Revenue Ruling 99-21: Tax Treatment for Adding a Member
The tax treatment for adding a member to a single-member LLC depends on the transaction's structure, which dictates the consequences for basis and gain.
When a single-member limited liability company (SMLLC) adds a second owner, it undergoes a transformation for tax purposes, changing its federal tax classification. In Revenue Ruling 99-5, the Internal Revenue Service (IRS) provides guidance on the tax consequences of this transition. The method used to add the new member dictates the tax outcomes for the original and new owners, as well as for the newly formed entity.
Understanding the Entities Involved
A single-member LLC is a “disregarded entity” for federal income tax purposes, meaning the IRS ignores the LLC as a separate entity from its owner. All the business’s income, deductions, gains, and losses are reported directly on the owner’s personal tax return, often on Schedule C with their Form 1040. The LLC itself does not file a separate federal income tax return.
When a second member is added, the LLC’s default tax status changes to a partnership. A partnership must file an annual informational return, Form 1065, “U.S. Return of Partnership Income,” which reports the business’s financial activity. The partnership does not pay income tax but “passes through” these items to its partners via a Schedule K-1, which each partner uses to report their share of financial results on their personal tax returns.
Transaction One: Sale of Interest to a New Member
One way to add a member is for the new person to purchase a portion of the ownership interest directly from the original owner. The IRS recharacterizes this transaction as a two-step process. First, the original owner is treated as having sold a percentage of each individual asset held by the LLC to the new member, and the original owner must recognize any resulting gain or loss.
The gain or loss is calculated on an asset-by-asset basis. For each asset deemed sold, the gain is the difference between the portion of the sales price allocated to it and the owner’s adjusted basis in that same portion. This gain or loss is characterized as ordinary or capital depending on the asset’s nature; for example, selling inventory produces ordinary income, while selling a building held over a year results in a capital gain.
Following the deemed asset sale, the second step occurs. The original owner and the new member are treated as contributing their respective shares of the LLC’s assets to a newly formed partnership. The new member’s initial tax basis in their partnership interest is equal to the amount they paid. The new partnership’s basis in the assets includes the original owner’s carryover basis for the retained portion and the new member’s cost basis for the purchased portion.
Transaction Two: Contribution by a New Member
A different set of tax rules applies if the new member makes a financial contribution directly to the LLC for an ownership interest. In this scenario, the IRS views the transaction as a contribution of property to a partnership. The original owner is treated as contributing all of the existing assets of the LLC, while the new member contributes their own cash or property.
This type of transaction is generally tax-free, so neither the original owner nor the new member recognizes any income or loss from their respective contributions. This non-recognition treatment allows new capital to be brought into an enterprise without creating an immediate tax liability.
The original owner’s basis in their new partnership interest is equal to the adjusted basis of the assets they contributed from the original LLC. The new member’s basis in their partnership interest is the amount of cash or the adjusted basis of the property they provided. The new partnership takes a carryover basis in all the assets it receives, meaning its basis is the same as the contributing partners’ basis in those assets before the contribution.