A limited liability company (LLC) member who makes a contribution to the LLC of property with a fair market value (FMV) different from its basis may be required to recognize gain or loss upon a subsequent distribution of the contributed property to another member. Under Sec. 704(c)(1)(B), a distribution of contributed appreciated or depreciated property within seven years of the date of contribution requires the contributing member to recognize remaining precontribution gain or loss on the date of such distribution.
The amount and character of the gain or loss is determined as if the LLC had sold the property to the distributee member for its FMV on the date of distribution. The precontribution gain or loss recognized is the difference between the FMV and tax basis of the property on the date of contribution, reduced by any portion of that amount already taken into income by the contributing member before the date of distribution under the Sec. 704(c) rules.
An installment obligation received by an LLC or partnership and property acquired pursuant to a contributed contract are treated as Sec. 704(c) property under the rules for distributions of contributed property to the extent that the installment obligation or the acquired property is Sec. 704(c) property under the substituted basis rules of Regs. Sec. 1.704-3(a)(8). As a result, if the installment obligation or property acquired pursuant to a contributed contract is distributed by an LLC or partnership to a member or partner other than the contributing member or partner within seven years of the contribution, the contributing member or partner may recognize gain or loss under Sec. 704(c)(1)(B) (Regs. Secs. 1.704-3(a)(8) and 1.704-4(d)).
It appears the contributor must recognize gain or loss as if he sold the contributed property and realized the gain or loss directly. As a consequence, the contributor recognizes the gain or loss for the year that includes the date of the triggering distribution, rather than the year that includes the last day of the LLC’s tax year in which it makes the distribution.
Distributions of Built-In Loss Property
While Sec. 704(c)(1)(B) requires the recognition of any built-in gain or loss, built-in loss triggered by a distribution of property contributed by a member who holds more than a 50% interest in the LLC is disallowed due to the application of Sec. 707(b)(1)(A). Though not specifically mentioned in the Sec. 704 regulations, this issue is addressed in the preamble to the regulations (T.D. 8642).
Required Basis Adjustments
If a member recognizes gain or loss under the Sec. 704(c)(1)(B) rules, the distributee member’s basis in the distributed property is the LLC’s basis in the property immediately before the distribution increased by any gain recognized by the contributing member or decreased by any loss recognized by the contributing member. The contributing member’s basis in his or her LLC interest is also increased or decreased to reflect the recognized gain or loss (Regs. Sec. 1.704-4(e)).
Example: On Jan. 10, 2009, A and B form a real estate development company, BBH LLC, which is classified as a partnership for federal tax purposes. A contributes two parcels of land, each with a basis of $25,000 and an FMV of $50,000. B contributes $100,000 in cash. In 2012, BBH distributes one parcel of the land contributed by A to B. At the time of the distribution, the FMV of the parcel is $75,000.
A recognizes a gain of $25,000 on the date of distribution, the difference between the FMV and tax basis of the distributed parcel on the date of contribution. B’s basis in the distributed parcel is $50,000—the LLC’s $25,000 basis before the distribution plus the $25,000 gain recognized by A. A’s basis in his LLC interest is $75,000—the $50,000 basis of the contributed properties plus the $25,000 gain he recognizes on the distribution. If the real estate were held by the LLC as inventory, the character of the gain would be ordinary.
Successors to the Contributing Member
A successor to a contributing member is exposed to the potential for gain or loss on a subsequent distribution of contributed property in the same manner as the original contributor (Regs. Sec. 1.704-4(d)(2)). Consequently, when a member who previously contributed appreciated or depreciated property transfers all or a portion of his or her LLC interest, whether by sale, gift, or otherwise, a proportionate share of the taint—the Sec. 704(c) exposure—carries over to the transferee member. If, within seven years of the contribution, the contributed property is distributed to a member other than the transferee-successor, the transferee will recognize the precontribution gain or loss attributable to the interest.
A successor member’s exposure to this potential gain increases the importance of the optional basis adjustment under Sec. 754. If a purchaser pays for unrealized appreciation attributable to contributed property, the election may help him or her avoid recognition of some or all precontribution gain should a triggering distribution occur.
Exceptions to the Rule Requiring Gain Recognition
There are several exceptions to the rule requiring recognition of gain by a contributor of appreciated or depreciated property if the property is distributed to another member within seven years.
Exception for Distributions of Like-Kind Property
A member who contributed appreciated or depreciated property to an LLC does not recognize gain or loss upon distribution of the contributed property to another member if the contributor receives a qualifying distribution of like-kind property (Regs. Sec. 1.704-4(d)(3)). In such cases, to the extent of the value of the like kind property received by the member, the property received is treated as if it were the contributed property. The property received by the contributor must be of a like kind to the contributed property such that it would qualify for nonrecognition treatment under Sec. 1031 if it were directly exchanged for the contributed property.
A qualifying like-kind distribution to the contributor must be made by the earlier of the 180th day after the distribution of the contributed property or the due date (including extensions) of the contributing member’s tax return for the year the distribution of the contributed property occurred (Regs. Sec. 1.704-4(d)(3)).
Regs. Sec. 1.704-4(d)(3) provides that the gain or loss the contributing member would have recognized because of the distribution of contributed property is reduced by the amount of built-in gain or loss in the distributed like-kind property in the hands of the contributing member immediately after the distribution. The built-in gain depends on the FMV of the distributed property compared with its basis in the hands of the contributing member immediately after the distribution.
Deemed Distributions Resulting From a Technical Termination
When 50% or more of the interests in LLC capital and profits is transferred by sale or exchange within a 12-month period, an LLC is treated as having been terminated and a new LLC formed for tax purposes. A technical termination is deemed to result in the pretermination LLC’s transferring all of its assets to a new LLC and then distributing the ownership interests in the new LLC to its members. The potential for Sec. 704(c) gain recognition by the members is not altered by the technical termination (Regs. Sec. 1.704-4(c)(3)).
Proposed regulations govern the application of Sec. 704(c)(1)(B) and Sec. 737 to assets-over mergers. In an assets-over merger, Sec. 704(c)(1)(B) and Sec. 737 do not apply if, as part of the same plan or arrangement, a partnership or an LLC classified as a partnership (the transferor entity) transfers all of its assets and liabilities to another partnership or LLC (the transferee entity) in exchange for ownership interests, and the transferor entity distributes ownership interests in the transferee entity in liquidation (Prop. Regs. Secs. 1.704-4(c)(4)(i) and 1.737-2(b)(1)(i)). Sec. 704(c)(1)(B) does apply to a subsequent distribution by the transferee entity of Sec. 704(c) property it received in the assets-over merger (Prop. Regs. Sec. 1.704-4(c)(4)(ii)). The proposed regulations also provide that Sec. 737 applies when an owner of the transferor entity receives a subsequent distribution of property (other than money) from the transferee entity (Prop. Regs. Sec. 1.737-2(b)(1)(ii)).
For property contributed to the transferor entity (original contribution), the amount of original Sec. 704(c) gain or loss is the difference between the property’s FMV and the contributing owner’s adjusted basis at the time of contribution (to the extent such difference has not been eliminated by Sec. 704(c) allocations, prior revaluations, or in connection with the merger). In the case of property contributed with original Sec. 704(c) loss, Sec. 704(c)(1)(C) provides special rules for determining the basis of the property contributed.
According to the proposed regulations, the seven-year period will not restart with respect to the original Sec. 704(c) gain or loss as a result of the merger. Accordingly, a subsequent distribution by the transferee entity of property with original Sec. 704(c) gain or loss is subject to Secs. 704(c)(1)(B) and 737 if the distribution occurs within seven years of the contribution of the property to the transferor entity (original contribution). However, with respect to new Sec. 704(c) gain or loss, the seven-year period in Secs. 704(c)(1)(B) and 737 begins on the date of the merger. Consequently, a subsequent distribution by the transferee entity of property with new Sec. 704(c) gain or loss is subject to Secs. 704(c)(1)(B) and 737 if the distribution occurs within seven years of the merger.
No original Sec. 704(c) gain or loss is recognized under Sec. 704(c)(1)(B) or Sec. 737 if property that was originally contributed to the transferor entity is distributed to the original contributor. If property has new Sec. 704(c) gain or loss, then a subsequent distribution of such property within seven years of the merger to one of the former owners of the transferor entity (former owner) is subject to Sec. 704(c)(1)(B) only to the extent of the other former owners’ shares of such gain or loss (preamble to REG-143397-05).
New Sec. 704(c) gain or loss is allocated among the owners of the transferor entity in a manner consistent with the principles of Regs. Secs. 1.704-3(a)(7) and 1.704-3(a)(10). In addition, the owners of the transferor entity are deemed to have contributed an undivided interest in the assets of the partnership or LLC. The proposed regulations provide that the determination of the owners’ undivided interest for this purpose is made by the transferor entity using any reasonable method.
Regs. Sec. 1.704-4(c) contains additional exceptions to the general rule requiring the recognition of built-in gains and losses under Sec. 704(c)(1)(B) for the following distributions:
- Distributions of property contributed to the LLC prior to Oct. 4, 1989 (Regs. Sec. 1.704-4(c)(1)).
- Certain distributions in complete liquidation of a member’s interest (Regs. Sec. 1.704-4(c)(2)).
- Complete transfers of all LLC assets and liabilities to a newly formed LLC (Regs. Sec. 1.704-4(c)(4)).
- The incorporation of an LLC by any method provided there are not actual distributions to members and the LLC is liquidated (Regs. Sec. 1.704-4(c)(5)).
- Distributions of undivided interests in property previously contributed by the distributee member to the extent of the undivided interest originally contributed (Regs. Sec. 1.704-4(c)(6)).
An anti-abuse provision gives the IRS the power to recast transactions structured with the principal purpose to avoid the ramifications of Sec. 704(c)(1)(B) based on the facts and circumstances (Regs. Sec. 1.704-4(f)(1)). One example of an abusive situation is the postponement of actual distributions of property until seven years after contribution while increasing the economic risks and benefits derived from the property relative to the distributee member (Regs. Sec. 1.704-4(f)(2)).
This case study has been adapted from PPC’s Guide to Limited Liability Companies, 17th edition, by Michael E. Mares, Sara S. McMurrian, Stephen E. Pascarella II, Gregory A. Porcaro, Virginia R. Bergman, William R. Bischoff, James A. Keller, and Linda A. Markwood, published by Thomson Tax & Accounting, Fort Worth, Texas, 2012 (800-323-8724; ppc.thomson.com).
Albert Ellentuck is of counsel with King & Nordlinger LLP, in Arlington, Va.