LLCs: the tax tail wagging the investor. (LLCs & LLPs).

As the first generation of limited liability companies (LLCs) ages, individuals are frequently called on to invest funds in an existing LLC in exchange for an ownership interest. This brings with it the question of what exactly the new investor owns. If an investor is not cautious, he could possibly lose out. LLCs are generally taxed as partnerships. As a result, they are governed by partnership tax law. This law is exceedingly important, because every well-drafted LLC document references and incorporates partnership tax law.

Two Fundamental Concepts

Partnership tax law sets forth the concepts of a capital account and of a revaluation.

Capital accounts. An owner has a capital account. The capital account is the accumulation of the owner's investment plus income and less losses and distributions. The capital account represents the dollar amount that the owner would receive if the entity were liquidated.

If an owner's capital account is zero or negative, he cannot receive any cash at liquidation and would be forced to recognize income if the entity were liquidated.

Revaluations. When new equity interests are issued, an LLC can adjust capital accounts either up or down to reflect the increase or decrease in the LLC's value. This is a revaluation, a book-up or book-down. For instance, self-created goodwill and earnings potential of patents would be candidates for a book-up.

The existing owners' capital accounts are increased or decreased to reflect the appreciation or depreciation in the LLC'S value. As a result of the change to the owners' capital accounts, the existing owners would receive an increased or decreased right to future cash distributions.

Capital accounts and revaluations ensure that each owner eventually receives in distributions the amount the LLC earned or lost while the person was an owner. In a world accustomed to S corporation structures and their rigid adherence to doing everything pro rata, the concept of capital accounts and revaluations is exceedingly foreign. A problem arises when taxpayers try to apply S rules to LLCs.

Example: U, an LLC, is a startup technology company. An electronics company is currently negotiating for a license of U's next-generation technology. U requires working capital to operate properly. Due to the expenditures related to development efforts, U's assets equal its liabilities. Therefore, the existing equity and the existing owners' capital accounts are zero.

K, an investor, believes that the fair market value (FMV) of U's assets is $4 million more than shown on the books. K agrees to invest $1 million in exchange for a newly issued 20% ownership in U's profits and losses.

Before K's investment, U had four equal owners. After K's investment, U has five equal owners.

Prior to K becoming an owner, each of the four owners was entitled to $1 million of value (25% x $4 million). Because K injected $1 million into the partnership, the assumption is that each owner would be entitled to $1 million of value (20% x $5 million) if everything were sold for cash and the cash distributed.

Unfortunately, that assumption is absolutely incorrect. Per the LLC agreement and the tax law, each of the five equal owners is entitled to 20% of the gain on sale. For example, if the owners decide to sell the assets to an electronics company instead of licensing the technology, the LLC would recognize a $4 million gain. Each owner would be allocated $800,000. The $800,000 gain would be added to each of the historic owners' zero beginning capital account. Therefore, each historic owner would have an $800,000 "ending" capital account and would be entitled to that amount of cash in liquidation.

K, however, walks away a winner. The $800,000 gain is added to his capital account of $1 million, for an ending capital account of $1,800,000. That is how much he is entitled to in liquidating proceeds.

The same type of problem exists when the FMV of the LLC'S assets is less then the recorded book cost. In such a case, the investor loses his money to the historic LLC owners.

Avoiding the Problem

The historic owners are not being given credit in their capital accounts for the appreciation or depreciation of the LLC's value. As a result, the new owner shares in the appreciation or depreciation.

To avoid the problem, the owners need to do a revaluation. In a revaluation, the owners agree to the LLC's value. The assets are booked up or down to recognize any decrease or increase in value, and the owners' capital accounts are increased or decreased to reflect the change in value.

Determining the value of the assets is a matter of agreement among the owners. They can agree on a value among themselves or hire valuation experts and go to great lengths to arrive at the value. When new equity is being offered for a price, the LLC's value can easily be inferred based on the issue price.

In the example, the owners should have agreed that the LLC's assets were worth $4 million more than they were on the books, booking up the assets accordingly. Due to the book-up, each of the historic owners' capital accounts would have been increased to $1 million each. At the time the assets were sold, their value would have resulted in zero gain. Therefore, their capital accounts and K's capital account would have all been $1 million, and that is how much each would have received in liquidating distributions.

The example assumes the almost immediate sale of the assets to illustrate the problem. The problem, however, does not require an immediate sale. If the assets are really worth $4 million more than shown on the books, this problem would not arise until U sells its assets.

Revaluations are generally not automatic; they are optional. Therefore, without a specific agreement between the owners on a book-up or -down, no revaluation would have occurred.

APB No. 17 dictates the use of the historic cost method of accounting. Therefore, a book-up or -down would not be recorded on issued financial statements. Instead, it would be recorded on separately maintained adjusted capital account worksheets. Because LLC tax returns generally use the financial statement capital accounts, the owners' capital shown on the tax return would not reflect any revaluations that occurred in the past.

Tax Adviser's Role

Many clients involve their tax adviser when they make an investment in an LLC. If the client does not directly involve the adviser in the negotiations, often he sends the LLC operating agreement to the adviser for review.

If an adviser participates in negotiating or reviewing the documents, he would need to be aware of the issues noted to properly guide his client.

This issue is even more important when the economy is turbulent. Investor bailouts of floundering LLCs are becoming fairly common. While an investor might be negotiating a bargain price on the front-end of an investment, he might be unknowingly losing large amounts of cash on the back-end by not addressing a revaluation. Properly advising an investor of the pitfalls and opportunities in this situation will give tax advisers loyal and happy clients.

FROM KUNO S. BELL, CPA, J.D., PEASE & ASSOCIATES, INC., CLEVELAND, OH