Business interest realignment through revaluations and special allocations.

The rapid evolution of the limited liability company (LLC) from essentially a two-state curiosity to the preferred entity of choice for business structure, has thrust Subchapter K to the front of every tax adviser's practice. A primary benefit of being taxed as a partnership under Subchapter K lies in the tremendous flexibility available to its owners, particularly in arranging the manner in which profits and losses should be shared. This flexibility makes Subchapter K one of the few truly creative weapons in a knowledgeable practitioner's arsenal. An excellent example of this flexibility is the ability to restructure profit and loss allocations.

During the life cycle of any business, the business and its owners will have changing needs or circumstances. Entities structured as partnerships or LLCs can quickly adapt to these changes. As the following example illustrates, it is possible to restructure the allocations associated with various aspects of a particular business without having to break apart the business in a taxable transaction.

Example: An LLC, A, was formed in 1993, and since that time has been involved in two distinct lines of business--the manufacture and sale of baseball bats and the manufacture and sale of fishing poles. A has quickly gained a reputation for producing high-quality products in each market, and with the growth of sales through catalogs and the Internet, the value of the business has risen dramatically over the years. A's members include N, L and R, who currently have stated ownership interests of 45%, 45% and 10%, respectively. The three members (who are not related) have shared in the management of both lines of business.

Currently, L sees substantial growth opportunity in the fishing pole business, and would like to focus all his energies in that direction, while N sees the same opportunity in the baseball bat business; R would like to retire. However, business and financing considerations prevent A from being divided at this time.

The members would like to restructure A into two divisions and provide L and N with complete control of a division. In addition, the allocation of the profits and losses would be restructured, so that a preferred return equal to 5% of the capital invested in each division would be allocated between L and N equally, with all remaining profits from each division being allocated to the respective member.

Proposed methodology. The members' objectives can easily be accomplished in the following manner:

1. Revalue (i.e., bookup) all LLC assets to fair market value (FMV);

2. Redeem the interest of the minority member; and

3. Amend the operating agreement to properly provide for:

* Recognition of the revaluation and

* Revised income and loss allocation provisions.

Technical analysis. To restructure the profit- and loss-sharing arrangement and be certain that the IRS will respect the future allocations, a capital account and asset revaluation must occur. This process is important for both tax compliance and protection of the members' interests, by measuring and agreeing on their rights to the LLC's economic value immediately prior to the restructuring. The preservation of each member's economic rights is supported by a requirement in the operating agreement that liquidating distributions be made in accordance with positive capital account balances.

Revaluing capital accounts. The revaluation process under Regs. Sec. 1.704-1(b)(2)(iv)(f) is accomplished by booking up the assets and capital accounts to their respective FMVs. Because the restructuring involves an adjustment to the members' economic relationships, the revaluation is only for purposes of Sec. 704(b) book and capital accounts. With nonrelated members, the Service should respect the values ultimately agreed on by the parties as arm's-length, even in the absence of a formal valuation.

An important twist in Regs. Sec. 1.704-1(b)(2)(iv)(f)(5) is that this type of a revaluation is only permitted when there is a related contribution or distribution of property that is more than de minimis in amount. (In the example, the redemption of R's interest will be a sufficient distribution for this purpose.) The rationale for this requirement is that a related contribution or distribution, should compel the members to make certain that the valuations adequately reflect FMV, to protect their own economic interests and prevent the rules from being used inappropriately.

Meeting substantial economic effect. A properly amended operating agreement is a necessity if the restructure is to be successfully executed. Specifically, the agreement must be drafted to satisfy the Regs. Sec. 1.704-1(b)(2) substantial economic effect requirements, so that the Service will respect allocations of profit and loss. Under Regs. Sec. 1.704-1(b)(2)(ii)(b), these requirements must be satisfied throughout the full term of the partnership. Thus, there must be a properly drafted agreement from the entity's original formation, so that allocations can be modified in the future (with the comfort of knowing that the safe harbor requirements for having allocations respected have been satisfied).

In the example, it is not difficult to create an operating agreement that meets the "economic effect" portion of the requirements. In addition, any allocations should also be considered "substantial" within the meaning of Regs. Sec. 1.704-1 (b) (2)(iii), because it is not expected that any allocations will be considered either shifting or transitory at the time they are included in the operating agreement.

Application of Sec. 704(c) to revalued assets. There is a unique element to Sec. 704(c) that might also be considered. It is certainly a possibility that the members may be interested in distributing noncash assets, at some time in the ensuing seven-year period. Sec. 737 rules generally require that a contributing member recognize precontribution gain on Sec. 704(c) assets distributed to another member within seven years of being contributed to an LLC. While the LLC assets will, for some purposes, be considered Sec. 704(c) assets at the time of the revaluation, it does not appear they fall within this situation. However, there is no current authority specifically addressing this issue, either supporting or refuting that conclusion. The logical interpretation of the rules is that Sec. 737 will not apply to the Sec. 704(c) gain created in the revaluation, so that a triggering of gain recognition under Sec. 737 on a distribution of property within seven years should not occur.

Alternative if revaluation trigger is not present. As noted, Regs. Sec. 1.704-1(b)(2)(iv)(f)(5) requires that a capital account revaluation occur in connection with a contribution or distribution of money or other property that is more than de minimis in amount. The example includes the liquidation of a retiring member, which makes that requirement easy to satisfy. However, if the members have the same desire to completely restructure and realign their interests in the LLC, but do not anticipate having the necessary contribution or distribution trigger, a formal revaluation of the assets and capital accounts will not be available to properly measure and freeze the members' current economic interests.

An alternative way to accomplish the same objectives would be to amend the operating agreement to specifically allocate the built-in gain to the members in the same manner as it would have been allocated under Sec. 704(c) had there been a revaluation. The amended agreement can then also provide revised allocation provisions for future profits and losses. This might involve complex agreement drafting, but is a good alternative if a contribution or distribution trigger cannot otherwise be accommodated.

Conclusion

The example illustrates several important principles that today's practitioner should recognize:

1. The superior flexibility of Subchapter K relative to other entity choices;

2. The importance of having a properly drafted operating agreement from the origination of the entity; and

3. The ability under Subchapter K to formalize (without IRS challenge) the economic agreements frequently made by a handshake between business partners.

FROM JOSEPH E SCHLUETER, J.D., CPA, MOLINE, IL