Accounting for LLC Conversions

oday, limited liability companies can be found everywhere. With their flexible management structure, LLCs have become a common way to own and operate a business. Professionals (doctors, lawyers, accountants and engineers) as well as software and computer-based companies and a wide array of other small businesses are increasingly using this form of organization. LLCs offer owners—generally known as members—the liability protection of a corporation and the tax structure of a partnership.

As LLCs increase in popularity, CPAs are confronted with complex tax issues, particularly when ownership of the LLC changes. The IRS issued revenue rulings 99-5 and 99-6 to address issues surrounding the conversion of a single-member LLC to a multiple-member LLC and the conversion of a multiple-member LLC to a single owner entity. This article explains the rulings and discusses proper accounting procedures for the transactions they highlight. In addition, it supplements the examples in the rulings and offers some useful planning tips for CPAs (see box below for a summary).

SINGLE-MEMBER TO MULTI-MEMBER LLC

Revenue ruling 99-5 provides guidance on proper accounting procedures when a single-member LLC converts to a multiple-member LLC. The ruling addresses the conversion issue from two perspectives:

• A sole member sells a half interest to another person.
• The new member contributes property, including cash, to the LLC in exchange for a half interest instead of buying part of an existing member’s ownership interest.

The tax treatment of each perspective is best explained by using these examples.

Perspective one. Albert has been the sole member of an Arkansas LLC for five years. The LLC has two assets, $10,000 in cash and equipment with a $25,000 fair market value (FMV) and an adjusted basis of $10,000. Albert sells 50% of his ownership interest to Betty for $17,500. The members do not elect to treat the LLC as an association for tax purposes. (Failing to make this election ensures the entity, by default, will be taxed as a partnership.) Before the sale, Albert’s basis in his partnership interest (his “outside” basis) was $20,000. (Outside basis is a member’s basis in his or her membership interest; inside basis is the LLC’s basis in all assets it owns.)

Analysis. According to the revenue ruling, the LLC becomes a partnership when Albert sells an ownership interest to Betty. The entity no longer can be treated as separate from its owners since by definition it is now a partnership under the Uniform Partnership Act. Accordingly, Betty’s acquisition is treated as a purchase of a proportionate ownership interest in each LLC asset. Initially, Albert is treated as selling a 50% interest in each asset, all of which are deemed owned by him for federal tax purposes. Thus, Albert must realize and recognize a $7,500 gain on the sale of half of the LLC assets (FMV of assets [$35,000] less total adjusted basis [$20,000] multiplied by percentage sold [50%]).

N ext, Albert and Betty are considered to have contributed their ownership interests to the “new” partnership. The contribution is nontaxable because neither a partnership nor any of its partners recognize gain or loss when individuals contribute property in exchange for a partnership interest. Betty’s outside basis equals her $17,500 purchase price; Albert’s outside basis equals the basis in his remaining 50% share of LLC assets ($10,000). The partnership takes a carryover basis in the assets Albert contributes. Therefore, the partnership will have a $27,500 “inside” basis in the property deemed contributed by Albert and Betty.

The partnership’s $27,500 inside basis equals the partners’ total outside basis. This should be the result because if the partnership sold the equipment today, it would recognize only a $7,500 gain, representing the equipment’s remaining unrecognized gain. Recall that half of the equipment was deemed sold by Albert and was the primary reason he recognized a $7,500 gain. To preserve the one level of taxation inherent in partnerships, the equipment should have a basis in the new partnership of $17,500. Presumably, this basis consists of Albert’s $5,000 contribution basis (one-half of the equipment) plus Betty’s $12,500 purchased interest in the partnership’s assets. (Since there is only $10,000 cash and Albert contributed half of it, the maximum amount of Betty’s contribution allocable to the partnership’s cash “basis” is $5,000. The remaining $12,500 of her contribution is allocated to the equipment’s adjusted basis.)

Albert’s holding period for the partnership interest is five years. He is allowed to “tack” on the asset’s holding period before the sale because the property deemed exchanged and the partnership interest received have the same basis and the property deemed contributed was used in a trade or business. Conversely, Betty’s holding period begins the day after she purchases her ownership interest.

IRC section 1223(2) requires the partnership to take the transferred holding periods of Albert and Betty in the assets received, which means the partnership will have a five-year holding period in the equipment deemed contributed by Albert and a zero holding period in the half deemed contributed by Betty. This results in a “split” holding period for the equipment. If the partnership sells the equipment tomorrow for its FMV, the gain would be half long term and half short term.

This situation is a classic trap for unsuspecting CPAs, since equipment usually is not divided before it is sold. CPAs also usually don’t consider the possibility of a single asset having multiple holding periods. However, the Taxpayer Relief Act of 1997 makes understanding this transaction crucial, given the disparity between short-term and long-term capital gain rates. By carefully tracking the holding periods of assets over time, CPAs will be able to properly advise clients on the likely tax consequences before the assets are sold. Any gain the partnership recognizes on the sale of the equipment ultimately will have to be reported by the partners and properly classified on their own tax returns.

Perspective two. Albert has been the sole member of an Arkansas LLC for five years. The LLC has $10,000 of cash and equipment with a $25,000 FMV and an adjusted basis of $10,000. Subsequently, Betty contributes $35,000 to the LLC for a one-half ownership interest. She is now a 50% owner of the LLC; the members do not elect to treat the LLC as an association for tax purposes.

Analysis. According to the revenue ruling, the LLC becomes a partnership when Albert sells an ownership interest to Betty. Once again, the entity no longer can be treated as separate from its owners—it is now a partnership. Accordingly, Betty’s purchase is treated as a purchase of a proportionate ownership interest in each LLC asset.

Initially, Albert is treated as contributing all of the LLC’s assets in exchange for his half interest in the newly formed partnership. Betty is considered to contribute the cash in exchange for her interest. Once again, neither the partners nor the partnership recognizes any gain or loss on the deemed contribution and receipt of the assets. Betty’s outside basis equals the $35,000 purchase price; Albert’s equals the $20,000 adjusted basis of the assets he contributes to the partnership. The partnership takes a carryover basis in the contributed assets of $55,000 ($20,000 adjusted basis from Albert plus $35,000 adjusted basis from Betty).

In this situation, the inside basis and the combined outside basis are equal—$55,000. This should be the result since the equipment’s $15,000 unrecognized gain is still preserved. If the partnership sold the equipment tomorrow for its presumed $25,000 FMV, it would recognize a $15,000 gain that Albert and Betty would report. This result should not change, regardless of how the transaction is recast for tax purposes. The tax avoidance rules still apply if the equipment is sold, assuming the equipment was appreciated property when Albert contributed it. If the equipment is distributed to Betty or if Albert receives a distribution of subsequent partnership property within seven years of its contribution date, he is still responsible for part, if not all, of the property’s built-in gain. Albert’s holding period is five years while Betty’s holding period begins the day after her cash contribution to the partnership. Similarly, the partnership will have a five-year holding period in the equipment it received from Albert.
When comparing the two perspectives, questions arise about the preferred method of bringing a new owner into the business. The answer depends on the seller’s intent. When the seller wants solely to increase personal cash flow, perspective one may make the most sense since it results in the seller’s receiving more money. For example, the seller’s interest in perspectives one and two is apparently worth $35,000—the value of the business assets. When Albert sells 50% of his interest, the sale price should be $17,500. This results in equal partners, each with an equally valued ownership interest. When he sells half of his partnership interest for $17,500, Albert pockets the proceeds.

If the seller seeks an infusion of capital into the business, he or she will find it more beneficial to use the approach outlined in perspective two. The seller does not recognize any gain on the sale and, presumably, can command more money. Technically, the value of the business ($35,000) is attributable to its sole owner. Thus, the purchaser would have to contribute equally for the partners to be equal. Therefore, Albert should demand a minimum of $35,000 from Betty.

MULTI-MEMBER TO SINGLE-MEMBER LLC

Revenue ruling 99-6 provides guidance when a multiple-member LLC is converted to a single-owner entity for tax purposes. The ruling also addresses the conversion issue from two perspectives.

• One LLC member sells his or her full ownership interest to another member, making the transferee the sole owner.
• LLC members sell their full ownership interests to a nonmember.

These examples best explain the tax treatment of each perspective.

Perspective one. Andrea and Bob have been the equal owners of an LLC for five years. The LLC has $5,000 in cash; equipment with an FMV of $20,000 and a $10,000 adjusted basis; and a building worth $75,000 with an adjusted basis of $25,000. Andrea sells her half interest to Bob for $50,000. He is now the LLC’s sole member.

Analysis. Initially, the partnership is terminated under IRC section 708 because 50% was sold within a 12-month period. Additionally, because Andrea has sold her partnership interest to Bob, she must recognize a $40,000 capital gain—the excess of the amount she realized ($50,000) over her outside basis ($10,000). Moreover, the partnership is considered to have made a complete liquidating distribution to both partners upon Bob’s purchase of Andrea’s interest. Subsequently, Bob is deemed to have acquired—by purchase—the assets distributed to Andrea in the liquidation. Bob’s basis in those assets will be his $50,000 purchase price. Bob’s holding period in the assets attributable to Andrea’s interest begins to run the day after the sale since he acquired the assets by purchase and not by distribution from the partnership.

Bob also is deemed to have received a liquidating distribution of the assets attributable to his former half interest in the now-terminated partnership and may be required to recognize gain or loss. IRC section 731(a), which governs the distribution, says the distributee partner recognizes gain only when the amount of money distributed exceeds the partner’s outside basis immediately before the distribution. On this basis, Bob will not be required to recognize any gain since the amount of cash he is deemed to have received in the liquidating distribution ($2,500) does not exceed his outside basis ($10,000). Bob is not allowed to recognize a loss on the distribution because he received property (equipment and building) other than money, unrealized receivables and inventory.

T he final issue to be resolved is the basis Bob takes in the distributed assets attributable to his half interest in the former partnership. The Taxpayer Relief Act of 1997 altered the traditional manner in which basis was allocated among properties received in a liquidating distribution. Essentially, the act modified IRC section 732(c) and outlined a three-tier allocation process for properties received in liquidating and certain nonliquidating distributions.
Initially, Bob must take a substitute basis of $10,000 in the assets attributable to his half interest. The first tier of the allocation process requires Bob to allocate his outside basis ($10,000) to the $2,500 in cash. The second tier does not apply to Bob since he did not receive any unrealized receivables or inventory items in the distribution. Finally, the third tier assigns carryover bases of $5,000 to the equipment and $12,500 to the building. Since the $17,500 total adjusted bases of the equipment and building exceed Bob’s remaining outside basis of $7,500 ($10,000 initial basis less $2,500 assigned to cash), the total adjusted bases of the equipment and building must be decreased by $10,000 to equal Bob’s outside basis.

The decrease is allocated initially to properties with unrealized depreciation. Neither the equipment nor the building has any unrealized depreciation because each property’s FMV exceeds its adjusted basis. Next, the $10,000 decrease is allocated in proportion to the properties’ relative adjusted bases. Thus, the equipment will be allocated $2,857 of the decrease while the land will be allocated $7,143. The equipment’s share of the decrease is computed as follows: $10,000 allocable decrease multiplied by half of the equipment’s basis ($5,000) divided by the $17,500 total bases of the properties. Similarly, the building’s share of the decrease is computed by multiplying the $10,000 allocable decrease by half of the building’s adjusted basis ($12,500) divided by the $17,500 total bases.

Bob’s basis in 50% of the equipment deemed distributed to him in liquidation is $2,143 ($5,000 carryover basis less the $2,857 share of the decrease). His basis in the building is $5,357 ($12,500 carryover basis less the $7,143 decrease). Therefore, Bob will have a $50,000 cost basis in the assets attributable to Andrea’s half interest (cash, $2,500; equipment, $10,000; building, $37,500). Bob’s holding period in these assets begins the day after the purchase. He will have a substitute basis of $10,000 in the assets attributable to his half interest and deemed distributed to him in liquidation of the partnership (cash, $2,500; equipment, $2,143; building, $5,357). Bob will be able to tack the partnership’s holding period in this half of the assets onto his holding period, giving him a five-year holding period in half of the assets. Bob is allowed to do this because the assets were deemed distributed to him and not purchased.

Perspective two. Andrea and Bob have been equal owners of an LLC for five years. The LLC has $5,000 in cash; equipment with a FMV of $20,000 and an adjusted basis of $10,000; and a building worth $75,000 with an adjusted basis of $25,000. Andrea and Bob sell their half interests to Carol for $50,000 each, leaving Carol as the LLC’s new owner. Andrea and Bob both have a $10,000 outside basis in their ownership interest.

Analysis. Under revenue ruling 99-6, the partnership is deemed to terminate under section 708 because none of its partners are carrying on any part of its business as a partnership. Additionally, Andrea and Bob each must recognize a $40,000 capital gain upon the sale of the partnership to Carol (excess of the amount realized [$50,000] over the adjusted basis in the partnership [$10,000]). From Carol’s perspective, the ruling treats the partnership as making a liquidating distribution of all assets to Andrea and Bob with Carol purchasing those assets from the partners immediately after the distribution. Hence, Carol will take a cost basis in the assets of $100,000. Presumably, the assets are deemed purchased for their FMV, leaving Carol with a basis of $5,000 in the cash, $20,000 in the equipment and $75,000 in the building. Likewise, Carol’s holding period in the assets begins to run the day after the sale, because she acquired the assets by purchase and not by distribution.

Which option a seller selects again depends on his or her motivation. Perspective two lends itself to situations where both owners agree to sell—and leave—the business. Conversely, the first perspective likely will benefit owners who have a contractual agreement to sell their ownership interests to each other. While perspective two is easier for accounting purposes, the importance of perspective one cannot be overstated, given the prevalence of buy–sell agreements, rights of first refusals and other ownership transfer restrictions. Thus, behind every potential death, bankruptcy, divorce or retirement lurks the complex accounting process outlined in perspective one. The exhibit on page 80 illustrates the effects of conversion under both perspectives.

THE PREFERRED BUSINESS ENTITY

The importance of revenue rulings 99-5 and 99-6 will increase as the LLC continues to become America’s preferred business entity. While the LLC offers many tax and nontax advantages, it also offers a great disadvantage: The application of subchapter K and its myriad intricate partnership taxation rules and procedures. Unfortunately, as LLCs become more prevalent, CPAs and their clients will encounter complex partnership issues, such as those in revenue rulings 99-5 and 99-6, more frequently. Proper planning requires a strong understanding of the technical interplay between the sellers’ desire and the various partnership provisions in the IRC. The inability to resolve issues such as split holding periods, gain or loss recognition and basis will leave some taxpayers with undesirable present and future tax consequences.