By: Tamara Pow
A limited liability company (“LLC”) can terminate for tax purposes even though it has not been dissolved with the California Secretary of State , resulting in potential tax consequences for the members. Members should be aware of when this could happen, the tax consequences that could result, and potential planning opportunities to avoid it.
What causes a tax termination? Under Internal Revenue Code Section 708, an LLC terminates for tax purposes in two different circumstances. First, when it ceases to do any business. If the LLC’s primary business is abandoned, an LLC will not terminate if it is still doing any business. However, if all business is discontinued, the LLC will automatically terminate on the date it is wound up and all assets are distributed to the members. Second, an LLC will terminate for tax purposes if fifty percent or more of the total interests in capital and profits of the LLC is sold or exchanged in any 12 month period. This can be the result of one sale or multiple sales, but multiple sales of the same interest during the same 12 month period are not aggregated.
What is the effect of a tax termination? The tax termination of an LLC results in a deemed distribution of the LLC assets to the members in proportion to their percentage interests, and a recontribution by the members of those assets to a new LLC. The LLC’s taxable year closes for all members as of the tax termination. This results in the LLC having to file two short year tax returns for that year. It could also result in bunching of LLC income on the members’ tax returns. Also, members may recognize gain if the amount of money deemed distributed to them exceeds their basis in the LLC. ( Click here to see my blog on LLC basis.
Can members avoid a tax termination? With careful planning, an LLC may be able to avoid a tax termination. Members can consider dividing sales of membership interests into two sales that are more than 12 months apart. Members can also consider reducing the selling member’s interest in either capital or profits before the sale through a distribution or an amendment to the operating agreement. Members can also avoid a tax termination by structuring the transaction as the liquidation of a member rather than a purchase by other members.
For any change in ownership interest in an LLC, the members should talk to their tax advisor in advance to determine if the change could result in a tax termination, and if so, whether that tax termination would cause adverse tax consequences.
Tamara B. Pow is a founding partner of Strategy Law, LLP in downtown San Jose, California where she practices business and real estate law including LLC formations, operations, transfers, conversions and dissolutions. Her tax background, including time as a tax consultant at Price Waterhouse, LLP, as well as her MBA and real estate brokers license help her in advising owners of LLCs and other business entities.
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 articles should be addressed directly to Strategy Law, LLP.