As in Example 2, V has a $6,000 built-in gain with respect to the inventory. He also has a $3,000 builtin gain in the real estate he receives ($7,000 FMV – $4,000 basis), for a total built-in gain of $9,000. This makes sense because he had a $20,000 basis in the LLC and received cash and property with an FMV of $29,000 ($10,000 cash, inventory worth $12,000, and real property worth $7,000).
Members’ tax basis in property received in liquidation
If no gain or loss is recognized on a liquidating distribution, the member’s aggregate basis in the property received equals the member’s basis in his or her LLC interest just before the distribution, reduced by the cash and marketable securities distributed (Sec. 732(b)). Special rules apply where multiple properties are distributed in a liquidating distribution or where the total carryover basis of distributed properties exceeds the member’s basis in the LLC. Basis is assigned to the distributed properties as follows:
- Subtract the amount of cash and marketable securities received from the member’s predistribution basis in his or her LLC interest.
- Any remaining basis is allocated first to distributed unrealized receivables and inventories in amounts equal to the LLC’s basis in those assets.
- Remaining basis is then allocated to the other distributed assets (other than unrealized receivables and inventory) in amounts equal to the LLC’s adjusted basis.
- Any basis increase (i.e., the distributee member’s basis over and above the LLC’s basis in the distributed assets) is then allocated to appreciated assets (other than unrealized receivables and inventory) in proportion to each asset’s respective amount of any unrealized appreciation. However, basis should not be allocated in excess of FMV.
- Any remaining basis increase is allocated to assets (other than unrealized receivables and inventory) in proportion to their FMVs.
Note: Proposed regulations issued in 2014, which would become effective if and when finalized, provide special rules that result in a Sec. 704(c)(1)(C) basis adjustment when built-in loss property is contributed to an LLC classified as a partnership (Prop. Regs. Sec. 1.704-3(f)(2)).
Depreciating property received in a liquidating distribution
A member that receives a liquidating distribution of depreciable property acquires a depreciable basis in the property determined under the rules discussed above. To the extent a member’s basis does not exceed the LLC’s basis, the member steps into the LLC’s shoes and continues to depreciate the property using the remaining life and method used by the LLC (Sec. 168(i) (7)). If the member’s basis exceeds the LLC’s basis, the excess is treated as newly acquired property that is placed in service by the member at the time of distribution. This excess basis is subject to the depreciation rules, lives, and methods in effect at the time of the distribution (Sec. 168(i)(6)).
Note: Special rules apply to claiming bonus depreciation on a qualifying asset that is acquired and distributed to a member in the same tax year.
Holding period for distributed assets
A member’s holding period for property received in a nontaxable distribution includes the holding period of the LLC (Secs. 735(b) and 1223(2)). This rule applies whether the member receives the property in a current distribution or a liquidating distribution.
Suspended losses
If an LLC distributes assets to a member in a liquidating distribution and those assets have been used in a passive activity, the member continues to carry over any suspended passive activity losses (PALs) with respect to that activity. The suspended PAL is allowed without limitation if the member disposes of substantially all of the passive activity (or interest in the activity) in a taxable disposition to an unrelated third party (Sec. 469(g)). Accordingly, if a member receives only cash in complete liquidation of an LLC interest, any suspended PALs generated by the LLC’s activities should be fully deductible in the year of the liquidating distribution, as long as the member does not own any interests in the same activities outside the LLC.
Any taxable gain recognized by a member on an LLC’s liquidation is treated as income from the LLC’s at-risk activity (Prop. Regs. Sec. 1.465-66(a)). Accordingly, suspended at-risk losses can be used to offset the gain, if any, upon liquidation. However, if there is no gain on the liquidating distribution and the member continues the at-risk activity, it appears the member should carry over the suspended losses to offset future income or until the member has additional at-risk basis. These suspended at-risk losses can be applied only against future income or other future at-risk basis from the same activity (Sec. 465(b)(5)).
Any losses suspended under Sec. 704(d) due to a lack of basis in the member’s LLC interest (outside basis) are not carried over by the member after the LLC’s liquidation. Because the suspended losses have not reduced the member’s basis in the LLC interest, the suspended losses effectively constitute additional basis to the member when (1) determining gain or loss, if any, on the liquidating distribution; or (2) determining the basis of distributed assets.
Members may be allocated excess business interest expense from an LLC that reduced their basis in the LLC but that they have not yet treated as paid or accrued (and, therefore, not yet deducted at the member level). When such a member disposes of the LLC interest, this remaining excess business interest expense increases the member’s basis in the LLC (outside basis) immediately before the disposition. Following the disposition, the member is not entitled to any deduction for the excess business interest expense that increased the member’s outside basis (Sec. 163(j)(4)(B)(iii)(II)).
Nontax considerations
The liquidation of an LLC may have a number of legal implications. Under state law, there may be questions regarding who remains liable for LLC liabilities distributed to members, required notifications to creditors of the LLC’s intent to liquidate, required changes in legal title to distributed assets, required notification to the state of the LLC’s intent to liquidate, compliance with applicable bulk sales acts (if the LLC’s assets are to be sold prior to liquidation), etc.
In addition, legal issues may surround the application of the operating agreement or other LLC governing documents to the liquidation transaction. For example, the operating agreement may be unclear regarding what methods should be used to value distributed property when members will not receive pro rata distributions of all LLC assets. Clients should seek legal advice before liquidating an LLC.
Contributor
Shaun M. Hunley, J.D., LL.M., is an executive editor with Thomson Reuters Checkpoint. For more information about this column, contact thetaxadviser@aicpa.org.
