Question: I am contemplating purchasing an interest in a limited liability company as an investment. What tax consequences if any I should be concerned with?
Answer: Various tax issues must be addressed in connection with the purchase of an interest in a limited liability company (“LLC”). Of particular concern is ascertaining if there will be sufficient cash distributions from the company to satisfy your associated tax obligations. Limited liability companies with more than one owner or member are usually treated as partnerships for tax purposes requiring their members to report their proportionate share of the company’s income on their personal tax returns. Just because LLC income is being allocated to you does not necessarily mean you will be receiving a corresponding distribution of cash from the company. You do not want to be in the unenviable position of having to report income from the LLC without receiving a cash distribution to pay the tax attributable to that income. You should review the company’s governing documents, most importantly the company operating agreement, to verify that there will be sufficient tax distributions so you will not be faced with “phantom income”.
A similar concern arises if the LLC commenced its business or investment activity before you became a member. If so, you could be faced with a different form of phantom income as you could be required to report taxable income earned before you become a member without having received a distribution of any portion of that income. There are various methods of preventing members from being allocated income for a pre-ownership period. You should ascertain whether the company will follow an income allocation approach that will prevent you from reporting this income.
If you are investing in a company which has already commenced business or investment activity, you should compare the price you are paying to purchase the membership interest to the book value of your proportionate share of the company assets as reflected on the most recent company balance sheet. That is, you should determine if the value of the assets reflected on the company’s financial statements differs from the company value computed with reference to your purchase price. If the price you are paying is more than your proportionate share of the book value of the company’s assets, the assets in the company may have appreciated in value since the time the company was created. In such case, if the LLC assets are sold at some point, you could be taxed on your proportionate share of this gain. This creates a somewhat unfair result for you in that the gain inherent in the assets at the time you become a member is taxed to you when in fact you paid a market value price for your membership interest. You should review the LLC operating agreement and/or inquire of the company’s management as to whether a separate election, a 754 election, has been or will be made which will allow you to avoid paying taxes on the gain that existed before you became a member.
While conducting your own review to determine if an investment is appropriate, you presumably have determined the amount of your initial capital contribution and whether you are required to make additional capital contributions to the company. There are, however, circumstances, where LLCs require cash contributions from members in less obvious ways. Tax rules require that each LLC member have a capital account reflecting the member’s economic interest in the company. Each member’s capital account is increased by the amount of the member’s capital contributions to the company and the member’s pro rata share of company earnings and gains; a member’s capital account is decreased by the member’s share of company losses and distributions from the company. If a member has a negative capital account, the tax rules in some circumstances require the member to restore the deficit capital account when the LLC is liquidated or otherwise ceases activity. The company’s operating agreement will indicate whether or not a member is obligated to restore a deficit capital account balance. If the company operating agreement imposes a deficit restoration obligation on members, you might reconsider your intention to invest or perhaps consider creating a separate entity to become the owner of your interest which may limit your personal exposure for future capital contributions.
Prospective investors in limited liability companies must carefully review all of the LLC operative documents. The amount of required contributions, fees paid to the owners of the company, business prospects and other material business issues must be addressed. Tax issues can create surprises for LLC owners and prospective LLC investors should properly address these issues to ensure the investment is suitable.
The Tax Corner addresses various tax, estate, asset protection and other business matters. Should you have any questions regarding the subject matter or if you have questions you want answered, you may contact Bruce at (312) 648-2300 or send an e-mail to firstname.lastname@example.org.