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2003-2004 Homeward Bound Series:
Real Estate Practitioner's Guide to the Tax Aspects of Real
Estate Transactions: Selected Topics
Thursday, May 6, 2004
MSU Management Education Center, Troy
Seminar Handbook
Cosponsored by:
Real Property Law Section
State Bar of Michigan
and
The Institute of Continuing Legal Education
1020 Greene Street
Ann Arbor, Michigan 48109-1444
(877) 229-4350
FAX (877) 229-4351
www.icle.org
2003-2004 Homeward Bound Series:
Real Estate Practitioner's Guide to the Tax Aspects of Real Estate
Transactions: Selected Topics
Thursday, May 6, 2004
MSU Management Education Center, Troy
Faculty List
William B. Acker
Kemp Klein Umphrey Endelman & May, PC
201 W. Big Beaver Rd #600
Troy MI 48084
Phone: 248-528-1111
Fax: 248-528-5129
E-mail: William.acker@kkue.com
Gordon Goldie
Plante & Moran, PLLC
2601 Cambridge Court #500
Auburn Hills MI 48326
Phone: 248-375-7430
Fax: 248-603-5654
E-mail: Gordon.Goldie@plantemoran.com
Dean A. Rocheleau
Plante & Moran, PLLC
27400 Northwestern Highway
Southfield MI 48034
Phone: 248-223-3225
Fax: 248-603-5855
E-mail:
Richard A. Shapack
Butzel Long, PC
100 Bloomfield Hills Parkway #200
Bloomfield Hills MI 48304
Phone: 248-258-4475
Fax: 248-258-1439
E-mail: Shapack@butzel.com
Faculty Biographies
2003-2004 Homeward Bound Series (May 2004)
Real Estate Practitioner's Guide to the Tax Aspects of Real Estate Transactions
The panel will discuss essential federal income tax issues in drafting and structuring
limited liability company operating agreements concerning capital contributions,
allocations of tax items, cash flow, property distributions and self employment tax. Also,
federal income tax treatment regarding real property leases with deferred or prepaid rent
will be considered.
William B. Acker is a shareholder and director of Kemp, Klein, Umphrey, Endelman &
May, PC in Troy. He is chairperson of the Section's Federal Tax Aspects of Real Estate
Transactions Committee. He has written many professional articles and has frequently
lectured on the Section's Homeward Bound Series and the Tax Section's After Hours Tax
Seminars.
Gordon Goldie is a CPA and a tax associate in Plante & Moran, PLLC's Auburn Hills,
Michigan office. He has a diversified client base with specialties in the real estate and
construction industries. He also specializes in structuring transactions involving LLCs,
partnerships, and S Corporations. Mr. Goldie is also a member of Plante & Moran's Real
Estate and Construction Industry Group where he assists in coordinating the administration
of the firm's real estate and construction industry practice, including training initiatives and
knowledge sharing.
Dean A. Rocheleau is a tax partner with Plante & Moran, PLLC in Southfield. Mr.
Rocheleau advises clients concerning the income tax and business aspects of their real
estate and construction operations. He is an active member of the State Bar of Michigan
Taxation and Real Property Law Sections and a frequent presenter on income tax related
topics including like kind exchanges.
Richard A. Shapack, Butzel Long, P.C., Bloomfield Hills, Michigan. His practice is
concentrated in business law, real estate and estate planning with special emphasis on tax
planning. Mr. Shapack is a Fellow of the American College of Tax Counsel, a Fellow of
American College of Trust and Estate Counsel and is certified by the Florida Bar as a
Board Certified Tax Lawyer. He has been a speaker at numerous ABA Real Property and
Tax Section meetings, the State Bar of Michigan Real Property Law Section, ICLE, the
Tax Management Real Estate Advisory Board and the NYU Real Estate Institute.
Real Estate Practitioner's Guide to the Tax Aspects of
Real Estate Transactions: Selected Topics
by
William B. Acker
Kemp Klein Umphrey Endelman & May, PC
Gordon Goldie
Plante & Moran, PLLC
Dean A. Rocheleau
Plante & Moran, PLLC
Richard A. Shapack
Butzel Long, PC
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R E A L E S T A T E P R A C T IT IO N E R ’S G U ID E T O
T H E T A X A S P E C TS O F R E A L E S T A T E
T R A N S A C T IO N S : S E L E C T E D T O P IC S
+ In co m e T ax Issu e s w he n S tructu rin g
a n L LC O p e rating A g ree m en t
B as ic O p e ra tin g
A g re em e n t P ro visio n s
6 O rga niza tion date and te rm ination date
+ O rga niza tion date – cann ot pre ced e d ate A rticles of
O rga niza tion are filed
+ T erm ina tion da te – shou ld it be othe r than pe rpe tua l?
6 M ana gem ent b y m an age rs or m em bers
+ W ho sh ould be authorized to act on beh alf of or bind LL C ?
+ S e lf-e m p loym en t in com e if m e m b er-m a nage d (exc eption: real
estate ren tal)
6 F isc al year end /m ethod of accou ntin g
+ T ax ye ar m u st be the tax year of a m ajority of th e m em be rs
+ W hich m ethod (c ash vs . accrua l) w ill defer re cog nition of n et
ta xab le inc om e?
+ Is there a prohib ition on usin g the ca sh m e tho d (e.g.,
inventories)?
Continued on the next page
B as ic O p e ra tin g
A g re em e n t P ro visio n s
6 In itial cap ital con trib ution s
+ O ne or m ore cla sse s of m e m b ership
+ C a sh, prope rty, service , or no con trib utio ns
+ W hat is the fair m ark et va lue of pro perty or se rvic es
co ntributed? (include in O .A .)
6 A d dition al capital call (and delin quen cy default) pro vision s
+ W hat is the procedu re to de term in e w hether add ’l co ntributions
w ill b e requ ired?
+ W hat is the pena lty if th e contributions are not m ade ?
! D ilution of m em bership interest (ho w d ete rm ined ?)
! T rea t as loan from o the r m em be rs (interest? h ow rep aid?)
! E x pulsion fro m L.L.C .
Continued on the next page
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B as ic O p e ra tin g
A g re em e n t P ro visio n s
6 R e strictio ns on transfer of m em be rsh ip interests or red em ption b y
LL C
+ N o transfe rs perm itted
+ T ran sfers pe rm itted w ith m ana ger or m em bers a pprova l
+ R igh ts of tran sfe ree – m em ber or assign ee?
+ R igh t of first re fus al o r firs t offer to LL C o r o the r m e m b ers
+ B u y-sell p rovisions in ope rating agreem ent
! A m ou nt - disc ounted, p rorata F M V , excessive
! T im in g o f paym e nts
! N e ed for ad equa te intere st (A FR )
S ervice s fo r C ap ital In teres t
6 V a lue is taxa ble as gua ranteed pa ym ent to recip ient – m ay be
de ductible by LLC
6 If n o restric tions – taxed c urrently a t FM V (IR C § 83)
6 If restrictions – taxed w h en restrictio ns lapse or w hen IR C § 83 (b)
election m ade by recip ie nt (e le ctio n dead lin e: 30 days after re ceipt
of intere st)
6 D istingu ishe d from service s for P rofits Interest on ly – recipient
sh are s in futu re pro fits a nd apprecia tion of LL C – no current ta x on
re cipien t
Continued on the next page
S ervice s fo r C ap ital In teres t
6 M em bers A a nd B each contribute $100 ,00 0 cash to L LC for d ow n
pa ym ent on acquisition of lan d; each rece ive 37.5% LLC intere st.
6 M em ber C obtains an LL C in terest o f 25% fo r the re al e sta te
de velop m e nt exp ertise sh e w ill pro vide to the LLC .
6 Is su e – if th e L LC m a kes no profit o n the land de velop m e nt project,
w h at doe s C receiv e u pon dissolution?
+ $5 0,0 00 (25% of $ 200 ,00 0 cash co ntribution) – C ap ital in terest
+ $0 (2 5% of LLC ’s p rofits) – P rofits interest
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G en era l E co n o m ic A rra n g e m en t
6 P rofits and Lo sse s (allocation of lo sse s a nd ded uctions, a llocation
of incom e and gain s, any specia l allocatio ns, IR C § 704(b)
re quire m e nts)
6 D istrib utio ns (dis trib ution of o peratin g cash flo w s, d istributio ns of
excess debt p roceeds, pro perty sale proce eds, liq uidating
proce eds, o r any prefe rential rights)
6 Is there h arm on y b etw een the alloca tion of profits and losses an d
distrib ution provis ions?
Continued on the next page
G en era l E co n o m ic A rra n g e m en t
6 R e strictio n o n, or m and ate s for, d istributions
+ D iscre tion ary distrib ution s only
+ M and ato ry ta x d istributions – pro vide stand ard or form ula
+ W hat if there is a cha rgin g o rder?
+ W hat if there a re bank o r o the r le gal or con tractual restriction s
on distrib ution s?
6 G uaranteed pa ym ents to m em bers for servic es pro vided or use of
ca pita l – n ot ba sed on ne t incom e (IR C § 707(c))
+ F or se rvic es, com para ble to a salary
+ C o m p are w ith p referred return on capita l (p aid only if pro fitable)
IR C § 7 04(b ) A llo c atio n s
6 “B ook” Incom e concept for m e m b ers’ capita l accou nts a nd
alloc atio ns
+ B a sed on F M V of con trib ute d a nd distribu ted assets
6 A llocation of m e m b ers’ share of in com e, ga in, loss , ded uction, or
credit can be rede term in ed by IR S taking in to accoun t all facts and
circum stances if:
+ T he O peratin g A gre em ent is silen t, or
+ T he A llocatio ns in the O peratin g A gre em ent do n o t have
“s ubstan tial eco nom ic effect”
6 I.R .S . tests LLC allocation s base d o n the “p artners’ in terest in th e
pa rtn ers hip”
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“B o o k ” In co m e o f IR C § 70 4(b )
6 T he § 704 (b) regula tion s refer to m aintaining ca pital accoun ts
ba sed on “b ook” incom e
6 T his is differe nt th an “fin ancia l bo ok” incom e o r the “in ternal
accou nting ” of th e L LC
6 It d oes re fer to F M V accou nting for con trib ute d a nd distribu ted
assets unde r the ru les establis hed by th e L LC O pera ting A gree m e nt
6 T hre e p oss ible cap ital accounts req uired :
+ R e gulation § 704 (b) “b ook”
+ In com e ta x b asis
+ F inan cial S ta tem en t (G A A P ) basis
A llo ca tio n s w ith R e sp ec t to
C o n trib u ted P ro p e rty
6 W hen m em bers con trib ute ap preciated or deprecia ted prope rty to
an LL C , it results in different § 704 (b) an d tax bases
6 S p ecial ta x a llocation of incom e, gain , lo ss, a nd dedu ctions fo r
property contributed by m em ber
6 A m em ber co ntributing assets w ith built-in g ain cou ld receiv e le ss
ta x deprecia tion th an the y w ould otherw ise be en title d if they did not
co ntribute it to the LLC (or con trib ute d cash instea d) but g ain is n ot
cu rre ntly taxa ble
6 IR C § 7 04(c) – trad ition al m ethod , tra dition al w ith curative
allocatio ns, rem edial m e tho d, other re aso nable m ethod
6 O peratin g a gre em ent sh ould sp ecify w hich m eth od sho uld be use d
by LL C – m em bers have conflictin g interests
A llo ca tio n s o f IR C § 7 04(b ) -
D ed u c tio n s an d L o ss es
6 R e course D e ductions – S a fe H arbor in IR S § 70 4(b ) regu la tion s
+ D o es O pera ting A g ree m e nt re quire se parate econo m ic ca pita l
accou nts for m e m b ers (§ 1 .70 4-1 (b)(2)(iv))?
+ A re liq uidating distribu tions m ad e p urs uant to such p ositive
ca pita l accou nt balan ces?
+ D o m em bers have D e ficit R estora tion O bliga tions, or
! U n com m on in L LC ’s
+ D o es the A gree m e nt have a Q ua lified In com e O ffset provis ion?
! C a nnot a llo cate lo sse s to M em bers w ho are not a t risk w h en
other m em bers are at risk
Continued on the next page
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A llo ca tio n s o f IR C § 7 04(b ) -
D ed u c tio n s an d L o ss es
6 N o m em ber is at risk for these lo sse s – len der is at risk
+ H o w shou ld losses be allo cated w he n there is no econo m ic
effect on th e M em be rs?
6 N o nrecourse D ed uctions – S a fe H arbor in IR S § 70 4(b) regula tion s
+ D o es agreem ent a llo cate in the sam e m anne r a s recourse
de ductions (in acco rdan ce w ith §1 .7 04-2 (e))?
+ D o es agreem ent h ave m inim um ga in charg eba ck pro visio n?
! M inim um ga in – A m ou nt of no nre course deb t in e xce ss of
ta x basis o f a ssets se cured by deb t - - tax gain re cog nized
by m em bers if p rop erty is repo sse sse d b y le nder
T ax D ec isio n s
6 S h ould th e A rticles of O rg aniza tion an d/o r O p erating A g reem en t
state that the LLC w ill be m a nage d b y a m an ager for S E ta x
pu rposes?
+ Y e s, un le ss it is a rental real estate or investm ent activity
6 D o es the A gree m e nt sp ecify a m em be r o r m an age r to m a ke tax
de cision s?
+ W ould facilita te dec ision -m aking
6 D o es the A gree m e nt sp ecify a T ax M atters P artne r?
+ If L LC is subje ct to I.R . S . con solida ted au dit pro ced ures
+ M ust b e a n L LC m e m b er, n ot a n onm em be r m an ager
Continued on the next page
T ax D ec isio n s
6 D o e s th e A g re e m e n t b in d th e L L C to m ake a § 7 54 e le ction d ue to
m e m be rsh ip tra ns fe rs o r ce rta in distrib u tion s?
+ E le ctio n a llo w s tra n sferee to increa se ta x b asis of L LC asse ts
+ M a n da to ry ye s or no or w h o d ec ide s?
+ If p e rm itted , sho u ld tran sfe re e p a y fo r a d dition a l acco u nting fee s?
6 D o e s th e A g re e m e n t stip u la te a profit/lo ss cu toff m e tho d w h en a
m e m be r’s in te re st ch an g es?
+ S pe cific cuto ff o r p ro ra ta p ortio n o f y ea r
6 D o e s th e A g re e m e n t p ro h ib it tran sfe rs th at co uld te rm ina te th e L L C for
tax p u rp os es (IR C § 7 0 8(b )(1 )(B ))?
+ O r th at vio la tes se cu rities law s?
+ 5 0% o r m ore ch a ng e in L L C ’s p ro fits an d c ap ita l w /i 1 2 m on th
p erio d
+ R e q uire s tw o ta x re turns, n ew ta x e le ctio ns, re sta rt de p re cia tion
p erio ds
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R E A L E S T A T E P R A C T IT IO N E R ’S G U ID E T O
T H E T A X A S P E C TS O F R E A L E S T A T E
T R A N S A C T IO N S : S E L E C T E D T O P IC S
+ L LC C on trib u tio ns
! C o ntrib ution s of
A p pre cia ted P ro p erty
[ §70 4(c)]
! V o lu n tary
R e va lua tio ns
[R e verse §7 04 (c)]
L L C C o n trib u tio n s
6 C o ntrib ution s – IR C § 72 1
+ G en era lly no n taxab le fo r con trib utin g m e m b ers a nd LL C
- E xce ption : In vestm en t C o m p an y (S e cu ritie s L LC )
+ Tax ba sis of co ntrib ute d asse ts ca rryover to L LC
+ B a sis in L LC m e m b ersh ip is e qu al to ba sis in con tribu ted a sse ts
T yp es o f C a p ita l A cc o u n ts
6 F in an cial statem en t b asis (G A A P )
6 T a x ba sis
6 E co no m ic ba sis
+ §70 4(b ) “bo o k” ca pital a ccou nts
+ 3 rd set of b o oks
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T ra n sac tio n s th at C re ate D iffe ren ce s
b etw ee n “B o o k ” an d T ax C a p ital
6 C o ntrib ution s of a p pre ciate d pro pe rty
6 Issu a nce o f a pa rtn ership in tere st by a pa rtn ership tha t o w ns
a pp recia te d p rop e rty
6 R e de m ption o f a p a rtne rsh ip inte rest b y a p artne rsh ip th at ow n s
a pp recia te d p rop e rty
6 T ra n sfe rs of p a rtne rsh ip inte re sts
“B o o k” C a p ita l A c co u n ts:
P ro p e rty C o n trib u tio n E xa m p le
A B
Building Cash
Basis $ 50,000
$100,000
FMV $100,000
50% 50%
AB, LLC
$150,000 Tax Capital
$200,000 Book Capital
“B o o k ” R e va lu a tio n E xa m p le:
P re -C o n trib u tio n O w n ersh ip
A B C
(1/3) (1/3) (1/3)
$10,000 $10,000 $10,000
ABC, LLC
$30,000 Tax & Book Capital
$75,000 FMV
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“B o o k ” R e va lu a tio n E xa m p le:
P o s t-C o n trib u tio n O w n e rsh ip
A B C D
(25%) (25%) (25%) (25%)
$10,000 $10,000 $10,000 $25,000
$25,000
ABCD, LLC
$55,000 Tax & Book Capital
$100,000 FMV
“B o o k ” R e va lu a tio n E xa m p le:
P o s t B o o k -U p O w n e rsh ip
A B C D
(25%) (25%) (25%) (25%)
$25,000 $25,000 $25,000 $25,000
$25,000
ABCD, LLC
$55,000 Tax Capital
$100,000 Book Capital
S ectio n 7 04(c ) A llo c atio n s
6 D e fin itio n o f te rm s - IR C § 70 4(c)(1 )(A )
+ §70 4(c) g ain = P re-con tribu tio n ga in on con tribu ted o r
“b oo ke d up ” pro pe rty
+ C o ntrib uting p artn er(s)
!P ro pe rty con trib utio n = P artn er w ho con trib utes pro p erty
to the p artn ersh ip
!V o lu n tary re va lu atio n (b oo k-up ) = E xisting pa rtn ers
+ N o n-co ntribu ting pa rtn er(s)
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S ectio n 7 04(c ) A llo c atio n s
6 M ust clo se th e ga p b etw ee n tax an d “bo ok” b asis via spe cia l
a llocatio ns*
+ D e du ctio ns
+ G ain/lo ss
6 S e le ctin g m e tho d to close g a p
+ C o uld ha ve a su bsta ntial ta x im pa ct
+ N e go tiate rig h t to se le ct
* D e m inim is rule applies if “book” value does not differ from basis by m ore than 15% of basis or
$20,000.
D ep rec ia b le P ro p erty E xa m p le
B
A Equipment
Cash Basis $ 2,000
FMV $10,000
$10,000 Remaining Life
= 4 years
50% 50%
AB, LLC
Tax Capital: A= $10,000 B = $2,000
Book Capital: A & B = $10,000
Depreciation: Book = $2,500, Tax = $500
D e p re cia b le P ro p e rty E xa m p le
T ra d itio n a l M eth o d (P ag e 3 -1 2 , E x am p le 3 )
P a rtn er A P a rtn er B
B ook C apital T ax B ook T ax
$10,000 C apital C apital C apital
F orm ation 1,000 $10,000 $10,000 $2,000
Y ear 1 – C ash F low (1,250) 1,000 1,000 1,000
Y ear 1 - D epreciation 1,000 (500) (1,250) 0
Y ear 2 – C ash F low (1,250) 1,000 1,000 1,000
Y ear 2 - D epreciation 0 (500) (1,250) 0
S ale of E quipm ent 0 0 4,000
$9,500
T otal $11,000 $9,500 $8,000
C apital gain/loss on liquidation $ 0
($1,500) $ 0 $1,500
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D e p re cia b le P ro p e rty E xa m p le
R e d e d ia l M eth o d (P ag e 3 -1 7, E x am p le 2)
P a rtn er A P a rtn er B
B ook C apital T ax B ook T ax
$10,000 C apital C apital C apital
F orm ation 1,000 $10,000 $10,000 $2,000
Y ear 1 – C ash F low (1,250) 1,000 1,000 1,000
Y ear 1 – D epreciation (500) (1,250) 0
R em edial 1,000 (750) 750
Y ear 2 – C ash F low (1,250) 1,000 1,000 1,000
Y ear 2 – D epreciation (500) (1,250) 0
R em edial 0 (750) 750
S ale of E quipm ent 0 0 4,000
$9,500
T otal $9,500 $9,500 $9,500
$ 0
C apital gain/loss on liquidation
$ 0 $ 0 $ 0
§70 4(c ) M eth o d C o n sid era tio n s -
R e g u latio n § 1 .70 4-3
6 T ra d ition al M eth o d – F a vo rs pro pe rty con trib utor*
6 R e m e d ia l A llocatio n M e tho d – F avors cash co ntrib uto r*
6 T ra d ition al M eth o d w ith C ura tive A llo cation s – T ypica lly the
com pro m ise po sition
6 M eth od selecte d b y tax m atters p artn er if n ot pro vide d for in
p artn ersh ip ag ree m en t
6 C a n u se d iffere nt m e tho d s fo r d iffe re nt p rop ertie s
6 C a nn ot ch an g e m etho ds on ce se le cte d for a g iven p rop erty
* If p ro pe rty “b o o k” valu e > b a sis
R E A L E S T A T E P R A C T IT IO N E R ’S G U ID E T O
T H E T A X A S P E C TS O F R E A L E S T A T E
T R A N S A C T IO N S : S E L E C T E D T O P IC S
+ L LC D istribu tio ns - P ote ntia l T ax
Issu e s
29
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L L C D is trib u tio n s
6 D istrib ution s – IR C § 73 1
g ain w h e n cash distrib utio ns excee d ba sis in LL C
+ T a xab le
m em be rship in tere st
+ C a shinclu d es m arketa ble se curitie s an d re d uctio n of
m em be r’s sh are of liab ilitie s
+ G en era lly,n o g ain recog nized on d istrib u tio n o f n on cash
p rop erty to a m e m b e r
L L C D is trib u tio n E xam p le
Y ear 1
6 M em be r “A ” co ntrib ute s $1 ,00 0 to a n LL C in x1
6 M em be r “A ”’s sh a re o f loss in x1 is $ < 50 0> a nd ta x-e xem pt
incom e is $ 10 0
6 M em be r “A ” receives a $6 00 cash d istribu tion in x1
6 M em be r “A ”’s ba sis is $ 0 a t th e en d o f x1 a nd th e ca sh
d istrib u tio n is no t ta xa b le
L L C D is trib u tio n E xam p le
Y ear 2
6 M em be r “A ”’s sh a re o f incom e in x2 is $ 1 ,50 0
6 M em be r “A ” receives a $2 ,00 0 distribu tion in x2
6 M em be r “A ”’s ba sis is $ 1,5 0 0 b efo re the x2 d istribu tio n
6 If ca sh distrib utio n: $ 5 00 taxa ble g ain to M e m b er “A ” ($ 2,0 00
d istrib u tio n in excess o f $ 1,5 0 0 b asis)
6 If p rop e rty d istribu tion : N o ta xa ble ga in to M e m be r “A ”, b ut
p rop erty d istribu ted h as a ba sis of $ 1,50 0 (e qu a l to M em be r
“A ”’s tax b asis in L L C )
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“M ix in g B o w l T ran sac tio n s”
6 R e ca p of C on trib u tio n a nd D istrib utio n T ax R u le s
+ C o ntrib ution s of ca sh a nd oth er pro pe rty to a n LL C a re
g en era lly tax-fre e (§ 7 21 )
+ D istrib ution s of no ncash pro pe rty are g en era lly tax-fre e;
d istrib u tio ns o f cash a re taxa ble o nly to the exte nt the y
e xcee d LL C M em b er’s tax ba sis (§ 73 1)
6 Id ea : A vo id ta xa ble sa le of assets b y u sin g a n LL C to facilitate a
sale o r e xch an ge of assets
“M ix in g B o w l T ran sac tio n s” -
E xam p le
6 O n 1 /1 /x3 – M e m be r “A ” co ntribu te s p rop e rty w ith a va lu e of
$ 60 ,00 0 an d a ta x b a sis of $ 20 ,0 00 to LL C
6 O n 1 /1 /x3 – M e m be rs “B ” a nd “C ” e ach co ntribu te $1 5,00 0 ca sh
6 O n 7 /1 /x3 – M e m be r “A ” re ceive s a ‘distrib utio n’ of $3 0,0 00
re du cing h is n et co ntribu tio n to $ 3 0,0 00
6 M em be r “A ” is a 50 % L LC m e m be r an d M e m b e rs “B ” an d “C ”
a re 2 5% L LC m e m b ers
D is g u ise d S ale
6 IR C § 7 07 (a )(2)(B )
+ “d ire ct or ind ire ct tra nsfer of p rop e rty o r m on ey”
+ “re la ted d ire ct or ind ire ct tra nsfer of p rop e rty o r m on ey”
+ “tra nsfe rs… w he n view ed to ge the r”
+ “cha racte rized a s a sale or e xch an ge ”
6 C o ng ress’ G o al – T o recast re la te d ta x-free con trib u tio ns a nd
ta x-fre e distrib ution s as ta xa b le sa le s.
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D is g u ise d S ale - E x am p le
6 O n 1 /1 /x3 – M e m be r “A ” co ntribu te s P rop erty “Z ” w ith a value of
$ 60 ,00 0 an d a ta x b a sis of $ 20 ,0 00 to LL C
6 O n 1 /1 /x3 – M e m be rs “B ” a nd “C ” e ach co ntribu te $1 5,00 0 ca sh
6 O n 7 /1 /x3 – M e m be r “A ” re ceive s a ‘distrib utio n’ of $3 0,0 00 cash
6 P re sum ed D isg u ised S a le – T a xa ble ga in to M e m be r “A ” o f
$ 20 ,00 0
+ S a le o f 50 % of p ro pe rty by M em be r “A ”
($ 30 ,00 0 S ale P rice Le ss $ 10 ,0 00 T a x B a sis)
6 M em be r “A ”’s tax b asis in the A B C , LL C intere st is red u ce d from
$ 40 ,00 0 to $ 20 ,0 00
D is g u ise d S ale –
G en era l R u le
6 R e gu la tion § 1.7 07 -3(b )(2)
+ F a cts an d circu m sta nce s – tw o -pa rt te st:
(1) O n e tran sfer w o u ld no t h ave be en m ad e b ut for the oth er;
an d,
(2) N on -sim ulta ne ou s tran sfers are n ot d ep e nd en t u po n
e ntre pre ne u ria l risks o f LL C o pe ratio ns
D is g u ise d S ale -
R elev an t F a cto rs
6 R e gu la tion § 1.7 07 -3(b )(2)
+ C e rtain ty o f tim in g a nd a m o un t o f d istrib utio n to p rop erty
tra nsfe ror
+ E n fo rce ab le righ t to su b se qu en t tra nsfe r by p rop erty
tra nsfe ror
+ O blig a tio ns to m ake co ntribu tion s to L LC to facilitate tra nsfers
+ O blig a tio n to m ake lo an s to LL C to facilitate tra nsfe rs
+ L LC is ob lig ate d to incur de bt to m ake tran sfers
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D is g u ise d S ale -
R elev an t F a cto rs
6 R e gu la tion § 1.7 07 -3(b )(2)
+ L LC h o ld s m o ne y or liq uid asse t b eyo nd its re aso na ble
b usin ess ne e ds
+ E ffective excha ng e of b urd e ns an d be ne fits o f o w ne rship o f
p rop erty
+ T ra n sfe r fro m the LL C is disp rop ortio na te to m e m b er’s
con tin u in g p erce nta ge inte rests
+ R e cip ie ntm e m b er ha s little or no ob lig ation to retu rn or re pa y
con sid era tio n
D is g u ise d S ale -
T w o – Y ea r P re su m p tio n s
6 R e gu la tion § 1.7 07 -3(c); -3 (d)
+ T ra n sfe rsm a de w ith in tw o ye ars o f e ach o th er a re pre su m ed
to be p art o f a sa le
+ T ra n sfe rsm a de m ore th an tw o yea rs a pa rt a re pre su m e d n o t
to be p art o f a sa le
+ Tax retu rn disclosure re qu ire d if tra nsfe rs w ith in tw o yea rs
a re n ot trea ted a s a d isgu ise d sa le (R e g. S s 1 .7 07 -8)
D is g u ise d S ale -
E xclu d e d D istrib u tio n s
6 R e gu la tion § 1.7 07 -4
+ R e aso na ble g ua ra nte ed p aym e n t for use o f cap ital
+ R e aso na ble p re ferre d re tu rn o n in ve sted ca p ita l
+ P ro po rtion ate o pe ratin g cash flo w d istribu tio n
+ R e im b ursem e nt o f p refo rm ation exp en ditu res (key excep tion )
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R elate d D ee m ed M em b er S a le s –
D is trib u tio n o f C o n trib u te d
P ro p erty to A n o th er M em b e r
6 IR C § 7 04 (c)(1)(B ) – D istrib u tio n o f con tribu ted p rop erty to
a no the r m em be r
+ T a xab le sale to d istribu tee m em be r
+ S e ven ye a rs fro m co n trib utio n d ate
+ G ain or loss to co ntrib uto r as if sold for F M V on distrib utio n
d ate
+ L im ite d to co ntribu to r’s p recon trib u tio n g a in
+ C o ntrib uting m em be r m ust still be a m e m b e r at d a te o f
d istrib u tio n
+ L ike-kind excha ng e p o ssib le if o the r qu a lifyin g like -kind
p rop erty is d istribu te d to con tribu tor
D is trib u tio n o f C o n trib u te d
P ro p erty to A n o th er M em b e r -
E xam p le
6 O n 1 /1 /x3 – M e m be r “A ” co ntribu te s P rop erty “Z ” w ith a value of
$ 60 ,00 0 an d a ta x b a sis of $ 20 ,0 00 to LL C
6 O n 1 /1 /x3 – M e m be rs “B ” a nd “C ” e ach co ntribu te $6 0,00 0 ca sh
6 W ith in 7 ye ars o f 1/1/x3, P ro pe rty “Z ” is d istribu te d to M em be r
“C ” in full re d em ptio n o f h er L LC in tere st
6 T a xab le sale o f P rop erty “Z ” by M em be r “A ”
+ T a xab le g ain o f $ 40 ,00 0 recog nized by M em b er “A ” in yea r of
tra nsfe r of P rop erty “Z ” to M e m be r “C ” if value of pro pe rty
increa sed or sta ye d co nsta nt
+ If va lu e o f P ro p erty “Z ” de cre ase s p rior to d istrib utio n, taxab le
g ain to M em b er “A ” ba se d on lo w e r va lue
R elate d D ee m ed M em b er S a le s –
D is trib u tio n o f O th e r N o n c ash
P ro p erty to C o n trib u tin g M em b er
6 IR C § 7 37 – D istribu tion of oth er n o ncash pro pe rty to
con trib u tin g m e m b er
+ T a xab le sale to d istribu tee m em be r
+ S e ven ye a rs fro m co n trib utio n o f p rop erty b y d istribu te e
m em be r
+ D istrib ute e m e m b e r’s ga in b ased o n F M V of pro pe rty
re ce ive d in e xce ss o f b asis in L LC m e m be rsh ip inte re st (le ss
cash received )
+ L im ite d to co ntribu to r’s p recon trib u tio n g a in
+ N /A if co ntrib uto r is a lso the d istrib utee
+ N /A if disg uised sale o r §7 0 4(c)(1)(B ) rules a pp ly
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D is trib u tio n o f O th e r N o n c ash
P ro p erty to C o n trib u tin g M em b er -
E xam p le
6 O n 1 /1 /x3 – M e m be r “A ” co ntribu te s P rop erty “Z ” w ith a value of
$ 60 ,00 0 an d a ta x b a sis of $ 20 ,0 00 to LL C
6 O n 1 /1 /x3 – M e m be rs “B ” a nd “C ” e ach co ntribu te $3 0,00 0 ca sh
6 O n 2 /1 /x3 – LL C b uys P ro pe rty “Y ” fo r $6 0 ,00 0 ca sh
6 W ith in 7 ye ars o f 1/1/x3, P ro pe rty “Y ” is d istribu ted to M em be r
“A ” in red em p tio n o f h er L L C in te rest
6 T a xab le sale o f P rop erty “Z ” by M em be r “A ”
+ T a xab le g ain o f $ 40 ,00 0 recog nized by M em b er “A ” in yea r
P ro pe rty “Y ” is received if tax b asis o f M em be r “A ”’s LL C
inte rest re m a ins at $2 0,0 0 0 o r it de cre ase s a n d valu e o f
P ro pe rty “Y ” re m ains a t $6 0,00 0
R E A L E S T A T E P R A C T IT IO N E R ’S G U ID E T O
T H E T A X A S P E C TS O F R E A L E S T A T E
T R A N S A C T IO N S : S E L E C T E D T O P IC S
+ M inim izing S elf-
E m plo ym ent T axes fo r L LC
M em bers
S E T a x O ve rview
6 S E T ax is S o cial S ec urity Ta x e quiv alent for self-em plo yed
individuals
6 S e lf-e m p loye d ind ividua ls p ay both the em plo yee and em plo yer
po rtio ns of th e tax, o r 15.3% , un der IR C § 1 401
6 M axim um for O A S D I po rtio n o f 1 2.4 % is $ 87,900 in 2004
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P erso n s S u b je ct to S E T a x
6 R e g. § 1.1 401-1(c) in dica tes S ole P rop rietors, Ind epe nden t
C o ntractors, and C e rta in P artners are su bject to S E T ax
6 R e g. § 301.770 1-3(b)(1) indicate s tha t d om estic LLC m em bers a re
treated as pa rtn ers (m ulti-m em ber) or sole proprie tors (sin gle
m em ber)
T yp es o f In co m e S u b jec t to S E T ax
6 IR C § 1 402(a) indicate s S E incom e inclu des ne t in com e from an y
trade or bu sine ss of an individual, a nd
6 D istrib utive share o f in com e or loss fro m any trade or b usine ss
ca rrie d o n b y a pa rtnership of w hic h he/she is a p artner, and
6 It g enerally exclude s rental o f rea l estate, divid end s a nd inte rest,
ga in /loss fro m sa le of a capita l asset, and distrib utive share
alloc ate d to a lim ite d p artner
L im ited P a rtn e r E xc ep tio n
6 IR C § 1 402(a)(13) provid es tha t the distrib utive share o f incom e
attrib uta ble to a lim ited partner is no t S E In com e
6 H o w eve r, “g uaranteed paym ents” fo r serv ices re nde red are S E
In com e
6 IR C § 7 07(c) defines a guaranteed pa ym ent to in clude a ny
pa ym ent m ade to a pa rtn er fo r serv ices provid ed w ith out re gard to
th e n et incom e o f the pa rtn ers hip
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P ro p . R eg . § 1 .14 02(a )-2(h )
6 P rom ulgated on Ja nuary 16, 19 97
6 A tte m p ts to expan d S ta tutory an d R egu la tory S ch em e for Lim ite d
P a rtner S E Inco m e E x em ptio n to LLC m em bers
6 T o be effective fo r in dividu al’s firs t taxable ye ar beg in ning after the
R e gulation is p ublish ed as fina l
6 T herefo re, it is not la w currently
W h en W ill It B e F in a l?
6 U n der T axp aye r R elief A c t of 199 7 it could not b e T e m p or F inal
be fore July 1, 19 98 – w e a re still w aiting
6 T he pro ject is still op en but no t on the IR S ’ lis ting of p rojec ts to b e
ad dressed
6 IR S see m s to b e w aiting for con gre ssio nal g uidan ce
F u n ctio n a l R u le s fo r L im ited
P artn e r D e sig n atio n
6 A n ind ividua l is treated as a lim ite d p artner un less:
+ H e /sh e h as person al liab ility for d ebts o f LLC (“Liability T es t”);
or
+ H e /sh e h as authority to contract on beha lf o f the LL C
(“M a nag em ent T est”); or
+ H e /sh e p articipa tes in th e trad e o r b usin ess of the LLC for m o re
th an 500 ho urs in the taxa ble y ear (“P a rtic ipation Te st”)
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L ia b ility T e st
6 T he Liab ility Te st w ill not ap ply to a M ic higan LL C
6 M C LA § 450 .45 01(2) state s that m em be rs are n ot liable for L LC
ob lig atio ns
6 T he te st app lies O N LY to the m e m b ers po sitio n in th e L LC , n ot to
de bts pe rso nally gua ran tee d
M a n a g e m en t T e st
6 In a M ichiga n L LC , all m em bers h ave th e a bility to c ontrac t on
be half of the LLC unle ss th e A rticles of O rg aniza tion states th at the
LL C is to b e m an aged by m an agers (M C LA § 450 .44 01)
6 A ll m e m b ers of a ‘m em ber-m ana ged’ M ichiga n L LC w ould be
treated as ge nera l pa rtn ers for purposes of th e P rop . R egs.
P artic ip a tio n T es t
6 T his te st w ou ld b e a pplied an nually to e ach m em ber
6 N o re quire m e nt to an nua lize in sh ort years
6 N o attributio n rules ap ply betw een relatives or fo r service s p rovided
th rou gh entities – all h ours m ust be perform e d b y the m em ber
directly for th e L LC
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T w o S E T a x A b s o lu tes
6 G uaranteed pa ym ents are S E incom e
6 A m em ber th at is a ‘s ervice partne r’ in a ‘service pa rtnership’ can not
be a lim ited partne r
6 A se rvic e p artnership pro vide s h ealth, law , e nginee ring ,
architecture , accounting, a ctu aria l sc ience , or con sulting service s
E xce p tio n s to G en era l R u le s (b u t
n o t A b s o lu te R u les )
6 LL C m em be rs not m ee ting any o f the 3 te sts m ay still be c onsid ere d
lim ited partn ers if th ey can m eet e ithe r o f the tw o exceptions based
on other m em bers being treated as lim ited pa rtn ers :
+ O w ne r of T w o C lasses of M em bership
+ O w ne r of O ne C lass o f M e m b ership
O w n er o f T w o C la ss es o f M em b ersh ip
6 If a m em ber o w ns tw o classes of m em bership , it is po ssib le that he /s he
m ay be treated as a gene ral partne r in on e class an d a lim ited pa rtn er
in the other if:
+ M em bers holding a su bstantial pa rt (d efin ed as 20% ) o f one class
are trea ted as lim ite d p artners, and
+ T he m em ber has the sam e rig hts an d o bligations w ith resp ect to
th at cla ss as do th e m em be rs bein g trea ted as lim ited p artners
6 P rovid es relief to m a nage rs w ho m ay ow n tw o classes o f L LC
m em bership
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O w n er o f O n e C las s o f M em b ersh ip
6 If a m em ber is co nsid ered to b e a ge neral pa rtner so le ly beca use of
th e P articipa tion T est, he m ay be co nside red a lim ited partne r if:
+ O th er m e m b ers trea ted as lim ited pa rtn ers o w n a “sub sta ntia l,
co ntin uing inte res t” in tha t spe cific cla ss, a nd
+ T he m em ber’s rights a nd obliga tions w ith reg ard to the spe cific
cla ss are ide ntical to tho se of th e o the r m em be rs treated as lim ited
pa rtn ers
6 P rovid es relief to a n on-m an age r m em be r in a m anag er-m a nag ed LLC
A B A R es p o n s e
6 In July 1999 , the A B A recom m ende d e lim ina ting the lim ite d p artner
excep tion and replacing it w ith an S E incom e e xclu sion fo r a
re aso nable ra te of re turn on a p artner’s u nreturned cap ital
6 A IC P A e ndo rse d in 200 0
S tru ctu rin g L L C s to M in im ize S E
T ax
6 S e lection of M anag er-M a nage d L LC
6 U s e o f M u ltiple C lasses of O w nership
6 O th er S truc turing A lte rna tive s
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M a n a g e r-M an ag ed L L C s
6 M em bers not de signa ted as m ana gers w ill be treated as lim ited
pa rtn ers for S E T ax if th ey participa te less than 50 0 h ours d uring
th e year
6 If they w ork m ore than 500 ho urs, the y m a y still b e lim ite d p artners
if others o w ning m ore than 20% o f the sa m e cla ss are lim ited
pa rtn ers
M a n a g e r-M an ag ed L L C s
6 N o nm em bers m ay be selected as m ana gers o f the LL C ; th is could
inclu de:
+ N o nm em ber em ployees of the LLC
+ S p ouse o r fam ily m e m b ers of a m em ber
+ E n tity c ontrolled by a m em ber (e.g ., S C orp)
6 P a y a m an agem en t fee to the m a nag er
+ If a n e ntity, the LLC m em ber co uld pro vide all o f his/her
se rvic es as an office r o f the m ana ger
6 M C LA § 450 .44 02(2) perm its nonm em be r m a nage rs
U se o f M u ltip le C las se s o f
M e m b e rsh ip
6 U s e o f tw o cla sse s to sep ara te m anag ers an d n onm ana gers m ay a llo w
larger non m a nag er class to be tre ate d a s lim ited partners
6 T he classes could be se t u p for an active group (g ene ral partner) and a
ca pita l-con trib utin g g rou p (lim ited partne rs)
+ P a y a variab le in centive fe e to m a nage r class o r
+ P a y a p referred return on invested cap ital to non m anag er class
+ C a nnot b e a gu aran tee d paym en t unde r R egs
+ W ould allow m em bers tha t are bo th active and capita l-co ntributing
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