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As stated in Taxation of Limited Liability Companies and Partnerships, limited liability companies are taxed as partnerships by default. This discussion of the tax consequences of contributions to partnerships will also apply to limited liability companies unless the limited  liability company has elected to be taxed as a corporation.

Tax Consequences to Partners and Members of LLCs

Contributions to a partnership are generally tax free.  No gain or loss is recognized by a partnership or any of its partners as a result of a contribution of property by a partner to the partnership in exchange for a partnership interest.[1]

As a general rule, a contribution of services in exchange for a partnership interest will not qualify for tax-free treatment.[2] As a result, the interest received is taxable to the partner. The timing of the income recognition depends on whether the partner’s right to withdraw from the partnership or dispose of the partnership interest is restricted and other facts and circumstances.[3] But if a person receives a mere profits interest for the provision of services to or for the benefit of a partnership in a partner capacity or in anticipation of becoming a partner, the Internal Revenue Service will not treat the receipt of such an interest as a taxable event for the partner or the partnership, as long as:

  • the profits interest does not relate to a substantially certain and predictable stream of income from partnership assets, such as income from high-quality debt securities or a high-quality net lease;
  • within two years of receipt, the partner does not dispose of the profits interest; or
  • the profits interest is not a limited partnership interest in a “publicly traded partnership” within the meaning of Code § 7704(b).[4]

A “profits interest” is one that does not give the owner any interest in the current assets or the entity or the right to receive distributions on liquidation.

Comparison to Corporations: Regardless of whether a corporation is a C corporation or an S corporation, a shareholder’s receipt of stock in exchange for services provided to the corporation is immediately taxable unless the stock is nontransferable or subject to a substantial risk of forfeiture.[5] This mirrors the treatment of a partner’s exchange of services for a capital interest in a partnership. But, unlike corporations, a partnership allows the partner to receive a non-capital profits interest on a tax-free basis.

Gain must be recognized on the contribution of property to a partnership that would be considered an “investment company” if it were incorporated.[6] An “investment company” is a partnership in which more than 80 percent of the fair market value of contributed property (exclusive of cash and non-convertible debt obligations) consists of publicly-traded securities held for investment.[7]

The partner’s basis in the partnership interest acquired in exchange for a contribution of property to the partnership equals the amount of money and the partner’s adjusted basis in any property contributed to the partnership, plus the amount of gain (if any) recognized by the contributing partners for transfers to an investment company.[8]

Important Note: Special rules apply if the partners are contributing property that is subject to a liability. If the partnership assumes any of the contributing partner’s liabilities, the assumption is treated as a distribution of money to the partner.[9] Similar rules apply to corporations.[10]

Tax Consequences to the Limited Liability Company or Partnership

No gain or loss is recognized by a partnership as a result of a contribution of property by a partner to the partnership in exchange for a partnership interest, regardless of when the contribution occurs.[11] The partnership’s basis in property contributed to the partnership in exchange for a partnership interest equals the contributing partner’s basis in the contributed property, increased by any gain recognized by the contributing partner for transfers to an investment company.[12]

 

[1] I.R.C. § 721(a).

[2] Treas. Reg. § 1.721-1(b)(1).

[3] Id.

[4] Rev. Proc. 93-27, 1993-2 C.B. 343. But see Notice 2005-43 (June 13, 2005).

[5] I.R.C. §§ 351(d), § 83(a).

[6] See I.R.C. § 351(e).

[7] I.R.C. § 721(b).

[8] I.R.C. § 722.

[9] I.R.C. § 752(b).

[10] I.R.C. § 357(c).

[11] I.R.C. § 721(a).

[12] I.R.C. § 723.