Accounting for LLC Conversions – Change in IRS Classification

I previously expressed my love for LLCs here.  I like that a Single-Member LLC (“SMLLC”) is a disregarded entity for income tax purposes and does not need to file a separate stand-alone tax return. If the SMLLC is owned by an individual the income and expenses of the LLC are reported on Form: 1040; Schedule C. This will save the owner annually in tax preparation fees.

Going from a SMLLC (Disregarded Entity) to a Multi-Member LLC

What happens when a SMLLC becomes a Multi-Member LLC?

General Rule: A SMLLC is a disregarded entity for tax purposes; whereas a multi-member LLC is taxed as a partnership.

What are the tax consequences of converting a disregarded entity to a partnership?

The disregarded entity is converted to an entity that is now taxed as a partnership.  There are generally two scenarios in which a SMLLC would convert to a multi-member LLC.  Scenario I– the sole owner of the SMLLC sells a portion of his or her interest in the LLC to an outside person or entity thereby creating a multi-member LLC.  Scenario II-the sole owner of the LLC does not sell any portion of his or her interest in the LLC.  Instead, the LLC issues additional shares to a new member establishing a multi-member LLC.

IRS Revenue Rule 99-5 provides guidance on both Scenarios:

Scenario I:

 A is the sole owner of a SMLLC.  B is an individual not related to A who purchases 50% of the LLC from A for $5,000. A does not contribute any portion of the $5,000 to the LLC.  A & B continue to operate the business as co-owners creating a partnership.

Tax Consequences: This is a sale of 50% interest in the LLC.  However, B is buying the interest from A which is different than if B was buying the interest directly from the LLC. IRS Guidance:  B’s purchase of 50% of A’s ownership interest in the LLC is treated as the purchase of 50% of each of the LLC’s assets, which are treated as being held directly by A for tax purposes. Immediately thereafter, A and B are treated as contributing their respective interests in those assets to create a partnership in exchange for an ownership interest in that partnership.

Taxability of Transaction: There is no gain or loss recognized by A or B as a result of converting a disregarded entity into a partnership.  However, A may be required to recognize a gain on the sale of the LLC interest to B; to the extent the purchase price exceeds A’s basis in the assets being treated as sold.

Basis in the LLC interest: B’s basis in his partnership interest would be $5,000 (purchase price); A’s basis in his partnership interest would be his basis in the assets being contributed to the newly formed partnership.

Basis of Property in the Hands of the LLC: The basis of the property being treated as contributed to the partnership by A and B is the adjusted basis of that property in A’s hands and B’s hands immediately after the deemed sale (of 50% of assets from A to B)

Holding Periods: A keeps his previous holding period.  B holding period in his LLC interest starts the day following the purchase of the LLC interest from A.

Scenario II:

A is the sole owner of a SMLLC.  B contributes $10,000 to the LLC in exchange for a 50% interest in the LLC.  IRS Guidance: B’s contribution is treated as a contribution to a partnership in exchange for an ownership interest in the partnership.  A is treated as contributing all the assets of the LLC to the partnership in exchange for a partnership interest.

Taxability of Transaction:  There is no gain or loss recognized by A or B as a result of converting a disregarded entity to a partnership.

Basis in the LLC interest: B’s basis in his partnership interest is $10,000 (purchase price).  A’s basis in his partnership interest is equal to A’s basis in the assets being treated as contributed to the partnership.

Basis of Property in the hands of the LLC: The basis of the property contributed to the partnership by A is the adjusted basis of that property in A’s hands. The basis of the cash contributed by B is $10,000.

Holding Periods: A keeps his previous holding period.  B holding period in his LLC interest starts the day following the contribution of money to the LLC.

Going from a Multi-Member LLC to a SMLLC (Disregarded Entity)

What happens when a Multi-Member LLC becomes a SMLLC (Disregarded Entity)?

A multi-member LLC being taxed as a partnership will no longer be taxed as a partnership.

In general, for tax purposes a partnership is terminated if:

• No part of any business, financial operation, or venture of the partnership continues to be carried on by any of its partners in a partnership. OR
• “Technical Termination” occurs if within a 12-month period there is a sale or exchange of 50% or more of the total interest in a partnership.

What are the tax consequences of converting a partnership to a disregarded entity?

There are generally two scenarios in which a multi-member LLC would convert to a SMLLC.  Scenario I– A member of an LLC buys out the remaining members of the LLC.  Scenario II– All members of an LLC sell their interests in the LLC to an unrelated party who subsequently becomes the sole member of the LLC.

IRS Revenue Rule 99-6 provides guidance on both Scenarios:

Scenario I:

A and B are equal partners in AB an LLC.  A sells his entire interest in AB, to B for $10,000.  After the sale the business continues to operate under the LLC entity which is now owned solely by B.  IRS Guidance: The AB partnership terminates under §708(b)(1)(A) when B purchases A’s entire interest in AB.

Taxability of Transaction:  A has sold his partnership interest and must recognize any gain or loss resulting from the sale of his interest to B.

The transaction may also be taxable to B. IRS Revenue Rule 1999-6 explains that the AB partnership is deemed to have made a liquidating distribution of all of its assets to A and B, following this deemed distribution B is treated as acquiring the assets deemed to have been distributed to A.

B would recognize gain if the deemed distribution of assets to him exceeded his basis in the LLC.  This is basically a normal “distribution in excess of basis” situation on a deemed distribution.

NOTE: This LLC is now a disregarded entity for tax purposes so we are concerned about the assets (former partnership assets) basis and holding periods in the hands of B (the sole-member)

Basis of Property:  B’s basis in the assets attributable to A’s one-half interest in the partnership is $10,000 (the price B paid for A’s interest).  B’s basis in the assets received by the deemed distribution would be his adjusted basis in his partnership interest less any money received.  See §732(b)

Holding Periods: B’s holding period for the assets acquired begin on the day immediately following the date of sale.  However, B’s holding period in the assets received under the deemed liquidating distribution of B’s partnership interest will include the partnership holding period for those assets.

Scenario II:

C and D are equal partners in CD, an LLC. C and D sell their entire interest in the LLC to E an unrelated person in exchange for $10,000 each ($20,000 total purchase price).  After the sale the business will continue to operate as the LLC.

Taxability of Transaction:  Both C and D will recognize any gains or loss resulting from the sale of their partnership interest in the LLC.

NOTE: This LLC is now a disregarded entity for tax purposes so we are concerned about the assets (former partnership assets) basis and holding periods in the hands of B (the sole-member)

Basis of Property: is $20,000 (purchase price). The CD partnership is deemed to have made a liquidating distribution of assets to C and D.  Immediately following this distribution, E is deemed to have acquired all the former partnership assets for $20,000.

Holding Periods:  E’s holding period begins on the day immediately following the date of sale.

Recap 

This post demonstrated the procedures to account for changes in tax classification occurring when a SMLLC converts to a multi-member LLC or when a multi-member LLC converts to a SMLLC.  This post is based on IRS Revenue Ruling 99-5 and 99-6 which was drafted by Matthew Lay of the IRS Office of Assistant Chief Counsel and Mark D. Harris of the IRS Office of Associate Chief Counsel.

Disclaimer: This article is offered for general information and educational purposes and not intended to be tax or legal advice.