept – The amount of
income within the corporation that is
distributable as dividends
 Current E&P added to historical AEP
updates economic activity for the year
p. 182

Current yearend taxable income
Increased by:
+ Tax-exempt income
+ Amount subtracted under DRD
+ Capital gain deferred under 453
+ Depreciation under an accelerated method
Calculating AEP
p. 182

Calculating AEP
Decreased by:
− Depreciation using S/L method
− Federal income tax and applicable penalties
− Dividends paid
p. 183

AAA
Increases
+ Separately stated income amounts
+ Nonseparately stated income
+ Depletion deductions in excess of basis
No adjustment for tax-exempt income
p. 184

Decreases
− Separately stated losses
− Nonseparately stated losses
− Expense items not deductible
− Member depletion deductions for oil
and gas properties
No adjustment for expenses related to
tax-exempt income
AAA
p. 184

AAA
1. Decrease – Ordinary distributions
2. Decrease – Net negative adjustments
3. Decrease – Redemption distributions
Purpose – Limits the distribution that will not
be treated as a dividend
Distribution in excess of basis treated as a
capital gain
p. 184

OAA
Tax-exempt income
Deductions related to
tax-exempt income
Federal tax amounts for
C corporation years
p. 186

LLC[S] with No AEP
 Nontaxable return of basis
 Excess of basis is treated as gain
from the sale of property
p. 186

Example 21
Beginning basis $20,000
Income items $30,000
Distributions (30,000)
Nondeductible expenses ( 5,000)
Losses (10,000)
Ending basis $ 5,000
p. 187

Example 22
2010 beginning basis $5,000
Income items $10,000
Distribution ($45,000) ($15,000)
2010 ending basis -0-
$30,000 distribution is capital gain
p. 187

LLC[S] with AEP
1. Distributions reduce AAA
2. Distributions come from AEP and are
taxed as dividends
3. Distributions are taxed as capital gain
p. 187

Example 23
Basis AAA
Beg balance $50,000 $30,000
Income 40,000 40,000
Loss ( 5,000)
Distributions (40,000) (40,000)
Basis adj for loss ( 5,000) _______
Ending balance $45,000 $25,000
p. 188

Example 24
Basis AAA
Beg basis $ 90,000 $80,000
Income items 10,000 10,000
Distributions ( 10,000) (10,000)
Exp. T-E income (100,000) 0
Ending balance - 0 - $80,000
p. 188

Special Election
p. 191
LLC[S] can elect to have distributions
come from…
AEP first rather than from AAA

Distribution of Property
1. Deemed Disposition
Must be characterized as sale at FMV to
members on pro-rata basis
2. Distribution of Property
Members are taxed on distribution
p. 191

Liquidating Distributions
 Series Distribution – members allowed
to use installment rules
 Disproportionate distributions –
characterized in 2 steps
 Cash or in-kind distributions – no
difference in tax position of members
p. 194

Loss Limitations
Distribution is not pro rata
or
Disqualified property is distributed
p. 195
Distributions to majority S/H – no loss
recognized if…
Property was acquired in a §351 transfer
and principal purposes was for LLC[S] to
recognize the loss
No loss recognized on property
distributed if…

Chapter 5:
Sale of Member Interest
LLC[P]
p. 201

Gain/Loss on Sale/Exchange
Gain/loss is a capital gain or loss
Exception for “hot assets”
p. 201

Basis Calculation
p. 202
Initial basis
+Additional contributions
+Adjusted basis of add’l property
contributed
+Share of income
- Money distributed
- Adjusted basis of property distributed
- Share of losses
- Depletion deduction

Holding Period
Gain can be either short- or long-term
p. 203

Installment Sale
Same rules as other installment sales
Member interest is personal property
p. 204

Termination Effect on Selling Member
LLC year closes for selling member
May use a pro-rata allocation
p. 204

Family Gifts
Donee should actively participate
 Transfer of control?
 Donee participate in management
and income distributions?
 Donee treated as a member?
p. 205

Example 2
Smith 50%
FMV $100,000
Basis $40,000
Jones 50%
FMV $100,000
Basis ????
Jones 50%
FMV
$100,000
Basis ????
Daughter 1 6.25%
Smith 37.5%
FMV $75,000
Basis $30,000
Daughter 2 6.25%
p. 205

Example 3
Smith 50%
FMV $100,000
Basis $40,000
Debt $45,000
Jones 50%
FMV $100,000
Basis ????
Debt $45,000
Jones 50%
FMV
$100,000
Basis ????
Debt $45,000
Daughter 1 6.25%
Smith 37.5%
FMV $75,000
Basis $30,000
Debt $33,750
Daughter 2 6.25%
p. 205

Termination Events
LLC is discontinued
50% ownership change within 12 months
p. 206

Technical Terminations Results
Old LLC New LLC
Assets and
liabilities Member
interests in
new LLC[P]
Remaining members
Member
interests
p. 207

Depreciation Issue
Dissolution and transfer of assets to
member = “step-in-shoes”
Technical termination = “fresh start”
p. 207

Basis Adjustment for New Member
Basis if purchased = price + liabilities
Basis if inherited = FMV + debt
p. 208

IRC §754 Election
Adjustment = inside basis – outside basis
§754 allocation:
1. Capital assets
2. Any other property
p. 208

§754 Adjustment
 Positive adjustments allocated solely to
appreciated assets
 Negative adjustments allocated only if
class has net depreciation
p. 209

Making the Election
p. 211
Name and address of LLC
Signed by any one member
Declare the LLC elects under §754
to apply provisions of §734(b) and
§743(b)

IRC §732(d) Election
Allows new member same adjusted
basis as §743(b) adjustment
p. 212

Example 10
$75,000Deemed sale (Debt)
$75,000Gain
$0Adjusted basis
$0Adjusted basis
$75,000Debt
$100,000FMV
p. 213

Situation 7[P]
Sale of an Interest –
LLC Not Terminated
p. 213

$269,520 = $89,842
3
$139,600 = $46,533
3
Outside $136,375
basis
p.214

$245,791 = $81,930
3
Inside basis $81,930
Outside basis – inside basis = §754 adjustment
$136,375 – $81,930 = $54,443
p. 214

Situation 8[P]
LLC is Terminated
p. 218

Situation 9[P]
No §754 Election
p. 226

Sale of Member Interest:
LLC[S]
p. 227

Sale of Member Interest
Sale of stock
IRC §338(h)(10) election
p. 227

Special Rules on Asset Sales
IRC §1060 applies:
 Goodwill or going concern value
attaches to assets
and
 Assets are sold in a fully taxable
transaction
p. 231

Installment Method
Type of assets must qualify
One or more payments received
after close of taxable year of sale
Note given by buyer must qualify
p. 234

Chapter 6: Withdrawal of a
Member
LLC[P]
p. 239

Liquidation Payments
IRC §736(b) payments – Payments for
underlying LLC property and goodwill
IRC §736(a) payments – Payments that
do not qualify as 736(b) payments
p. 240

736(b) payments are treated as:
 Reduction of basis
 Capital gain
p. 240

§736(a) payments are:
 Distributive share of income – if not fixed
and are determined with regard to LLC
income.
OR
 Guaranteed payments if fixed without
regard to income.
p. 240

 Determination of member’s interest in
underlying LLC property is up to the
members
 If done in arm’s length transaction –
generally accepted
p. 240

Fixed Payments
 If fixed amount will be received over a
set number of years – portion of each
payment is §736(b) property and balance
is §736(a) payment
 Ratio is §736(b) payments to total
payments
p. 241

Fixed Payments
First portion of §736(b) payments
are applied to basis reduction
When basis is recovered – the
balance is gain
p. 241

Example 1
Amount received –
Reduction in liabilities $12,000
Down payment $ 3,000
3 years @ $15,000 $45,000
Total $60,000
p. 241

§736 (b) payment is for:
Cash $ 1,000
Cows $20,000
Young Stock $10,000
Feed $10,000
Equipment $13,000
$54,000
p. 242

Portion of each payment treated
as §736(b) payment:
$54,000 ÷ $60,000 = 90%
p. 241

Total gain = $44,000
 $3,000 depreciation recapture
 $25,000 capital gain
 $10,000 ordinary gain from inventory
 $6,000 guaranteed payments
p. 242

Year 1: $15,000 received (12,000 + 3,000)
§736(b) payment
$15,000 x 90% = $13,500
§736(a) payment
$15,000 x 10% = $ 1,500
p. 242

Year 1: member must report the
following as ordinary income
1. $10,000 for inventory
2. $ 3,000 depreciation recapture
3. $ 500 return of basis
Member also reports $1,500 in
guaranteed payments
p. 242

Year 2: member reports the following
1. §736(b) payment: $13,500 is first
used to reduce basis – therefore,
zero is taxable
2. §736(a) payment - $1,500 is
guaranteed payment
p. 242

1. §736(b) payment: $13,500 reduces
basis by the remaining $2,000 and
$11,500 is capital gain
2. §736(a) payment: $1,500 is
guaranteed payment
p. 242

1. §736(b) payment: $13,500 is all
capital gain since basis is at zero
2. §736(a) payment: $1,500 is
guaranteed payment
p. 242

Variable Payments
Taxable gain on property is deferred until
basis is recovered, however…
 Depreciation recapture must be reported
in year of sale
 Ordinary income must be reported before
capital gain
p. 243

Example 2
Year 1: member receives $10,000 plus
reduction in liabilities of $12,000 = $22,000
First applied as §736(b) payments –
1. $ 3,000 depreciation recapture
2. $10,000 ordinary income for inventory
3. $ 9,000 basis reduction
p. 243

Year 2: member receives $17,000
Entire amount is 736(b) payment –
therefore, member reduces basis by
$7,000 and reports capital gain of $10,000
p. 243

Year 3 and later years
1. Member has $15,000 of capital gain
to report
2. Any other payments are 736(a)
payments taxed as ordinary income
p. 243

Other Allocations
Members may agree to any allocation
of §736(a) and §736(b) payments as
long as §736(b) payments do not
exceed FMV of assets in LLC
p. 243

Goodwill
Goodwill and unrealized receivables
are considered property under §736(b)
p. 243

Sale or Liquidation
Cash flow available to make payments
Tax considerations of withdrawing member
and remaining members
Loss reporting for sale – year of sale
Loss reporting for liquidation – not allowed
until payments are complete
Tax consideration of liquidated member
p. 244

Situation 10[P]
Complete Withdrawal -
Single Payment
p. 245

Situation 11[P]
Complete Withdrawal -
Series of Payments
p. 250

§736(b)% = Total §736(b) pmts ÷ amt realized =
$136,375 ÷ $251,533 = 54.22%
p. 252

Situation 12[P]
Complete Withdrawal –
Series of Payments Not
Fixed in Advance
p. 256

Order of Reporting
1. Depreciation recapture
2. Ordinary gain for inventory
3. Recovery of basis
4. Capital gain
5. §736(a) payments
p. 256

Withdrawal of a Member:
LLC[S]
p. 258

Share Redemptions
Occurs when C or S corporation
buys back its own stock
Could also be treated as a sale of
stock or units
p. 258

Sale or Exchange Treatment
Four Tests for Sale/Exchange:
1. Substantially disproportionate distribution
2. Termination of a member’s entire interest
3. Not essentially equivalent to a dividend
4. Partial liquidation test
Meeting any one is sufficient for sale
treatment.
p. 259

Substantially Disproportionate Test
Member must own < 50% of LLC voting
units
Member must control < 80% of voting
power than they had before redemption
Member must own < 80% of all
outstanding units
p. 259

Termination of Member’s Interest
Attribution rules apply unless attribution
waiver applies:
1. Prohibits member from retaining any
interest in entity
2. May not reacquire ownership interest
for 10 years
3. Formal agreement filed with IRS
p. 264

Distributions not
Equivalent to Dividend
IRC §301(b)(1) is not a concise test
Interpretation is found in case law
p. 266

Partial Liquidation
Must meet all of the following:
1. Not essentially equivalent to a dividend
2. Pursuant to a plan
3. Occurring within taxable year in which
plan is adopted or within succeeding
taxable year
p. 268

Sale vs. Distribution
Not elective
Redemptions under §302(b) automatically
treated as sales or exchanges
p. 269

Chapter 7: Death of a
Member
LLC[P]
p. 275

Alternatives Available
Terminate LLC
Continue with estate
Sell interest
Liquidate interest
p. 275
1.
2.
3.
4.

Questions
Decedent’s share of
income?
IRD?
Basis of interest?
1.
2.
3.
p. 275

Income to Date of Death
1. End of normal LLC year,
2. Sale of decedent’s interest, or
3. Complete liquidation of interest.
The member’s year closes the
earlier of:
p. 276

Income to Date of Death
Death is not a disposition of
a partnership interest
p. 276

Example 1
FMV $525,000
Adjusted basis 500,000
Step up in basis $25,000
Suspended loss $50,000
Lost due to step up 25,000
Deducted on final return $25,000
p. 276

IRD
Accrued for prior services rendered
Fees and commissions
Accrued interest
Savings bond interest
K-1 income
IRC §736(a) liquidation payments
Installment sale income
p. 277

Basis Adjustment After Death
FMV of member interest is:
 Increased for share of liabilities
 Decreased by share of IRD items
p. 278

Example 2
No §754 election made
 Mildred’s outside basis is FMV
 When property sold, Mildred’s
capital account is increased
 Mildred pays tax on the gain
p. 278

Liquidation Process
Complete outstanding transactions
Collect all debts
Sellall assets
Distribute cash to LLC creditors
and members
Render a final accounting
p. 279

Successor in Interest as Member
• Rights in specific LLC property
• Interest in profits and capital
• Right to participate in management
Transfer of deceased member:
p. 280

Sale of Deceased Member’s Interest
Possible to have the death and a
later sale of the interest treated as
two separate events.
p. 280

Liquidation of Interest
Can trigger IRC §751
p. 281

Situation 13[P]
Termination of the LLC
p. 281

Situation 14[P]
Successor in Interest
Continues in LLC
p. 284

Situation 15[P]
Sale of a Deceased
Member’s Interest
p. 284

Situation 16[P]
LLC Purchases
Deceased Member’s
Interest
p. 286

Death of a Member:
LLC[S]
p. 290

Uniform Limited Liability Company Act
May require automatic dissolution
May require the LLC to purchase the interest
Personal rep may only receive the rights—
does not become a member
Operating agreement may be written to
override these statutory provisions
p. 290

Tax Considerations
Step up in basis of member interest
Members receive their respective pro-rata
share of separately and nonseparately
stated items
Income apportioned on per-unit/per-day
basis
Special election to treat as 2 short years
p. 290–292

Redemption to Pay Estate Tax
Member’s interest > 35% of adjusted gross
estate
Member may use sale/exchange redemption
rather than distribution rules—if purpose is to
pay death taxes, funeral or admin. costs
Redemption must occur within 90 days of the
3-year limitation for assessment of estate tax
p. 294

For more information for
the University of Illinois
Tax School, visit
TaxSchool.Illinois.edu

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