Introduction To Transfers From LLC Property
The notion of transferring property from an LLC to an individual can be somewhat ambiguous. A transfer of property (or disbursement) from an LLC likely means that property will be taken out of the LLC for use by an individual. With that in mind, an LLC may transfer property for any number of reasons: the owner used his or her own money to buy the property and wants reimbursement; the property is split equally between two partners but one partner needs cash; a business pays an employee or contractor by giving them real estate instead of writing a check . Whatever the reason, it’s essential that you know how disbursements or transfers are taxed at both the corporate and personal levels and what ownership changes are legally required so both you and your company stay protected and that you’re able to minimize your tax obligations.
Property Transfer Tax Effects
When property is transferred to an individual from an LLC, it is viewed by the Internal Revenue Service (IRS) as a sale of property between commonly controlled entities. The transfer is also considered to be a "disguised sale." In general, disguised sales are analyzed under the transaction step plan, which considers (i.e., Section 707(a)(2)(B)) whether a transfer or series of transfers between commonly controlled entities would occur if the sale was not disguised as transfers. Because there is a common interest in the property between the two entities, the transactions between the entities will often be scrutinized for a fair market value assessment.
For example, when a limited liability company (LLC) transfers an asset to an individual, the effect of the transaction is determined by the capital account and liquidation rules of the LLC’s operating agreement. If the transfer decreases a member’s capital account and requires the individual to increase their liquidation amount, the individual will be taxable on the difference. In an instance where the opposite occurs and the individual receives a profit from the transfer, the amount will be taxed similarly to the distribution that would have been voluntarily issued.
From the perspective of the LLC, the property transfer will not be taxed as a capital gain to the LLC since the increase in an individual’s capital account from a contribution is not taxable from a tax perspective. However, if the contribution from the individual is issued with a reduction in the capital account of the LLC, the LLC will be required to increase the basis of the asset. This is why the agreement of the LLC must be performed with caution, because the implications of the transfer will depend on how the governing documents of the LLC treat both parties.
Possible Tax Planning Options
Though transferring real property from an LLC to an individual will generally result in a taxable event, there are various different ways that individuals and LLCs can employ tax strategies to minimize the impact of the tax. For instance, the Internal Revenue Service allows you to defer taxes with a "Like-Kind Exchange," defined by Internal Revenue Code § 1031(a). Deferring taxes in this way applies to exchanging property held for productive use in a trade or business or for investment, as long as the property you receive in return is of the same kind of property as the property you give up. The main requirements of the tax deferral language under 26 U.S.C. § 1031(a) are:
If the property transferred from the LLC were an interest in an office building, you probably would not be able to use a like-kind exchange to transfer the property from the LLC to yourself because an individual cannot own an interest in an office building unless he or she was a licensed broker. If the property transferred were a single-family home, you could rely on the like-kind exchange statute to minimize your tax burden but only if the property was held by the LLC for productive use in its trade or business or for investment. Should the property be part of the trade or business of the LLC, then the 1031 statute would not apply to the transfer.
If it turns out that a taxpayer cannot rely on a 1031 exchange either because the property cannot be exchanged or the requirements of the statute do not otherwise apply to the transaction, the taxpayer may still reduce her tax burden through other deductions available internally. For instance, Section 165(a) of the Internal Revenue Code allows taxpayers to deduct a loss sustained during the tax year if it is evidence of a transaction entered into for profit. Internal Revenue Code § 1231 allows an individual to deduct an ordinary loss resulting from the sale of any "depreciable property [that is] held for the production of income" or "any land improvements." Therefore, by following these guidelines, an LLC can transfer property to the members (and thus avoid paying tax) by making the transfer part of a legitimate tax planning strategy that allows losses incurred on the investment to be deducted. Deductions under § 165(a) require taxpayers to prove that the "lost" property was intentional.
Finally, if there is no way around having the property transfer being treated as a taxable event, then having the transfer occur in a tax year where the taxpayer’s income is significantly less than in other tax years may allow the taxpayer to pay significantly less tax on the "lost" property. Unless a taxpayer’s annual income is less than approximately $50,000, the individual will have to pay capital gains taxes on the "lost" property when the transfer is complete. Should the individual experience a year where her income falls well below $50,000, she can minimize her tax burden in this way as well.
Legal Issues Surrounding Transfers Of LLC Property
Many business owners and real estate investors choose to hold their properties in a limited liability company or LLC. This has many benefits, including protecting your personal assets in the event of a lawsuit. In fact, even if you are sued individually, your LLC can protect you. However, transferring property from an LLC to yourself can have unexpected consequences when it comes to tax and liability issues.
Generally, the IRS doesn’t classify transfers between an owning company and an individual as taxable actions. Unfortunately, that’s not always the case. Before transferring anything out of your LLC, it’s important to consult with a tax professional to ensure you are handling the date correctly. While a transfer out may not face tax penalties in the eyes of your company, the individual receiving the transfer may be held accountable for unpaid capital gains taxes on the transferred property.
Furthermore, transfers to an individual can leave the property subject to creditor claims. If you transfer property to yourself because you believe a creditor may make a claim against the LLC, the court may find the transfer invalid. Individuals who have worked in the past to separate themselves from the LLC may not realize that they have now put themselves back in the creditors’ path while unknowingly voiding their own limited liability agreement. Analyzing both legal and financial implications of any transfer will help avoid these issues.
Additionally, lending on a property that is held by an LLC can be difficult. Banks loaning money on a property want to know exactly who they are working with so they can assess risk. When real estate is held by an LLC, there is often much less information available to readily give potential lenders. For example, larger banks often will not provide loans on property unless it has been owned by the LLC for at least two years. These and other requirements can add up to slow the process. Consulting with legal and tax professionals will also help prevent future mistakes when it comes to securing loans.
Common Pitfalls
There are a few areas where it is easy to go wrong when transferring property from an LLC to an individual. The first is not picking a date for the transfer. Although the date of the transfers normally include the date that the sale closes or the gift is made, it is best to establish a firm date for the conveyance rather than use a more general date such as the closing date. This will ensure that the future owner will be able to clearly identify what interest they own in the property and it will help if the member is trying to take advantage of special tax treatment that is available in certain years.
Another common mistake is not drafting the LLC agreement so it accommodates this type of transfer. For example, most LLC operating agreements include restrictions on transferring an LLC member’s interest to outsiders. If the operating agreement requires the approval of other members for the transfer, it would be important to follow the terms of the operating agreement. Please note that even if the operating agreement does allow for the transfer, it could impose a right of first refusal on the property. With this type of right, the company, some or all members or another party have the option to purchase the interest on the same terms as they are offered to the outside party. Also, some agreements require that the members get appraisals before they sell their interest if an agreement exists with an outsider. If the LLC’s operating agreement has any restrictions on transferring its interests , members should check with their attorneys to make sure all conditions are met. If the transaction is a bargain sale or a gift, the member may still have to get appraisal in certain circumstances.
Failure to file a gift tax return can be another problem when a member is gifting their interest to a family member. Generally, gifts over a certain threshold must be reported to the IRS on a form 709 (United States Gift (and Generation-Skipping Transfer) Tax Return). There is one exception to this rule. If each of the members receives the same amount of interest, a single member should be able to report the gift on their form 709, their spouse will not need to file a form, and the other member will not be required to report receiving the gift. However, this exception will not apply if the members do not receive the same amount of interest. A common example where the members would not receive the same amount of interest is when one member used the company’s assets to secure loans and the other member paid off their share of the loans using cash. Before filing a gift tax return, members should consult with their tax attorneys to confirm they have properly prepared the form.
Even though LLCs are complete entities that can hold title to property, the IRS also requires that members treat themselves and the company as different entities. Therefore, it is improper for members to sell or gift an asset to themselves rather than to the entity first.
Cases And Examples
To provide a clearer picture of how the tax consequences of transferring property upon liquidation are managed in real-world scenarios, we can examine a few illustrative case studies.
Case Study 1: LLC to Individual
In this example, a married couple owns an LLC that is primarily engaged in the purchase and sale of real estate. After a few years of successful business operations, they decide to liquidate the LLC due to market changes. The couple sells the real estate, pays off any outstanding debts, and distributes the remaining cash evenly between them.
As an S-corp, the couple had reported their share of the corporation’s income on their personal taxes, not the corporation’s separate entity taxes. Following the liquidation, they reported the cash distributions as part of their personal income.
In this case, the transfer of cash from the LLC was seamless to the couple because the LLC had been paying taxes in accordance with state law in California and as a Sub-S Corp, it required little additional reporting or payment.
Case Study 2: LLC to LLC
In another hypothetical, we consider two related LLCs — an LLC that specializes in the design of products and another that manufactures the finished product. The parent LLC decides to move its manufacturing departments in-house and distribute shares of the manufacturing LLC to partners proportionate to their contribution to its formation. Each partner paid $400,000 toward the installation of the new machinery to the manufacturing LLC, which in turn issued them shares.
The manufacturing LLC incurs a loss of $100,000 during its first year because of its non-capacity, although the newly acquired machinery incurs major depreciation expenses. As capital is expensive, the manufacturing instances a net capital loss of $40,000.
This example illustrates how transferring property from an LLC to another business can be a straightforward process as long as the necessary steps for a corporate distribution (such as paying off liabilities) are followed. Since the property was distributed as payment for investment and services, the capital gains that might arise upon sale will become losses when the new LLC becomes profitable.
Case Study 3: LLC to LLC to individual
In this example, we have another two-LLC business setup, but instead of transferring machinery, the non-manufacturing business receives the distribution of cash in exchange for services performed by its partners. Each partner receives 50% of their capital contribution back to them as their share of the distribution. For the current year, they make a total of $200,000 because they did not take into account their investment losses; rather, they used the cash to buy up more business.
Without appropriate guidance, this scenario could have been expensive. The first LLC was liquidated, and its assets were sold at their fair market value and distributed equally to the partners. The business LLC should have used the $80,000 as needed to pay any obligations upon liquidation.
Conclusion-Planning Ahead
In conclusion, careful planning and consideration of the potential tax consequences of a transfer of property from a limited liability company (LLC) to an individual taxpayer is crucial to successfully managing the tax consequences of such a transfer. A transfer between an LLC and its member may be treated as a non-taxable exchange under Internal Revenue Code (IRC) § 731(a)(1). However, other factors , such as withholdings under IRC § 1445 for foreign disposition of real property, may be applied. Additionally, state and local tax laws may apply depending on the facts and circumstances of each transaction. To avoid unexpected liabilities, taxpayers should consider all potential tax consequences when planning a transfer of property. Taking a proactive and coordinated approach to tax planning can help achieve a more favorable outcome for taxpayers in such transfers.