By Dyches Boddiford
Since we have been discussing LLCs recently, I have had a couple of inquiries on this topic. So, I thought I would cover a short version of the answer in this article. Be warned, we are going to get a little technical here. But you need to understand the consequences of the conversion.
We will start with revenue ruling 99-5 that addresses the proper accounting procedures when a single-member LLC converts to a multiple-member LLC. The ruling addresses the conversion issue from two scenarios:
- A sole member sells a half interest to another person;
or
- New member contributes property, including cash, to the LLC in exchange for a half interest.
The tax treatment of each perspective is best explained by using examples.
Example – Method 1. Allen has been the sole member of Blue Sky LLC for five years. The LLC has two assets, $10,000 in cash and equipment with a $25,000 fair market value (FMV) and an adjusted basis of $10,000.
Allen sells 50% of his ownership interest to Ben for $17,500. The members do not elect to treat the LLC as a corporation for tax purposes, therefore, it will be taxed as a partnership by default.
Inside LLC CASH Equipment Totals
FMV $10,000 $25,000 $35,000
Basis $10,000 $10,000 $20,000
Outside LLC Allen’s Outside Basis $20,000
Before the sale, Allen’s basis in his partnership interest (his “outside” basis) was $20,000. (Outside basis is a member’s basis in his or her membership interest; inside basis is the LLC’s basis in all assets it owns.)
According to the revenue ruling 99-5, the LLC becomes a partnership when Allen sells an ownership interest to Ben. Accordingly, Ben’s acquisition is treated as a purchase of a proportionate ownership interest in each LLC asset.
Initially, Allen is treated as selling a 50% interest in each asset, all of which are deemed owned by him for federal tax purposes. Thus, Allen must realize and recognize a $7,500 gain on the sale of half of the LLC assets.
$35,000 FMV of assets
– 20,000 less total adjusted basis
———
$15,000
$15,000
50% multiplied by percentage sold
———
$7,500 gain on sale of 1/2 of assets
Next, Allen and Ben are considered to have contributed their ownership interests to the “new” partnership. The contribution is nontaxable because neither a partnership nor any of its partners recognize gain or loss when individuals contribute property in exchange for a partnership interest.
Ben’s outside basis equals his $17,500 purchase price; Allen’s outside basis equals the basis in his remaining 50% share of LLC assets ($10,000). The partnership takes a carryover basis in the assets Allen contributes. Therefore, the partnership will have a $27,500 “inside” basis in the property deemed contributed by Allen and Ben.
Confused yet? Well, there is more to it, like holding periods, split asset basis, etc. This is why I don’t normally suggest converting between single and multi-member LLCs or vice versa. It usually makes more sense to set up a new LLC.
Next time we will look at the second method where a new member contributes property, including cash, to the LLC in exchange for a half interest.