Deemed Asset Sales Under Rev. Rul. 99-5
Revenue Ruling 99-5 discusses the tax treatment of the purchase of some but not all of the membership interests in a wholly-owned LLC. Pursuant to Reg. § 301.7701-3(b)(1)(ii), unless electing otherwise, a domestic LLC with only one owner is treated as an entity disregarded as separate from its owner for income tax purposes. However, that raises the issue of how to treat an acquisition of less than 100% of the membership interests in the LLC. This is not an unusual circumstance, particularly because the Rev. Rul. 99-5 structure is often used in S corporation F reorganization transactions.
Rev. Rul. 99-5 explains two situations involving a wholly-owned LLC that is disregarded for income tax purposes. It is assumed in both situations that the resulting partnership is not treated as an investment company, all of the assets are capital assets or Section 1231 property, and there is no indebtedness.
In Situation 1, B, who is not related to A, purchases 50% of A’s interest in the LLC for $5,000. A does not contribute any of the $5,000 to the LLC. A and B continue to operate the business of the LLC as co-owners of the LLC.
In Situation 2, B, who is not related to A, contributes $10,000 to the LLC in exchange for a 50% interest in the LLC. The LLC uses all of the contributed cash in its business. A and B continue to operate the business of the LLC as co-owners of the LLC.
The IRS ruled in Situation 1 the LLC is converted to a partnership when the new member, B, purchases an interest in the disregarded entity from A. B’s purchase of a portion of A’s interest in the disregarded entity is treated as if B purchased 50% of the assets of the LLC, which are treated as if they were directly held by A. Immediately thereafter, A and B are treated as contributing their respective interests in the assets to a newly formed partnership in exchange for partnership interests.
Although for state law purposes the sale is structured as a purchase and sale of membership interests, the sale should be reported as an asset sale for Section 1001 purposes. The formation of the partnership itself is a tax-free Section 721 contribution. Under Section 722, B’s basis in the partnership interest is equal to $5,000, the amount it paid for the assets, A’s basis in the partnership interest is equal to the basis of the assets it contributed to the partnership (i.e, the assets that A did not sell to B). Under Section 723, the basis of the property in the hands of the partnership is the adjusted basis of the property in A’s and B’s hands immediately after the deemed sale. Under Section 1223(1), A’s holding period for the partnership interest includes A’s holding period in the property contributed to the partnership. B’s holding period begins on the day following the date of B’s purchase of the LLC interest from A.
The IRS ruled that in Situation 2, the LLC is converted to a partnership when B contributes its cash to the LLC. B’s contribution is treated as a contribution to a partnership in exchange for an interest in the partnership under Section 721(a). A is treated as contributing all of the assets of the disregarded LLC to the partnership in exchange for an interest in the newly formed partnership.
Under Section 722, B’s basis in the partnership interest is $10,000, the amount of cash it contributed to the partnership. A’s basis in the partnership interest is equal to A’s basis in the assets A is treated as contributing to the newly formed partnership. Under Section 723, the basis of the property contributed to the partnership is the adjusted basis of the property in A’s hands, plus $10,000 as to the cash contributed by B. Under Section 1223(1), A’s holding period for the partnership interest includes the holding period of the assets contributed. B’s holding period begins on the day following the date of B’s contribution of money to the LLC.
John G. Hodnette is an attorney with Fox Rothschild in Charlotte.