Volume 25 Issue 1 --January/February 2013
With the recent mushrooming in the number of single-owner LLCs, it is hardly surprising that situations would arise where the owners of such entities wish to sell interests in them to others.
What happens when the single owner of an LLC (taxed as a sole proprietorship) sells an interest in the LLC?
Suppose Mary Bright, a successful CPA with a 10-year old practice, decides that it is time to expand her practice by bringing in a partner. Her practice is organized as a single owner LLC. What if Mary sells a 50% interest in her LLC to another accountant, Tom Waters?
Even if structured as a sale of an LLC membership interest between Mary and Tom, for income tax purposes the transaction must be treated as a sale of 50% of each of the LLC’s assets from Mary to Tom. In other words, Mary will recognize taxable gain on any appreciated assets.
In essence, in Revenue Ruling 99-5, the IRS said it will treat the sale of the 50% LLC interest as distribution of all of the LLC assets to Mary followed by a sale of 50% of each asset to Tom, after which Mary and Tom each contribute their share of the assets to a new partnership.
This result can be avoided if the LLC issues a 50% interest to Tom in exchange for a capital contribution from Tom. That would be a non-taxable transaction as far the LLC is concerned. Of course, if Mary immediately took out the “capital contribution” as a distribution to herself, then maybe this would be treated as a disguised sale of assets.
Because a sale of an interest in a single owner entity is treated as an asset sale followed by the formation of a partnership, the sale itself is not a partnership transaction. As a result, there would be no § 754 election available.
If it is treated as a sale of assets in any event, why structure the sale as a sale of an interest in the LLC? Even though tax law treats it as a sale of assets, for state law purposes ownership of the LLC’s assets does not change, merely the ownership of the LLC. This means that ownership of all of the LLC assets as well as all contracts in the LLC’s name do not change under state law. This can be an advantage.
While it is clear that the basic sale of an LLC interest will be treated as an asset sale, there are many uncertainties relating to this increasingly common transaction.
Presumably, the transaction must be reported as an asset sale. Is this a sale of assets that would be subject to reporting as a sale of a trade or business under IRC § 1060? The answer to that is not clear. If there is a sale of substantially all of the LLC assets, then presumably § 1060 would apply and filing Form 8594 would be required. In that event, the allocation of the purchase price among the assets would need to be reported.
If there is a transfer of only a portion of the assets, it may not be clear whether they constitute a trade or business, which must be reported on Form 8594. The IRS uses a facts and circumstances test to make this determination, and there is little guidance in such situations.
What happens if a portion of Tom’s purchase price is allocated to good will? Can Tom take an amortization deduction under § 197?
The answer to this is also unclear. Clearly, Mary is not entitled to any amortization deduction for any self-created good will. On the other hand, if Tom purchased the good will as part of another trade or business and contributed it to the partnership, the partnership would be entitled to an amortization deduction.
IRC § 197 generally disallows any deduction for good will or going concern value unless acquired as part of the purchase of a trade or business (or a substantial part thereof) under § 1060, but as noted above it is often unclear whether the transfer of a partial interest in LLC assets would qualify as a transfer of a trade or business.
If the assets purchased by Tom could not be operated separately as a trade or business, then perhaps it would not be subject to § 1060 and there would be no amortization of the good will.
If, however, the sale is treated as a sale of a substantial portion of a trade or business, then under § 197, there could be an amortization deduction. Presumably any such deduction would have to be specially allocated to Tom.
Upon the deemed formation of the partnership, Mary and Tom will likely have very different bases in their partnership interests, even though their capital accounts will be similar. The resulting book-tax disparity can lead to a number of other implications under the partnership tax rules.
If you have questions about such transactions, please call the Tax & Business Professionals.
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