Limited liability companies are everywhere today. Because their management structure is flexible, LLCs have become a common way to own and run a business. Doctors, lawyers, accountants, engineers and software companies all use them. Many other small businesses do too.
LLCs give their owners, called members, the liability protection of a corporation. At the same time, they keep the tax treatment of a partnership. However, that partnership treatment creates hard questions when ownership changes. This article explains how LLC conversions are taxed and how to account for them.
Why LLC conversions need careful planning
An LLC with one owner is usually a disregarded entity for tax purposes. In contrast, an LLC with two or more owners is usually taxed as a partnership. So when members join or leave, the tax classification can change.
The IRS addressed these changes in two revenue rulings. First, Revenue Ruling 99-5 covers a single-member LLC that becomes a multi-member LLC. Second, Revenue Ruling 99-6 covers a multi-member LLC that becomes a single-owner entity. For background, see the IRS guide to limited liability companies.
Summary of the two rulings
Revenue Ruling 99-5 looks at two ways to add a new owner. In one, the sole owner sells a half interest to another person. In the other, the new owner contributes property in exchange for a half interest.
The better method depends on what the current owner wants. For example, if the owner wants personal cash, selling a half interest may be the best approach. On the other hand, if the business needs capital, a contribution usually works better.
Revenue Ruling 99-6 also looks at two approaches. In one, a member sells a full interest to the other member. In the other, all members sell their full interests to an outside buyer.
Again, the best option depends on the sellers’ goals. Owners often use the first approach when a buy-sell agreement applies, such as after a death, divorce or retirement. Meanwhile, the second approach fits best when all owners want to leave the business.
Single-member to multi-member LLC conversions
Revenue Ruling 99-5 explains the tax treatment when a single-member LLC gains a second member. It addresses two situations.
- Sale of a half interest. The sole member sells half of the ownership to a new person. In this case, the buyer is treated as buying half of each LLC asset. Then both owners are treated as contributing their assets to a new partnership. As a result, the seller recognizes gain or loss on the half that was sold.
- Contribution for a half interest. The new member contributes cash or other property to the LLC. Here, the original owner is treated as contributing all LLC assets to a new partnership. Generally, neither owner recognizes gain or loss on the contributions.
Multi-member to single-member LLC conversions
Revenue Ruling 99-6 explains what happens when an LLC taxed as a partnership ends up with one owner. As a result, the partnership terminates. The ruling also covers two situations.
- One member buys out the other. The seller is treated as selling a partnership interest. Meanwhile, the buyer is treated as receiving a liquidating distribution of part of the assets and buying the rest.
- All members sell to an outsider. The sellers are treated as selling their partnership interests. The buyer, in turn, is treated as buying the assets after the partnership distributes them.
Planning tips for LLC conversions
- Track each asset’s holding period carefully. After a conversion, some assets may have more than one holding period.
- Think about LLC conversions in two phases. The first is the type of conversion and its consequences. The second is any later sale of assets acquired in the conversion.
- Consider each member’s intent before recommending a method. Also, check whether an existing operating agreement already sets the method.
- Understand the tax results for every party. Over time, an advisor may represent a different party in each conversion.
- Remember that a conversion may trigger the basis allocation rules in IRC Section 732.
The preferred business entity
These rulings matter more as the LLC keeps growing as a favorite business entity. The LLC has many tax and nontax advantages. Still, it has one big drawback: the complex partnership tax rules of Subchapter K apply.
As LLCs spread, owners will face questions like these more often. Good planning requires a clear view of what the sellers want and how the partnership rules apply. Otherwise, issues such as split holding periods, gain recognition and basis can lead to costly tax results.
Get help with your LLC
Flex Tax and Consulting Group helps business owners form and manage LLCs in the U.S. We can also review the tax effects before members join or leave. To learn more, visit our business formation service page or book a free 15-minute call.