Taxation Essentials of LLCs and Partnerships - Larry Tunnell

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(again requiring a new taxpayer identification number) in exchange for interests in the partnership. Because corporate liquidations are generally fully taxable to both the corporation and its shareholders,11 the election to change status from a corporation to a partnership may have significant tax consequences.

      image Example 1-10

      Q and R each own 50% of the shares of Pheasant Ridge, LLC, formed four years ago. Following its formation, the company elected to be taxed as a corporation. Q and R each have tax bases of $120,000 in their LLC interests. The company owns assets with an aggregate tax basis of $250,000 and an aggregate value of $350,000. It has no liabilities. Effective January 1 of the current year, Pheasant Ridge, LLC filed Form 8832 electing to change its status from a corporation to a partnership for federal tax purposes.

      Pheasant Ridge will be deemed to liquidate on January 1 of the current year, distributing its assets to Q and R equally. This deemed distribution to Q and R is taxable to Pheasant Ridge as if it had sold its assets for their fair market values and distributed the proceeds to its shareholders. Accordingly, the LLC will recognize a $100,000 gain on the deemed sale and will owe federal income tax of $21,000 on its final income tax return. (The company has no other income in the year of liquidation, as it liquidated on January 1.)

      Q and R will also recognize taxable gain on the deemed liquidation. They will be deemed to have received a net distribution of $329,000 ($350,000 FMV of assets, less $21,000 tax liability to the federal government) in exchange for their shares in Pheasant Ridge. Their combined tax basis in these shares is $240,000 ($120,000 each). Therefore, they must recognize a combined gain of $89,000 ($44,500 each). Because they have held their shares for four years, the gain will be taxed as a long-term capital gain, subject to a maximum tax rate of 20%, plus a possible additional 3.8%, depending on the taxable income of the partners. Assuming they have no capital losses and their tax rate on long-term capital gains is 20%, they will each owe $8,900 in additional income taxes on the capital gains. Therefore, the combined tax cost of changing the LLC's federal tax status from a corporation to a partnership will be $38,800 ($21,000 corporate tax, plus $8,900 tax to Q, plus $8,900 tax to R).

      The election to change tax status should clearly not be made without full consideration of the potential costs and consequences.

      The partnership tax framework allows partners and partnerships wide latitude in structuring their companies and in dealing with one another. Formation of a partnership, like formation of a corporation, is generally a tax-free transaction. Indeed, the rules governing partnership formation are even more lenient than those governing corporate formation, in that there is no requirement that contributing partners have “control” of the partnership in order for the transaction to be tax-free. Also, like corporate formations, the partners' bases in assets contributed to the partnership carry over to the partnership (that is, the partnership takes a “carryover” basis in contributed properties), and the partners' initial bases in their partnership interest is generally equal to the basis of cash and other property contributed to the partnership in exchange for that interest. (However, a partner's basis in his partnership interest is also increased by his share of partnership liabilities, unlike the shareholder or corporation treatment of liabilities.)

      A major difference between partnerships and corporations, of course, is that the taxable income of the partnership is taxable to the partners, rather than to the partnership itself. Therefore, the reporting process by which the partnership's taxable income is reported to the IRS, and to its partners, is rather complex. Moreover, the process of accounting for partnership income is more complex in that the partners must account for their shares of partnership income or loss each year, whether or not any distributions of that income are received or additional contributions are made by the partners.

      Another major difference between partnerships and corporations is the treatment of distributions to partners. Because the partners are taxed directly on their shares of partnership income, distributions of that income are generally tax-free. Most distributions are treated as decreases in the basis of their partnership interests rather than as taxable income. To ensure that the distribution to a partner of his or her share of partnership income does not inadvertently trigger recognition of taxable gain, partners are required to adjust their bases in their partnership interests to reflect their shares of the partnership's income or loss each year. The result of these basis adjustments is that a partner will generally have sufficient basis to absorb a subsequent distribution of his or her share of partnership profit without triggering gain recognition.

      image Example 1-11

      However, because Arthur's tax basis in his partnership interest is increased by his $300,000 share of partnership income (to $400,000), the $150,000 distribution will be tax-free. His remaining tax basis in the partnership interest will be $250,000 ($400,000 - $150,000). Looked at another way, his basis in the partnership interest was increased by the $150,000 share of partnership profits which he did not withdraw from the partnership. By not withdrawing this portion of his share of profits, he essentially contributed those profits back to the partnership. His basis in the partnership interest is increased accordingly.

      Note that one result of the preceding framework is that the partners' aggregate bases in their partnership interests (outside basis) generally equal the partnership's aggregate bases in its assets (inside basis). This equality is important because it prevents taxpayers from using partnerships to manipulate the tax consequences associated with the sale or other disposition of property. Because the partners' outside bases in their partnership interests generally equal the partnership's aggregate inside basis in its assets, the same amount of gain or loss is recognized when a partner sells his or her interest in a partnership as would have been recognized if he or she had sold the asset(s) contributed to the partnership in exchange for that interest. Likewise, the partnership will recognize the same amount of gain or loss from the sale of its assets as the partners who contributed those assets would have recognized had they sold them directly, rather than through the partnership.

      image Example 1-12

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