By: Tamara Pow
Before you make a contribution to an LLC in exchange for a membership interest, beware that some member contributions to LLCs are taxable. For a limited liabilty company (“LLC”) taxed as a partnership, the general rule is that members do not recognize any tax gain or loss on their contributions to the LLC in exchange for a membership interest. After the contribution to the LLC, the member will get a basis in her membership interest equal to the basis she had in the contributed property and any pre-contribution gain or loss she had on the property will be allocated to her. However, watch out for these six exceptions to the rule of a member not recognizing gain or loss on a contribution of property to an LLC:
- Contribution of Services
Although the non-recognition rule is true for the contribution of property or cash to an LLC, the contribution of services to an LLC in exchange for a membership interest may be taxable depending on how the LLC agreement is drafted. This is a very complex tax analysis, that I will attempt to simplify here, but if you are considering contributing services to an LLC it is critical that you get the advice of a good lawyer or CPA that understands these complexities. Generally, if the service member receives a capital interest in the LLC (a right to receive money or property on the LLC’s dissolution), the member will immediately recognize ordinary income on the value of the capital interest received in exchange for the services. This recognition may be delayed until any contingency or substantial risk of forfeiture is satisfied. On the other hand, if the service member receives a profits interest, dependent on the LLC’s future profits, this will usually not cause recognition, unless the profits interest brings with it a substantially certain and predictable stream of income, or the member sells it within two years, or the profits interest is in a publicly traded partnership. Either way, an LLC generally recognizes no gain or loss on the issuance (or later vesting) of a membership interest provided in exchange for contributed services.
- Disguised Sale
If the contribution of property to the LLC is really a disguised sale restructured to look like a contribution in exchange for a membership interest, the member transferring the property will recognize gain. For example, if a member transfers property or money to an LLC and, within two years, gets property or money back, the transaction will be treated as a taxable exchange either between the member and the LLC or between the member and another member.
- Acquisition of Stock of a Corporate Partner
An LLC’s acquisition of stock of a corporate member in exchange for property may be taxable.
- Contribution of Property subject to Liabilities
If a member contributes property subject to liabilities and the LLC assumes the liabilities, or takes the property subject to them, the transfer of the property may cause tax recognition for the contributing member. The member is treated as receiving a distribution of cash equal to the amount of the liability assumed, if the member does not have enough basis to cover the deemed distribution, the member will recognize taxable gain.
- Investment Company LLC
If the LLC is classified as an investment company, the contributing member may recognize gain or loss on the contribution of property.
- “Boot” Received
If the contributing member receives some property in addition to the membership interest, this property is known as boot and will be treated as either a distribution from the LLC or a partial sale.
If all the members are contributing cash to an LLC, taxes on contributions are not a concern. However, if members are contributing services or property, or may fall into any of the exceptions above, be sure to check with your tax advisor prior to finalizing the structure and language of your operating agreement.
As an LLC attorney in the Bay Area, Tamara is often asked about the tax consequences LLC members face when making contributions to an LLC. Tamara uses her MBA, California real estate broker’s license and experience in public accounting, to consider all possible tax consequences when choosing the best form of business entity or structuring a member contribution to an LLC.
The information appearing in this blog does not constitute legal advice or opinion. Such advice and opinions are provided by the firm only upon engagement with respect to specific factual situations. Specific questions relating to this article should be addressed directly to Strategy Law, LLP.