For a deal lawyer, few transactions are more commonplace than the sale of LLC interests. Sadly, the tax consequences of even some of the most routine of these sales can be stranger than any reasonable person would expect. This article touches on a few basic tax concepts, but in this area even some of the basics tend to evoke astonishment. The complexity of the tax aspects is no reason to shun LLCs. In situations where the client has a choice, the authors rarely recommend any other form of entity. However, business lawyers who work with these entities should be forewarned that the benefits can come at the price of often bewildering tax rules.
The oddity of these tax principles becomes especially evident when comparing a simple sale of corporate stock with a sale of LLC units. We do not mean to suggest that the tax consequences of selling corporate stock are simple either. However, the rules on stock sales are generally more familiar to lawyers and, at least in most instances, tend to be more intuitive.
Note that some LLCs actually are classified as corporations for tax purposes or are disregarded – additional grounds for complexity and confusion. But most LLCs are treated as partnerships for tax purposes and those are the only LLCs we are going to deal with here.
A Simple Example
In 2010 Eva sells one of her shares of Paradise Inc. to Adam for $1,000. Paradise Inc. is a classic “C” corporation, subject to two levels of tax; it pays tax on its own income, and the shareholders pay additional tax when they receive dividends. Paradise Inc. pays some dividends out of its earnings. Paradise Inc. enjoys vigorous growth in value, and in mid-2012, Adam purchases one more share from Eva, this time paying $10,000. In early 2013, however, perhaps feeling some buyer’s remorse, Adam sells the second share for $10,000, the same amount he had paid for it. Since he sells the share at cost – and we’ll assume he had no transaction expenses – he recognizes no gain or loss.
Now take the identical facts, except that Paradise is an LLC taxed as a partnership, rather than a corporation. It would be natural – but, as it turns out, quite misguided – to assume that LLCs are something like corporations, so that if Adam sells the second LLC unit for $10,000, he simply breaks even. But that is unlikely to be the case.
LLC Basis in Constant Flux
One reason the sale of LLC interests is so complicated is that a member’s basis in an LLC interest changes so frequently. The amount that Adam pays for the units is only the starting point, and adjustments have to be taken into account to determine Adam’s basis. To a large extent, the reason the adjustments are needed is that the LLC does not pay tax on its own income. Instead, the members pay tax on the income as the LLC earns it, whether or not they receive distributions from the LLC. To determine which member is taxable on which portion of the income, the tax rules require an allocation of the income among the members. The allocation – which is essentially an accounting entry – increases a member’s basis, but the member generally is taxable on it even if the member receives no distribution. Conversely, when losses are allocated, the member suffers a decrease in basis but may be entitled to deduct a loss. Distributions reduce the members’ basis, offsetting the effect of income allocated. Contributions increase basis. Borrowing by the LLC is also allocated among the members, and each member’s share of that debt increases basis, even if such member has no liability on the debt. Each member receives an annual “Schedule K-1” from the LLC informing the member of these various adjustments.
To make things simpler, let’s assume that the LLC incurred no debt, suffered no losses, received no capital contributions, and distributed to the members exactly the same amounts as it allocated to them. With these assumptions, Adam’s basis in his LLC interest should be the amount he paid to acquire the interest, just as his basis in the corporate stock was the purchase price. But even with these assumptions, other complications await.
The “Blended” Tax Basis of LLC Units
Adam has a separate basis in each share of Paradise Inc. When he sells the second block of shares for what he paid, he has no gain or loss; it does not matter what he paid for the first block. Not so with Paradise LLC units. Adam’s basis in the different LLC units is blended or pooled; the division of his LLC interest into separate units has no significance under the tax rules.
Adam paid a total of $11,000 for his LLC units ($1,000 in 2010 and $10,000 in 2012). His basis in half the LLC interest therefore is only $5,500. When he sells half his LLC interest for $10,000, he recognizes $4,500 of income. This is so regardless of which unit he chooses to sell.
Thus, Adam has $4,500 more gain on selling the LLC unit than on selling the corporate stock. This is the result despite our assumption that Adam’s basis in both Paradise Inc. stock and Paradise LLC units equaled the purchase price, and even though in both cases the pricing of the transactions was the same. This does not mean LLCs are disadvantageous. If Adam had understood the relevant rules, some tax planning and restructuring might have served him well. For example, redemptions of LLC units can be tax-free in situations where comparable redemptions of corporate shares would be taxable. But Adam must understand the tax rules in order to see what alternatives might work better for him.
Capital Gain or Ordinary Income Depends on LLC Assets
We turn next to the character of Adam’s gain – is it ordinary income, capital gain, or a mixture? The answer will be important given the current tax rules. For individuals, the maximum tax rate on ordinary income is often nearly 20 percentage points higher than on long-term capital gain. But to determine which rates apply, we need to know the makeup of the LLC’s assets.
While the sale of LLC interests often results in capital gain, there are very large exceptions. To the extent the gain is attributable to so-called “hot assets” – i.e., inventory items and “unrealized receivables” of the LLC – Adam will recognize ordinary income instead of capital gain. While the first category seems straightforward, the latter category is a technical category that frustrates both tax and non-tax practitioners. In general, “unrealized receivables” refers to items that have not been taxed yet. For example, an account receivable of a medical practice that has not been included in income is an unrealized receivable. The definition, however, also extends to more esoteric concepts such as depreciation recapture.
It is generally much easier to figure out the character of gain on the sale of corporate stock. There is no need to examine the assets of the corporation because the tax rules don’t “look through” the corporation to its assets. Adam knows whether he has ordinary income or capital gain on selling Paradise Inc. stock without regard to the assets the corporation holds.
Let’s make another simplifying assumption about Paradise LLC: all its assets are “cold,” and so Adam’s gain on selling his units is entirely capital.
Adam’s Gain Is Partly Long-Term and Partly Short-Term
Under current law, for the seller to get a favorable tax rate on capital gain, the asset must be held longer than one year. Gain on capital assets held for shorter periods is still considered capital gain, and may sometimes be advantageous, but the advantages do not include any break on the tax rate. Short-term capital gain and ordinary income are taxed at the same rate.
Adam acquired his first unit in Paradise LLC more than a year before the sale, but he sold the second unit, which was held less than a year. However, just as the division of Adam’s LLC interest into units was ignored in determining the amount of his gain, that division is also ignored in determining his holding period (assuming Paradise LLC is not publicly traded). Under the tax rules, Adam simply sold half his interest in the LLC – from the tax viewpoint the attempt to separate his interest into two units has no effect. Adam’s holding period is divided, but the division ignores the existence of units. It turns out, in our simplified example, that 50 percent of his gain is short-term and 50 percent long-term.
In comparison, if Adam had recognized any gain on the sale of his second share of Paradise Inc. stock, all the gain would have been short-term. So in that instance the LLC holding period rule would have been more favorable. The rule for splitting the holding period of LLC interests may help or hurt, depending on the situation. The important point is to be aware of the rule and plan accordingly.
No Automatic Qualification for Most Favorable Rate
If Adam had recognized capital gain on the sale of Paradise Inc. stock, he could have determined his maximum tax rate without inquiring about the assets that the corporation happened to have. He would have qualified for the 20 percent maximum rate on long-term gain, although his short-term gain would have been considered ordinary income taxable at a maximum rate of 39.6 percent. (These rates do not include the 3.8 percent “Medicare” tax that went into effect in 2013, or any state and local taxes.)
The maximum long-term capital gain rate on the sale of LLC interests by individuals is generally 20 percent, just as it is on corporate stock. However, if the LLC holds depreciable real property, then a 25 percent maximum rate may apply to at least some of the gain. If any of Adam’s long-term capital gain on the sale of his LLC units is attributable to “collectibles” – such as art, antiques, metals, gems, stamps, or coins – held by the LLC, the maximum rate increases to 28 percent.
Some Issues Between Adam and the Buyer
The buyer of Adam’s LLC unit – call her Lilith – will start with a cost basis of $10,000, equal to the fair market value of the unit she just purchased. This is a reasonable result as far as it goes, but it may obscure the potential problems discussed below. (If Paradise LLC had any debt, Lilith’s basis might start off higher than $10,000, but we have stipulated that the LLC is debt free.)
For example, suppose that the LLC had earned a significant amount of income shortly before Lilith acquired her unit, and had distributed the proceeds to Adam, Eva, and any other members at the time. Since Lilith did not enjoy any benefit from that income, it would not seem fair to require her to pay tax on it. However, if she is not careful, she may be stuck with part of that tax bill.
As noted above, the tax rules require the LLC’s income to be allocated to its members. Under one allocation method the income is prorated – smoothed out as if the income had been earned each day of the year. Under that method, Lilith is allocated a portion of the income for the year based on the number of days she has been a member. It is irrelevant whether the income is earned before or after she buys in, or whether she gets the slightest benefit from the income. It is easy to construct examples where the new member bears catastrophic tax liability – perhaps more than her total purchase price – on income that she had no share of. Distortions of this kind do not arise on the sale of classic “C” corporations. Note that under our facts it is the buyer who is harmed by this distortion. In some instances, however, it would be the seller who suffers – for example, if Paradise LLC had incurred a significant loss before the sale, Lilith might be allocated some portion.
The way to prevent such distortions is to “close the books” as of the date that interests in the LLC change. If the books of Paradise LLC close when Adam sells units to Lilith, then Lilith would not be allocated any of the income arising before the sale. The LLC agreement may leave the choice between proration and closing the books to the buyer and seller, but it need not. It is possible that the LLC agreement will limit or even eliminate one or the other of the two methods. Adam and Lilith need to examine the LLC agreement.
Closing the books solves one kind of problem, but it fails to resolve another common but perhaps less obvious concern. When Lilith bought her units from Adam, the basis that the LLC had in its assets was likely quite low, much lower than fair market value. The difference between the low basis that the LLC has in its assets and the fair market value basis that Lilith has in her interest in the LLC may cause Lilith to be unfairly taxed. Tax practitioners refer to this as an “inside/outside” basis difference. Lilith has a high basis in her LLC interest (her “outside basis”), but her corresponding share of LLC assets has a low basis (her “inside” basis). For a variety of technical reasons, these types of differences can cause tax inefficiencies.
Here is an example of the problem. Suppose that the day after Lilith’s arrival the LLC sells the bulk of its assets for $27,000, and that all $27,000 is gain (i.e., these assets had a zero basis). If Lilith owns one-third of the LLC at the time, she is allocated $9,000 of taxable income. The LLC chooses to distribute $9,000 to Lilith, but – because the LLC has disposed of most of its assets – the value of her LLC declines from $10,000 to $1,000. Lilith plainly has not enjoyed $9,000 of income since acquiring her interest in the LLC. The value of her interest in the LLC did not grow between the time she acquired the interest and the time the LLC sold its assets. In reality, Lilith has simply received back $9,000 of her $10,000 investment. However, the tax rules fail to recognize that reality, and charge her with tax on $9,000 of income, unless the parties take action to alleviate the problem.
There is a tax election that can resolve this problem. When the election functions as intended, the basis of Lilith’s share of the LLC’s assets is increased and she avoids any consequences of an inside/outside basis difference. Critically, however, the election is made by the LLC, and not by Lilith. Depending on the terms of the LLC agreement, Lilith may or may not be able to require the LLC to have the election in place when needed. The availability of the election is an important consideration for Lilith when she is deciding whether to buy Adam’s units. The units may be less valuable if the election cannot be put in place.
More Trouble Areas
This article is not intended to provide a definitive survey of tax issues that need to be considered in confecting a sale of an LLC interest. However, in addition to the issues already mentioned, practitioners need to be aware of the following:
A sale of 50 percent or more of the LLC interests in a 12-month period can cause a “termination” of the LLC for tax purposes, even though the LLCs continuity as a business entity under state law is in no way impaired. While the real world consequences are often not dramatic, for some LLCs (particularly those which own property that qualifies for accelerated depreciation), the results may be significant.
Deemed Debt Relief
As noted, one component of a member’s basis in her LLC interest is her “share” of the LLC’s debt. For tax purposes, when a member sells an interest in an LLC, the actual consideration received is artificially adjusted by an amount equal to the change in her share of LLC debt. Depending on the details of the LLC debt and whether she sells all or a portion of her interest in the LLC, these rules can significantly complicate the amount of gain or loss she will have to recognize.
Differing Types of LLC Interests
If a member holds different classes of interests in an LLC (e.g., common and preferred units), the sale of one class and not the other can make application of the pooled basis rules even more complicated. In fact even when two LLC units are nominally of the same class, there may be differences between them. Whereas the sale of one of Adam’s two identical LLC units required him to assign half of his total basis to the unit that was sold, the same result does not obtain if the two units have different rights and economics. In that case, it will generally be necessary for Adam to determine the fair market value of both classes.
Economically, there is little difference between selling an interest in an LLC and having the LLC redeem such an interest. However, such transactions introduce a number of new issues, particularly if the LLC makes a noncash distribution to effectuate the redemption, which can create unintended consequences.
Tax issues are messy. No one would hold up the tax consequences of buying and selling stock of corporations as a model of simplicity and clarity. In our experience, however, the tax treatment of stock sales rarely elicits the kind of shock that comparable sales of interests in LLCs – that is, LLCs classified for tax purposes as partnerships – often arouses. Corporations cannot compete with many of the tax advantages that LLCs offer. However, the gap between what most lawyers would expect, and what the tax rules actually require, is larger in the case of LLCs than corporations. While it is never a good idea to rely solely on intuition in anticipating the tax consequences of a transaction, intuition is often especially unreliable when dealing with LLCs.