Investing in an LLC: Be Aware of the Disguised Sale Rules

 

A contribution of cash or property by an investor to a partnership (or an LLC taxed as a partnership) is not generally taxable to the investor or the partnership.  But such a contribution can result in a taxable event for both the investor and the partnership if the contribution is really a disguised sale.  The US Tax Court recently determined that the disguised sale rules of IRC Section 707 applied to a transaction involving a contribution of cash by an investor to a partnership in exchange for an allocation of state tax credits.

A recently issued revenue procedure provides a safe harbor under which the IRS will not challenge partnership allocations of IRC Section 47 rehabilitation credits by a partnership to its partners.  But that revenue procedure states that it does not describe the circumstances under which a transfer of state tax credits by a partnership to an investor might be treated as a disguised sale.

Partners generally may contribute capital to a partnership tax-free and may receive a tax-free return of previously taxed profits through distributions.  These beneficial non-recognition rules do not apply, however when the contribution transaction is found to be a disguised sale of property.   For federal income tax purposes, a disguised sale can occur if: (1) there is a transfer of cash or property by a partner to a partnership; (2) there is a related transfer of cash or property by the partnership to that partner; and (3) both transfers viewed together are properly characterized as a sale/exchange of property.

The relevant Treasury Regulations list several factors to be taken into consideration in determining whether a particular transaction should be treated as a disguised sale.   Any related transfers made between a partnership and a partner within a 2-year period are presumed to be a sale/exchange of property unless the facts and circumstances clearly establish that the transfers do not constitute a sale.

In the recent Tax Court case, an investor contributed cash to an LLC taxed as a partnership in exchange for certain state tax credits.  The Tax Court first found that the transfer of cash by the investor to the LLC in exchange for an allocation of state tax credits (within a 2-year period) was presumed to be a sale of property rights.   The Tax Court then determined that the transfers between the LLC and the investor should be characterized as a sale since the allocation of state tax credits by the LLC to the investor would not have occurred but for the investor’s contribution of cash to the LLC.  Finally, the Court found that the facts and circumstances in the case further confirmed that the transfers were a disguised sale since, among other things: (1) the timing and amount of the state tax credits were determinable with reasonable certainty at the time of the transfer of the cash contribution by the investor to the LLC; (2) the investor had a legally enforceable right to receive the state tax credits; (3) the investor’s right to receive the state tax credits was secured; and (4) the amount of the tax credits was disproportionately large in comparison to the investor’s general and continuing interest in the LLC’s profits.

Because the contribution of cash by the investor to the LLC was treated as a sale of property by the LLC to the investor, the LLC was required to recognize gain/income on the transaction, and the investor could not receive tax-free distributions (up to the amount of the contribution) from the LLC in the future.  This result could have been avoided had the investor bought an equity interest in the LLC and then received an allocation of the available state tax credits, along with all members of the LLC, based on their relative capital account balances.

The rules governing taxation of partnerships and partners can be quite complicated.  If you need assistance with any matter involving partnership taxation please give me a call or email at 937-223-1130 or Jsenney@pselaw.com.

 

AND ONE MORE THING.   Most business-sponsored retirement plans are required to have been established by the end of 2013 in order to get a tax deduction for 2013.   But one exception is the Simplified Employee Pension (SEP) plan. If you set up and fund your SEP by the due date of your 2013 business return (including extensions), you can still take a deduction for 2013. For example, if your business is a corporation using a calendar year for its tax year, the deadline to set up and contribute to a SEP for 2013 is March 15, 2014 (September 15, 2014, if you file for an extension).

You can set up a SEP for little or no cost at a bank, investment firm or insurance company. SEPs offer high contribution and deduction limits, minimal paperwork and no annual Form 5500 filing. You can contribute to a SEP even if you participate in an unrelated employer’s retirement plan. Contributions to a SEP are subject to certain SEP contribution limits.

If you need help with setting up a qualified retirement plan or any other issues related to your qualified or non-qualified plans, contact me at 937-223-1130 or Jsenney@pselaw.com.

AUTHOR: Jeff Senney
jsenney@pselaw.com


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