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.
While designed to be accurate, this publication is not intended to constitute the rendering of legal, accounting, or other professional services or to serve as a substitute for such services.
Redistribution or other commercial use of the material contained in Tax & Business Insights is expressly prohibited without the written permission of Tax and Business Professionals, Inc.
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