Limited liability companies are unique hybrid entities offering flexibility to their members. “Check the box” regulations permit LLCs, depending on the circumstances and elections made, to be taxed as corporations, partnerships or to be completely disregarded for federal income tax purposes. Where no elections are made, an LLC with one member is a “disregarded entity,” and an LLC with more than one member is taxed as a partnership.
Circumstances, however, can change. For example, assume A and B are members of an LLC, and A dies. Oftentimes, the death of a member leads to the buyout of the deceased member’s interest. What happens when B purchases A’s entire interest in the LLC and the LLC becomes a “disregarded entity” for federal income tax purposes?
B’s purchase of A’s entire interest in the LLC is treated as a termination of the LLC for tax purposes, but not for state law purposes. A’s estate is treated as selling its interest in the LLC. A’s estate must report gain or loss resulting from the sale of its interest to B. The results for A are straightforward.
B, on the other hand, is not treated as purchasing A’s interest in the LLC. The LLC is instead deemed to have made a liquidating distribution of all its assets to A and B. Thereafter, B is regarded as having acquired the assets distributed to A in the deemed liquidating distribution. B takes a cost basis in the assets attributable to A’s interest in the LLC equal to the purchase price for A’s interest in the LLC.
For the assets deemed to have been purchased by B, they receive a new holding period for purposes of determining the character of any capital gains, which begins on the day after the date of the sale. Therefore, B cannot include the holding period of the LLC for future sales of those LLC assets even though for state law purposes the LLC has continuously owned the assets.
Remember that the LLC was deemed to have made liquidating distributions of all of its assets to both members. B is regarded as receiving a distribution of those assets attributable to B’s interest in the LLC immediately before the sale. This is a recognition event for B, who must recognize gain or loss on the deemed distribution to the extent required by federal code. B takes a basis in the assets deemed to have been received in the liquidation of B’s interest in the LLC just as B would in a normal liquidating distribution. B would not receive a new holding period for the assets received in liquidation with respect to B’s interest in the LLC. The assets would continue to include the LLC’s holding period for these assets, except for inventory items.
Depending on the circumstances, these deemed transactions can be a trap for the unwary.
Davenport, Evans, Hurwitz & Smith, LLP, located in Sioux Falls, South Dakota, is one of the State’s largest law firms. The firm’s attorneys provide business and litigation counsel to individuals and corporate clients in a variety of practice areas. For more information about Davenport Evans, visit www.DEHS.com.