Rev. Rul. 99-6, Situation 2: Tax Consequences

IRS Revenue Ruling 99-5 provides guidance on the tax consequences when a limited liability company’s (LLC) membership changes, causing its classification to shift. An LLC’s classification can move between being a partnership and a “disregarded entity” that is treated as a sole proprietorship. This ruling clarifies the IRS’s view on these transformations, specifically in Situation 1. This scenario involves the conversion of a single-member LLC into a partnership through a direct sale of an ownership interest from the original owner to a new member.

The Factual Scenario of Situation 1

The transaction in Situation 1 begins with a single-member LLC, where the sole owner sells a portion of their ownership interest directly to a new member. For example, the original owner might sell a 50% interest in the LLC to a new individual in exchange for a cash payment. A defining characteristic of this scenario is that the payment for the ownership interest is made directly to the original owner, not to the LLC itself. This is a distinct fact pattern from a situation where a new member contributes cash or property to the LLC in exchange for an interest. In that alternative case, the new capital goes into the company’s accounts, increasing its assets. The fact that the original owner personally receives the funds is what drives the specific tax treatment.

The IRS Deemed Transaction Steps

For tax purposes, the IRS does not view the transaction as a simple sale of an LLC interest. Instead, it recharacterizes the event into a series of “deemed” steps to determine the tax consequences for all parties involved. The first step treats the original owner as selling a direct, undivided interest in each of the LLC’s underlying assets to the new member. If the new member purchased a 50% interest, the original owner is considered to have sold 50% of every asset held by the LLC, as if the entity did not exist at the moment of sale. Immediately following this deemed sale, the second step treats the original owner and the new member as contributing their respective interests in the assets to a newly formed partnership. At this moment, the disregarded entity ceases to exist for tax purposes, and a new partnership is formed.

Tax Consequences for the Members

The deemed transaction creates immediate tax consequences for both members. For the original owner, the deemed sale of assets requires recognizing gain or loss under Internal Revenue Code Section 1001. The owner must determine the difference between the cash received and their adjusted tax basis in the percentage of each asset sold. To illustrate, assume an LLC’s only asset is a building with a $100,000 adjusted basis. If the owner sells a 50% interest for $150,000, they are deemed to have sold assets with a basis of $50,000, resulting in a recognizable gain of $100,000.

For the new member, the primary tax consequence is establishing their tax basis in the purchased assets, which is their cost. In the example, the new member’s basis in their 50% interest in the building is $150,000. The subsequent deemed contribution of assets to the new partnership by both members is generally tax-free under Section 721.

Tax Consequences for the New Partnership

The new partnership’s basis in the assets it holds, known as the “inside basis,” is determined by the basis of those assets in the hands of the contributing members. This results in a blended basis for its assets, with a portion reflecting the original owner’s remaining adjusted basis and the other portion reflecting the new member’s cost basis. Using the prior example, the new partnership’s basis in the building would be $200,000. This is calculated by adding the original owner’s remaining $50,000 basis and the new member’s $150,000 cost basis. Section 704 requires the partnership to allocate tax items related to this built-in gain to account for the difference between the fair market value and the tax basis of the contributed property.

Each member’s basis in their partnership interest, or “outside basis,” is equal to the adjusted basis of the assets they were deemed to contribute. The original owner’s outside basis would be their $50,000 remaining basis, while the new member’s outside basis would be their $150,000 cost. The partnership’s holding period for the assets is split; the portion from the original owner includes their original holding period, while the portion from the new member begins on the date of the sale.