Rev. Rul. 99-5: Tax Treatment of LLC Conversions
Explore how IRS Rev. Rul. 99-5 guides the tax treatment for LLC ownership changes by defining the underlying deemed asset transactions for federal tax purposes.
An Internal Revenue Service (IRS) Revenue Ruling is an official interpretation of the tax code for a specific set of facts. Revenue Rulings 99-5 and 99-6 clarify the federal income tax consequences when a limited liability company’s (LLC) number of members changes, altering its federal tax classification. The rulings address two conversion scenarios: an entity converting from a partnership to a disregarded entity, and vice versa.
An LLC’s tax classification impacts how its income and losses are reported. A single-member LLC is disregarded by default for tax purposes, with its activities reported on the owner’s personal tax return. A multi-member LLC is treated as a partnership, requiring a separate partnership tax return.
Converting a Partnership to a Disregarded Entity
Revenue Ruling 99-6 addresses the tax consequences when a multi-member LLC, taxed as a partnership, becomes a single-member LLC. This conversion occurs when one person or entity purchases all ownership interests from the existing members, and the original partnership is considered terminated for tax purposes on the date of the sale.
Each selling partner is treated as selling their partnership interest to the buyer. To determine the tax consequences, a seller must calculate their capital gain or loss by taking the amount of cash and the fair market value of any property received and subtracting their adjusted basis in the partnership interest.
If the partnership holds “hot assets,” such as unrealized receivables and inventory items, a portion of the gain may be recharacterized as ordinary income. The buyer is not treated as purchasing partnership interests. Instead, the IRS constructs a two-step hypothetical process where the partnership is deemed to make a liquidating distribution of all its assets to its members. Immediately following this, the buyer is treated as purchasing all of the assets that were deemed distributed to the other members.
Converting a Disregarded Entity to a Partnership
When a single-member LLC (a disregarded entity) converts into a multi-member LLC (taxed as a partnership), Revenue Ruling 99-5 provides the guiding framework. This happens when the entity admits a new member. The ruling addresses two distinct ways this can occur.
New Member Buys Interest from the Original Owner
In the first scenario, the new member purchases an ownership interest directly from the original owner. The IRS recasts the transaction as a sale of a proportionate share of the LLC’s underlying assets from the original owner to the new member. Immediately after this deemed asset sale, the IRS views both the original owner and the new member as contributing their respective shares of the assets to a newly formed partnership. The original owner must recognize a gain or loss on the portion of the assets they are deemed to have sold.
New Member Contributes Capital to the LLC
The second scenario involves the new member contributing capital directly to the LLC for an ownership interest. The original owner is treated as contributing all the assets of the existing LLC to a newly formed partnership, while the new member contributes their capital. Contributions of property to a partnership for a partnership interest are generally tax-free, so neither party recognizes gain or loss on the formation in this scenario.
Determining Asset Basis and Holding Periods
The tax basis and holding period of assets and ownership interests are concepts that determine future tax liabilities upon a sale or depreciation deductions. The conversion of an LLC’s status under Rev. Rul. 99-5 and 99-6 directly impacts these attributes for all parties involved. The specific outcomes depend on the direction of the conversion.
Consequences of a Partnership-to-Disregarded Entity Conversion
When a buyer acquires all interests in a partnership, causing it to become a disregarded entity, the buyer is treated as having purchased the LLC’s assets. The buyer’s tax basis in these newly acquired assets is their total purchase price. This total cost must then be allocated among the individual assets of the LLC based on their respective fair market values at the time of the purchase.
This allocation is important for future depreciation and amortization deductions. A higher basis in depreciable assets will result in larger tax deductions over time. The buyer’s holding period for all the assets they are deemed to have purchased begins on the day immediately following the date of the transaction. This means the buyer cannot claim a long-term capital gain if they sell an asset shortly after the conversion.
Consequences of a Disregarded Entity-to-Partnership Conversion
When a disregarded entity becomes a partnership, the tax basis of the assets inside the new partnership is determined by the basis of those assets in the hands of the contributing partners. This is known as a “carryover basis.” For the assets contributed by the original owner, the partnership’s basis is the same as the owner’s basis in those assets right before the conversion. For any property contributed by the new member, the partnership takes a basis equal to that member’s basis in the property.
The partners also must determine the initial basis in their new partnership interests, known as their “outside basis.” The original owner’s outside basis is equal to their basis in the assets they were deemed to contribute to the partnership. The new member’s outside basis is the amount of cash and the basis of any property they contributed.
The holding period for the partnership’s assets contributed by the original owner includes the period the owner held them. Similarly, the partners can “tack on” the holding period of any capital assets they contributed to the holding period of their partnership interest.