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The costs of converting a partnership to an LLC.

One of the first decisions to be made when forming a new business involves the legal structure of the entity. The options include a sole proprietorship, partnership, limited partnership, or S or C corporation. In addition, 48 jurisdictions (including the District of Columbia and excluding Hawaii, Massachusetts and Vermont) now recognize limited liability companies (LLCs) as legal entities. An LLC is an unincorporated association organized under a state law that enjoys the tax advantages provided a partnership and much of the liability protection afforded a corporation. These characteristics make the LLC form of operation an attractive option for many small businesses, high-risk business ventures and professional firms.

Many articles have detailed the general characteristics of an LLC,(1) and the tax benefits of using an LLC within certain industries,(2) from the perspective of a start-up company electing a particular ownership structure. However, little is known about the cost of converting an existing entity to an LLC; this article provides a practical analysis of issues to consider in electing to convert an existing partnership to an LLC, including gain or loss nonrecognition, basis calculations and treatment of unrealized receivables and inventory ("hot assets"). Tax ramifications for investment partnerships, disguised sale issues and partnership allocation methods are also addressed.


The growth of LLC legislation in the United States has been remarkable. In 1977, Wyoming passed the first LLC statute,(3) followed by Florida in 1982.(4) LLCs are a unique structural option, providing limited personal liability to members at a single level of tax. The popularity of this form of entity led to a need for IRS approval to obtain the benefits. Rev. Rul. 88-76,(5) which provided that an LLC formed under Wyoming law would be treated as a partnership for Federal income tax purposes, accelerated the creation of LLC legislation in other states.

Although the LLC laws vary from having very rigid requirements (e.g., Wyoming) to being extremely flexible (e.g., Florida), the basic purpose of all state LLC statutes is the same: to afford to LLC members passthrough tax treatment and limited liability.

In ruling on LLC qualification issues, the Service's approach has been to examine the state law in question. Generally, however, the IRS has followed Regs. Sec. 301.7701-2, which provides that an unincorporated business receives partnership tax treatment only if it lacks two of the four major corporate characteristics.(6) LLCs may lack limited liability if members waive it to meet a net worth requirement.(7) Additionally, state law may prohibit professionals from escaping personal liability for malpractice. As a practical matter, members of professional firms organized as LLCs may not have limited liability. However, Rev. Ruls. 93-91(8) and 93-93,(9) addressing, respectively, Utah and Arizona LLCs, point out that the professional exposure of individual LLC members for malpractice does not eliminate the corporate characteristic of limited liability, because although there is limited liability for claims against the LLC, members also have personal liability in connection with a member's performance of services on behalf of the LLC. Nevertheless, most LLC members have limited liability; therefore, LLCs must fail two of the remaining three tests to achieve passthrough treatment.

Often, the LLC statute or the entity's articles of organization will determine which of the corporate characteristics are eliminated. The Wyoming LLC Act,(10) for example, requires that continuity of life and free transferability of interests be eliminated, while allowing (if the company so desires) for centralized management. The Utah LLC Act(11) allows each company the flexibility to decide which corporate characteristics it wishes to eliminate, permitting members to tailor the entity to their business needs. Given the importance of the partnership designation of an LLC for tax purposes, companies are frequently advised to request a letter ruling if an LLC agreement deviates from previously tested structures. As the Service continues to rule on the specific ownership characteristics of an LLC, a higher degree of certainty regarding tax treatment can be expected. The focus of tax planning then shifts to the cost of reorganizing existing entities into LLCs.

Conversion Costs of Partnership Transfers

As more states implement LLC legislation, it is critical that companies address the tax costs of converting an existing entity to an LLC. Many practitioners believe that partnerships can convert into LLCs easily and without tax ramifications, and so focus attention instead on the effort and cost of reorganizing S or C corporations into LLCs. Most letter rulings analyze whether an entity is classified as a partnership for tax purposes,(12) and only occasionally focus on the conversion issue. Recently, however, several rulings have addressed both issues.(13) In most cases, the tax implications of the conversion are of secondary importance to the partnership classification issue, or are overlooked altogether.

General Rule: Gain or Loss Nonrecognition

In 1984, the Service ruled on the Federal income tax consequences of converting an interest in a general partnership to an interest in a limited partnership, when each partner's interest in the partnership's profits, losses and capital were to remain constant and the general partnership's trade or business was to continue after the conversion. Rev. Rul. 84-52(14) concluded that no gain or loss would be recognized by either the partners or the partnership on the conversion. The ruling noted that gain recognition was possible if each partner's share of partnership liabilities shifted as a result of the conversion; however, as long as each partner's share of partnership liabilities remained the same, the Sec. 752(b) deemed distribution rules did not apply. Rev. Rul. 95-37(15) applied this holding to the conversion of an interest in a domestic partnership to an interest in a domestic LLC, concluding that conversion to an LLC would have the same tax consequences as the conversion of a general partnership interest to a limited partnership interest.

Sec. 721(a) provides that neither gain nor loss is recognized by the partnership or the partner on the partner's contribution of property in exchange for a partnership interest. Primarily, this rule applies to unrecognized gain created by differences between the tax basis of contributed property and the value of the partnership interest received in exchange for such property. Sec. 351(a) provides a similar rule for contributions to corporations, except that the shareholder must receive a controlling interest for the contribution to be tax free.(16)

Additionally, under Sec. 357(c), gain is generally recognized if liabilities transferred to a corporation exceed the aggregate basis of contributed assets. Under Sec. 752(b), partners do not generally recognize gain on the contribution of encumbered property from a partnership to an LLC, unless they are relieved of partnership liabilities in excess of the basis in their partnership interests.

Partnership Continuation

Under Sec. 708(a), if the business of the partnership continues after conversion to an LLC, the partnership has not terminated, and the LLC is considered a continuation of the partnership. In Letter Ruling 9226035,(17) all of a general partnership's partners contributed their interests in the partnership to an LLC in exchange for all of the interests in the LLC. They received the same pro rata shares of the LLC as they had held in the partnership. Immediately after the contribution, the partnership dissolved and distributed all of its assets to the LLC. Because the general partnership never became a subsidiary of the LLC, the tiered partnership rules did not apply.(18) The IRS concluded that the conversion of the general partnership to an LLC was not taxable to either the partners or the partnership, except as required by Sec. 752(b).

In Letter Ruling 9010027,(19) a limited partnership converted to an LLC. Because each partner's total percentage interest in the entity remained the same after the conversion, the transaction was tax free, except as required by Sec. 752(b), a determination that relied, in part, on Rev. Rul. 84-52 (previously discussed). In both the revenue and the letter ruling, it had been represented that the converting partner's interests in capital, profits and losses remained the same; this representation was critical, because different liability-sharing rules applied under "old" Regs. Sec. 1.752-1(e).(20)

Rev. Rul. 95-37 combined the holdings of Letter Rulings 9226035 and 9010027, concluding that the conversion of an interest in a domestic partnership into an interest in a domestic LLC treated as a partnership for Federal income tax purposes does not cause a termination under Sec. 708.

Partnership interests can, however, expand or contract and still receive tax-free treatment in certain circumstances. Under Regs. Sec. 1.708-1(b)(1)(i), if a transaction has meaningful economic consequences even though accompanied by additional contributions or distributions of property, it is not a taxable sale or exchange. As discussed below, if both a partnership contribution and a distribution occur as part of the conversion, the disguised sale rules(21) may apply. Additionally, a partner may recognize gain under Sec. 751 if his pro rata share of hot assets increases during conversion as a result of changes in his profit- or loss-sharing percentage.

Transfer of Partnership Interest

Partners may transfer their partnership interests by contributing them to a newly created or preexisting LLC. When partners transfer their partnership interests instead of contributing their proportionate shares of partnership assets and liabilities, in essence, they have converted the partnership to an LLC. Using this method to convert the partnership creates a tiered partnership structure, under which income items of the upper-tier partnership (the LLC) attributable to the lower-tier (old) partnership are allocated pro rata to each day that the LLC was a partner in the lower-tier partnership. Each day's allocation of income is then allocated among the LLC members in proportion to their membership interests.(22)

As was previously discussed, Letter Ruling 9226035 involved the transfer of partnership interests to an LLC; the IRS determined that the LLC was a continuation of the original partnership and, thus, the partnership had not terminated. Nevertheless, the transfer of a partnership interest to an LLC may qualify as a sale or exchange under Sec. 706(c)(2)(A)(i), and, if the percentage transferred is significant, the transaction will cause the partnership to terminate under Sec. 708(b)(1)(B). In other letter rulings,(23) the Service has held that an exchange terminating the first partnership occurred when 50% or more of the partnership interests in one partnership were contributed to an LLC. This point was emphasized in Evans,(24) in which a partner transferred his 50% interest in a partnership to a corporation in which he was the sole shareholder. Although no gain or loss was recognized by the transferor, the Seventh Circuit held the transfer to be a sale or exchange of a 50% interest in partnership capital and profits that terminated the partnership.

When the transfer of a partnership interest creates a taxable termination, Regs. Sec. 1.708-1(b)(1)(iv) provides that the following is deemed to occur: the partnership distributes its properties to the purchaser and the other remaining partners in proportion to their respective interests in the partnership properties; and, immediately thereafter, the purchaser and the other remaining partners contribute the properties to a new partnership, either for the continuation of the business or for its dissolution and winding up. Clearly, this treatment has a significant effect on the calculation of basis adjustments and the character of recontributed assets (discussed below).

Merging a Partnership With an LLC

Since qualifying LLCs are partnerships for tax purposes, the partnership merger or consolidation rules apply when partnerships merge with preexisting LLCs. Under Sec. 708(b)(2)(A), the LLC is a continuation of the partnership if the merging partners own more than 50% of the capital and profits of the LLC after the merger. Transactionally, the partnership contributes all of its assets and liabilities to the LLC in exchange for member interests in the LLC; the partnership then terminates, distributing the interests in the LLC to its partners in liquidation.(25)

After the merger, the bases of the assets are not recomputed under Sec. 732; rather, they are transferred basis property (as defined in Sec. 7701(a)(43)). Partners receiving a lesser share of the LLC's liabilities than they were allocated in the partnership recognize gain under Sec. 731(a) if the difference in liabilities exceeds their basis in the partnership immediately before the distribution.

Under Regs. Sec. 1.708-1(b)(2)(i), when partners in the merging partnership own less than 50% of the capital and profits in the LLC after the merger, both the partnership and the LLC terminate, creating a new partnership.

As a practical matter, a partnership and an LLC should not consider merging until after a careful analysis of any resulting income tax accounting problems, including basis, allocation of liabilities and hot asset issues.

Calculating Basis

The rules for calculating the basis of property contributed to an LLC are the same as those for property contributed to a partnership. Generally, Sec. 723 provides that the basis of property contributed to a partnership by a partner is the adjusted basis of the property to the contributing partner at the time of the contribution. However, when property is transferred to an LLC that qualifies as an investment partnership under Sec. 721(b), members increase basis by the gain recognized. According to Regs. Sec. 1.351-1(c)(1)(ii), an LLC will be treated as an investment partnership if, after the contribution, more than 80% of the value of its assets are held for investment and are readily marketable stock or securities or are interests in regulated investment companies or real estate investment trusts. Although members of an LLC qualifying as an investment partnership receive additional basis for any gain recognized under Sec. 721(b), basis is not adjusted for gain recognized when a partner receives Sec. 752 liability relief greater than the adjusted basis of assets contributed to the LLC, in clear contrast to the basis adjustment a shareholder receives for gain recognized under Sec. 357(c).

Under Sec. 722, a contributing partner takes an adjusted basis in his LLC interest equal to the basis of his original partnership interest at the time of contribution to the LLC. An exception under Sec. 751 provides that if the partner receives money or property attributable to hot assets in exchange for the transfer of his interest, he recognizes gain to the extent that the money or the fair market value (FMV) of property received exceeds the adjusted basis of his partnership interest immediately before the distribution. In contrast, as previously discussed, when the LLC is treated as a continuation of the partnership and all partnership assets are contributed to the LLC during the conversion, no gain or loss is recognized by the partnership, the LLC or the partners.

Sec. 732 provides that property distributed on a constructive termination of the partnership takes a substituted basis equal to the partners' bases in their partnership interests, less any money distributed. According to Sec. 732(b) and (c), basis is allocated first to money, then to hot assets, and finally, to other distributed assets in proportion to their adjusted bases to the partnership.

Allocating Liabilities

If an LLC assumes recourse debt of the partnership on a conversion, a shift in the partners' share of entity liabilities will occur. Regs. Sec. 1.722-1 provides that the partner's basis in the LLC is reduced by the portion of the debt assumed; the reduction is treated as a distribution to the partner under Sec. 752(b). Sec. 731(a) provides that the partner recognizes gain if the distribution exceeds the partner's basis in the partnership.

If the LLC assumes the partnership's recourse liabilities, some of the partnership's recourse creditors could require continuing guarantees by the transferors. In such case, the debt again qualifies as a recourse liability when guaranteed by the transferors, and no gain is recognized when the LLC assumes the debt. Even if the debt is otherwise nonrecourse, the members guaranteeing the debt are allocated all of the basis in it.

If recourse debt is assumed by the LLC during a conversion and creditors do not require continuing guarantees by the new members, a shift in each member's allocated basis in nonrecourse liabilties will occur. If a member's share of nonrecourse liabilities is reduced during the conversion from a partnership to an LLC, the member will recognize gain if his pro rata basis in the nonrecourse debt reduced his basis in his partnership interest. This is particularly significant when limited partners have deducted losses in excess of their investment in the partnership under Sec. 465(e) by including qualified nonrecourse financing in their at-risk basis. Additionally, if shifts occur between a member's allocated share of recourse and nonrecourse debt as a result of the LLC's assumption of certain debt, the timing of the conversion is critical. When a partner's share of partnership liabilities is reduced, Sec. 752(b) creates a deemed distribution of funds to him; Regs. Sec. 1.731-1(a)(i)(ii) provides that the distribution is deemed to the extent of his share of allocated partnership income for the year. These amounts are recognized at the end of the partnership's tax year; deemed distributions resulting from debt cancellation may also qualify for this treatment.(26)

If a partner's promissory note is held in a partnership and transferred to an LLC on a conversion, the partner receives no basis in the LLC on contributing the note; under Regs. Sec. 1.704-1(b)(2)(iv)(d)(2), a partner receives basis in the partnership only when the partner makes principal payments on the note. Under Regs. Sec. 1.704-1(b)(2)(ii)(c), a deficit restoration obligation will be deemed to exist, even if not expressly agreed to, to the extent of the outstanding principal balance on promissory notes contributed by the partner to the partnership. Thus, if a partner is not required by either law or the partnership agreement to fully restore a deficit capital account balance, his note becomes a recourse liability when contributed, creating an economic risk of loss for which he receives basis.

Unrealized Receivables and Inventory

As noted previously, a partnership can convert to an LLC without terminating if the partnership's business continues after the conversion. On conversion, partners are deemed to have received a proportionate share of the partnership's assets and liabilities in complete liquidation of the partnership, which they then contribute to the LLC. This also occurs when partners transfer their partnership interests to the LLC.

In either case, the partnership is considered to have two classes of assets in which each partner has an undivided interest: Sec. 751 hot assets (generally, unrealized receivables and substantially appreciated inventory) and non-Sec. 751 assets. The partners then contribute the property comprising these two classes of assets to the LLC in exchange for membership interests.

The contribution of the property to the LLC is generally tax free under Sec. 721(a). If the conversion causes shifts in the partners' profit-sharing percentages, however, there will also be a shift in their allocated pro rata shares of partnership assets, including hot assets. If partners receive a disproportionate allocation of such assets as part of the deemed distribution, the value of money received, and the FMV of any property received, are ordinary income under Sec. 751(a). This rule does not apply, according to Sec. 751(b)(2)(A), when the property received by the partner was contributed by him to the partnership.

Clearly, the gain recognition provisions for distributions of hot assets may have a significant effect on cash-basis partnerships, which include most professional and personal service partnerships. Such partnerships report income on the cash method, yet make liquidating distributions to their partners based on either their accrualbasis or Sec. 704(b) capital accounts. Partners receiving allocations of hot assets based on their fair market value (FMV) capital accounts could be allocated a different share than that based on their proportionate cash-basis interest in such assets. If partners are allocated less than their proportionate share of hot assets based on their cash-basis capital accounts, they are deemed to have sold their proportionate share of these assets for the consideration actually received. Partners allocated more than their share of hot assets based on their share of the partnership's cash-basis capital accounts are considered to have purchased such assets in exchange for their share of the non-Sec. 751 property relinquished. These partners have not "sold" an interest in partnership property and do not recognize gain under Sec. 751; however, they do recognize their proportionate share of the hot assets as ordinary income when they are converted to cash. Under Sec. 732(c)(1), the partners' basis in the hot assets is their carryover "cost" of the other partnership assets given up in exchange. To the extent that the partners' pro rata share of cash is forgone in exchange for a greater share of the hot assets, the basis of such assets is the lesser of their FMV or their carryover basis, plus the forgone cash.

Letter Ruling 9412030,(27) involving an accounting partnership in which the partner's interests in capital, profits and losses remained the same after conversion to an LLC, held that the conversion did not terminate the partnership. Neither the LLC, its members, the partnership nor the partners recognized gain on the conversion. Additionally, the LLC could continue using the cash method of accounting and the partnership's tax year-end.

Disguised Sales

Because a conversion of a partnership to an LLC may involve both a contribution of partnership property to the LLC and the receipt of a distribution from the partnership, partnerships considering converting must be careful not to run afoul of the disguised sale rules. Prior to the Tax Reform Act of 1984 (TRA '84), partners who furnished property to fund a newly created partnership could effectively be paid for their interest tax free, as long as the property was not later sold or the partnership subsequently terminated. This result was accomplished by treating the transaction as a contribution of property under Sec. 721 and a Sec. 731 distribution of cash to the former property owner. A number of court cases upheld this treatment; thus, certain transactions were not treated as a sale between the partner and the partnership. For example, in Otey,(28) the taxpayer contributed property to a partnership and the other partner contributed nothing. The partnership immediately borrowed construction money and, in accordance with the partnership agreement, distributed to Otey cash equal to the value of the property he had contributed to the partnership. The Tax Court, affirmed by the Sixth Circuit, treated these transactions as a contribution of property followed by a tax-free distribution.

Sec. 707(a)(2)(B), enacted by TRA '84 Section 73(a), provides that if (1) a partner directly or indirectly transfers money or other property to a partnership, (2) the partnership directly or indirectly transfers money or other property to the partner in a related transaction, and (3) when viewed together, both transfers would be categorized as a sale or exchange, the transaction will be treated as either a sale between the partnership and the partner, or as a sale between partners.

If disguised sale treatment is required under Sec. 707, neither Sec. 721 nor 731 will apply; the distribution of cash and other property by a partnership to a partner who later contributes it to an LLC will be treated as a sale of previously contributed property to the partnership.

Sec. 737 applies to property distributions that are not subject to Sec. 707, and requires that partners recognize gain to the extent that the FMV of certain distributed property exceeds the partner's basis in his partnership interest. Partners are subject to these rules if they contribute appreciated property to the partnership and the partnership subsequently distributes other property to them within five years.

The gain recognized under Sec. 737(a) is limited to the lesser of (1) the excess of the FMV of the property (other than money) received in the distribution over (2) the adjusted basis of the partner's interest in the partnership immediately before the distribution, reduced (but not below zero) by the amount of money received, or (3) the partner's "net precontribution gain" (NPG) (as defined in Sec. 737(b)). If a partner contributes multiple properties to the partnership, unrealized gains or losses are netted; the total gain recognized cannot exceed NPG. Nor is gain recognized if the partnership distributes property to the partner who originally contributed it.

If the distribution of partnership assets triggers a termination under Sec. 708(b)(1)(B), neither the disguised sale rules of Sec. 707(a)(2)(B) nor the deemed sale requirements of Sec. 737 apply.(29) Under Rev. Rul. 84-52, when a partnership converts to an LLC, generally, it does not terminate under Sec. 708, thus triggering gain to partners who receive distributions to which Secs. 707 and 737 apply.

Substantial Economic Effect

Sec. 704(b) requires that profit- and loss-sharing among partners must be based on each partner's percentage interest in the partnership. If allocations of profits and losses are not calculated on this basis, they must have "substantial economic effect" to be valid. An allocation must comply with either the general three-part economic effect test of Regs. Sec. 1.704-1(b)(2)(ii)(b) or the alternate economic effect test of Regs. Sec. 1.704-1(b)(2)(ii)(d). Additionally, the economic effect must be "substantial" (as defined in Regs. Sec. 1.704-1(b)(2)(iii)(a)).

To meet the general economic effect requirement of Regs. Sec. 1.704-1(b)(2)(ii)(b), the partnership agreement must provide that (1) the determination and maintenance of capital accounts is to be in accordance with Regs. Sec. 1.704-1(b)(2)(iv); (2) liquidating distributions are be made in accordance with each partner's positive capital account balance; and (3) any partner having a deficit balance in his capital account following the liquidation of his interest is unconditionally obligated to restore that balance to the partnership.

Partnerships lacking a deficit restoration provision can allocate profits and losses using the Regs. Sec. 1.704-1(b)(2)(ii)(d) alternative test for economic effect if the allocation does not create or increase, beyond the partner's obligation to restore, a deficit in his capital account. However, the partnership agreement must contain a "qualified income offset" provision that a partner who unexpectedly receives one of the adjustments listed in Regs. Sec. 1.704-1(b)(2)(ii)(d)(4)-(6) has to receive a special allocation of income to eliminate the capital account deficit as quickly as possible. This is an additional consideration for partners with deficit capital accounts.

To be valid, the economic effect of a particular allocation must also be "substantial," as defined in Regs. Sec. 1.704-1(b)(2)(iii)(a). In general, an allocation will not be substantial if there is a high probability that none of the partners will have adverse after-tax economic results. If certain partners receive after-tax economic gain as a result of the allocation, other partners must experience an economic loss.

Partnerships converting to LLCs having partners with deficit capital accounts must consider whether partners will be required to contribute cash to the partnership to eliminate their negative balances. Because partners must restore their deficit capital obligations to the partnership only when a taxable exchange of the partnership takes place, cash contributions to the partnership are not necessary when converting to an LLC.

Partners with deficit account balances could, however, recognize gain as a result of the conversion. If, within a 12-month period, there was an exchange of 50% or more of the total interests in partnership capital and profits, the partnership would terminate under Sec. 708(b)(1)(B). Each partner's capital account would then be adjusted to reflect the gain or loss that would have been allocated had the property been sold in a taxable transaction on the date the property was deemed distributed in liquidation.(30) If the allocated amount exceeded a partner's deficit capital account, that partner would not recognize gain. If, however, the property deemed distributed in liquidation created a loss, or property with a gain was specially allocated to the partner who originally contributed it and not to partners having deficit amounts, those partners would recognize gain to the extent of their deficit capital balances.

Alternatively, the partnership agreement could provide for a special allocation of gain on the sale of property to the partner(s) who were allocated related deductions (i.e., depreciation). A typical gain chargeback provision might require that if the property is sold at a profit, the gain is to be allocated to the partner(s) who received the special allocation of deductions, until the deductions previously taken are fully offset by the allocated gain. In the case of a partnership converting to an LLC, the deficit capital accounts of partners receiving a gain chargeback allocation could be eliminated entirely. To the extent that the FMV of the property deemed distributed in liquidation at least equals cost, a first-tier gain chargeback would be likely to eliminate any deficit. Such an allocation is not restricted by the Regs. Sec. 1.704-1(b)(2)(iii)(c) transitory allocation rules, because that regulation presumes that the value of the property equals basis in applying the substantiality tests.

Optional Basis Adjustments

As noted previously, under Sec. 708(b)(1)(B), if 50% of the partnership interests are transferred to a new or preexisting LLC, the original partnership terminates. On termination, the partnership may elect under Sec. 754 to adjust the basis of partnership property under Sec. 743 when a partnership interest is transferred, or to adjust basis under Sec. 734 if property is distributed. If the Sec. 754 election is made, the basis of partnership assets distributed to partners is adjusted before distribution, and is reallocated under Sec. 755(a) to reduce differences between each asset's FMV and basis. The basis of (1) capital assets and Sec. 1231(b) assets and (2) other partnership property must be allocated to property of a like character, under Sec. 755(b).

If a Sec. 754 election is not made, Sec. 732(c) provides that the basis of the property distributed is allocated first to unrealized inventory and accounts receivable, and then to the other property distributed. Regardless of whether the election is made, a partner takes the partnership's basis in the property distributed, which, under Sec. 723, is the partner's basis in such property plus and gain recognized on contribution; the allocation of total basis to all partnership assets can vary significantly, depending on whether the Sec. 754 election was made, because different provisions (i.e., Sec. 755 or 732) control the allocation.

Self-Employment Tax Issues

Prop. Regs. Sec. 1.1402(a)-18(31) addresses the treatment of certain members of LLCs for self-employment (SE) tax purposes. This regulation modifies those pertaining to the tax on SE income under Sec. 1402, and is effective for the LLC member's first tax year beginning on or after the date it is finalized.

SE tax is imposed on the SE income of every individual. Sec. 1402(b) defines SE income as an individual's net earnings from SE, subject to certain exceptions. Under Sec. 1402(a)(13), net earnings from SE do not include, for example, the distributive share of any item of income or loss of a limited partner, other than guaranteed payments. Because LLC members are not limited or general partners, Prop. Regs. Sec. 1.1402(a)-18 defines when an LLC member will be treated as either a general or limited partner for SE tax purposes.

An LLC member's net earnings from SE include the member's distributive share of income or loss from any trade or business carried on by the LLC, whether or not distributed to the member. A member of an LLC is treated as a limited partner whose distributive share of income or loss is not included in SE earnings if (1) the member is not a manager and (2) the entity could have been formed as a limited partnership rather than as an LLC. If a member meets these requirements, only guaranteed payments for services will be included in SE earnings.

For this purpose, Prop. Regs. Sec. 1.1402(a)-18(c)(3) defines a manager as a person who, either alone or together with others, is vested with the authority to make management decisions necessary to conduct the LLC's business. If there are no designated or elected managers of the LLC having such authority, all of the members will be treated as managers, even though some members may have greater management authority than others.

Although the proposed regulation is helpful in determining whether an LLC member's distributive share of income or loss is included in SE earnings, several questions remain unanswered. Are members having the power to elect managers treated as general partners? What if a member's authority is restricted to voting on extraordinary issues? Will members who have management authority but do not use it be treated as managers? Hopefully, the final regulations will provide answers.

Requesting a Ruling

Entities desiring a ruling on whether an LLC will be classified as a partnership for Federal tax purposes can turn to Rev. Proc. 95-10,(32) which specifies the conditions under which the IRS will consider a ruling request relating to the classification of a domestic or foreign LLC as a partnership. Publicly traded LLCs treated as corporations under Sec. 7704 cannot request a ruling under Rev. Proc. 95-10. While an LLC not meeting the requirements of Rev. Proc. 95-10 cannot apply for a ruling that it is a partnership for tax purposes, it may still be able to qualify as a partnership under existing regulations.

The IRS will consider a ruling request relating to the classification of an LLC only if the LLC has at least two members, based on all facts and circumstances. If the taxpayer requests a ruling that the LLC lacks continuity of life, free transferability of interests or limited liability, generally, the member-managers must own, in total, at least a 1% interest in each material item of the LLC's income, gain, loss, deduction or credit during the LLC's existence. If a required allocation under Sec. 704(b) or (c) temporarily causes less than 1% of the LLC's income, gain, loss, deduction or credit to be allocated to the member-managers, the ruling request must describe why the allocation is required.

If the LLC's total contributions exceed $50 million, the member-managers must own, in total, an interest of at least 1%, divided by the ratio of total contributions to $50 million.

Additionally, centralized management will be lacking if there are no managers, or if only member-managers own at least 20% of the total interests in the LLC. Likewise, free transferability of interests is lacking if a majority of nontransferring member-managers are required to approve a transfer.

Simplification of Classification Rules

Notice 95-14(33) provides that the IRS and Treasury are considering simplifying the classification regulations to permit taxpayers to treat domestic unincorporated business organizations either as partnerships or associations on an elective basis. Organizations having two or more associates and an objective to do business and divide the gains could make this election; however, it would not be available to organizations whose classification is determined under another Code provision (e.g., publicly traded partnerships, taxable mortgage pools, real estate mortgage investment conduits and certain trusts). Retroactive elections would not be allowed, and all members of the organization would be required to execute the election. The election would be binding on all members until superseded by a subsequent election.

An election to change classification would have the same tax consequences as a change in classification has now. Thus, a corporation electing to be a partnership would, for example, be treated as liquidating (a taxable event) and forming a new partnership.

Clearly, the new rules would make LLCs even more desirable, because an unincorporated business entity could have numerous corporate characteristics (as permitted by state statute), without losing partnership tax treatment.

The IRS has not yet decided whether a taxpayer's right to make such an election should be restricted or unrestricted. Additionally, it is concerned about the compliance burden that might result if classification could be changed at will.


Virtually every state in the U.S. has introduced LLC legislation to foster economic growth. The LLC offers the benefits of limited liability with passthrough tax treatment, thus eliminating double taxation.

These benefits are easily realized if an LLC structure is selected at the time an entity is organized. Although many revenue and letter rulings have concluded that converting a partnership to an LLC is tax free, these rulings have not addressed the more subtle issues involved when an existing partnership converts.

The conversion of a partnership to an LLC format triggers two events: (1) the liquidation of the partnership and (2) the formation of the LLC. As was discussed, the liquidation may trigger gain recognition for the partner and/or the partnership. Determining the tax cost of converting either a general or limited partnership into an LLC is not always straightforward; there may be a significant tax cost. Clearly, the tax cost of conversion can create a significant economic outlay that could impair a converting partnership's ability to continue as a viable, profitable entity.

(1)See, e.g., Mezzullo, "Limited Liability Companies: A New Business Form?," 50 Taxation for Accountants 18 (Jan. 1993); Tax Clinic, "LLCs Offer Tax Advantages," 24 The Tax Adviser 240 (Apr. 1993).

(2)See, e.g., Friedman, "Business Directions: The LLC," 35 National Real Estate Investor SS17 (June 1993); Horwood and Hechtman, "Better Alternative: The Limited Liability Company," 20 Journal of Real Estate Taxation 348 (Summer 1993); Lawrence and Norton, "Limited Liability Companies: The New Entity of Choice," 7 Real Estate Accounting & Taxation 5 (Winter 1993); Tax Ideas, "Limited Liability Companies in Real Estate Ventures," 22 Real Estate Law Journal 55 (Summer 1993).

(3)Wyo. Stat. [sections][sections] 17-15-116 to 17-15-143 (Michie Supp. 1994).

(4)Flo. Stat. [sections][sections] 608.401 to 608.514 (West 1995).

(5)Rev. Rul. 88-76, 1988-2 CB 360.

(6)All corporate and unincorporated entities have "associates" who have the objective of carrying on a business and dividing the gains or losses therefrom. The current status of the four remaining corporate characteristics under Regs. Sec. 301.7701-2(a)(1), limited liability, continuity of life, centralized management and free transferability of interests, is addressed in Frost, "Doubts Still Remain as to When an Entity Will be Taxes as a Partnership," 76 Journal of Taxation 376 (Dec. 1993).

(7)Rev. Proc. 89-12, 1989-1 CB 798; see, e.g., Texas Civ. Stat. Art. 1528n, Art. 4.03A (West Supp. 1995).

(8)Rev. Rul. 93-91, 1993-2 CB 316.

(9)Rev. Rul. 93-93, 1993-2 CB 321.

(10)Note 3.

(11)Utah. Stat. [sections][sections] 48-2b-101 to 48-2b-158 (Michie Supp. 1994).

(12)See, e.g., IRS Letter Rulings 9325039 (3/26/93) and 9333032 (5/24/93).

(13)IRS Letter Rulings 9321047 (2/25/93), 9350013 (9/15/93), 9407030 (11/24/93), 9412030 (12/22/93), 9416028 (1/18/94), 9416029 (1/18/94), 9417009 (1/17/94), 9421025 (2/24/94) and 9422034 (3/3/94).

(14)Rev. Rul. 84-52, 1984-1 CB 157, amplified by Rev. Ruls. 86-101, 1986-2 CB 94, and 95-37, IRB 1995-17, 10.

(15)Rev. Rul. 95-37, id.

(16)Sec. 368(c) defines "control" for Sec. 351(a) purposes as ownership of at least 80% of the value and voting power of the corporation immediately after the transfer.

(17)IRS Letter Ruling 9226035 (3/26/92).

(18)See Rev. Rul. 78-2, 1978-1 CB 202; see also Secs. 734(b) and 751(f). Sec. 706(d)(3) requires that any item of an upper-tier partnership attributable to a lower-tier partnership be allocated pro rata based on each day that the upper-tier partnership was a partner in the lower-tier partnership. Each day's allocation is then assigned to the partners in the upper-tier partnership based on their daily interests in such partnership.

(19)IRS Letter Ruling 9010027 (12/7/89).

(20)Under "old" Regs. Sec. 1.752-1(e), as it existed prior to issuance of Temp. Regs. Sec. 1.752-1T on Dec. 29, 1988, recourse liabilities were allocated among partners based on their respective loss-sharing ratios, and nonrecourse liabilities were apportioned among partners based on their profit-sharing percentages. The General Explanation of the Revenue Provisions of the Tax Reform Act of 1984, 98th Cong., 2d Sess. 251 (1984), states that Congress directed that the Sec. 752 regulations be revised to adopt an economic risk of loss basis for allocating partnership debt back to partners.

(21)Regs. Sec. 1.731-1(c)(3); Sec. 707(a)(2)(B).

(22)Rev. Rul. 77-311, 1977-2 CB 218.

(23)IRS Letter Rulings 8116041 (1/21/81) and 8229034 (4/20/82).

(24)Donald L. Evans, 54 TC 40 (1970), aff'd, 447 F2d 547 (7th Cir. 1971)(28 AFTR2d 71-5465, 71-2 USTC [paragraph]9597).

(25)See Rev. Rul. 68-289, 1968-1 CB 314.

(26)Rev. Ruls. 94-4, 1994-2 CB 20, and 92-97, 1992-2 CB 124.

(27)IRS Letter Ruling 9412030, note 13.

(28)John H. Otey, Jr., 70 TC 312 (1978), aff'd per curiam, 634 F2d 1046 (6th Cir. 1980)(47 AFTR2d 81-301, 80-2 USTC [paragraph]9817).

(29)According to S. Rep. No. 101-101, 101st Cong., 2d Sess. 198 (1989), such terminations do not create disguised or deemed sale distributions.

(30)Regs. Sec. 1.704-1(b)(2)(iv)(e)(1) and (b)(5), Example (14)(v).

(31)EE-45-94 (12/28/94).

(32)Rev. Proc. 95-10, IRB 1995-3, 20, superseding Rev. Proc. 89-12, 1989-1 CB 798.

(33)Notice 95-14, IRB 1995-14, 7.
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Title Annotation:limited liability company
Author:Elliott, Patricia C.
Publication:The Tax Adviser
Date:Aug 1, 1995
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