Single Owner LLC, Analytical comparison between Saudi System and US system.

Citation: James A. Fellows; Michael A. Yuhas, The Single-Member LLC or the Single-Shareholder S Corporation - A Life-Cycle Analysis of the Tax Consequences of the Chosen Path, 3 J. Passthrough Entities 33, 48 (2000) Provided by: <br>SMU Underwood Law Library

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Passthrough Entities/May-June 2000

The Single-Member LLC or the Single-Shareholder S Corporation? A Life-Cycle Analysis of the Tax Consequences of the Chosen Path

James Fellows and Michael Yuhas compare and contrast the tax consequences of forming, operating, selling and liquidating a business as either a single-member LLC or a single-shareholder S corporation.

Introduction

02000 J.A. Fellows and M.A. Yuhas

Look before you leap-Aesop, The Fable of the Fox and Goat

Fashions come and go, and the latest tax fashion appears to be the limited liability company (LLC). To the taxpayer seeking the passthrough nature of partner- ship taxation combined with the limited liability inherent in cor- porate operations, the LLC pro- vides an image of Voltaire's "best of all possible worlds." 2 At present, virtually all of the discus- sion in the tax literature has con- centrated on the use of the mul- tiple-member LLC to effect this dual purpose. However, nearly all states now specifically allow the formation of a single-member LLC. 3 Because the LLC is now available to one-member inves- tors, many sole proprietors can be expected to form an LLC, ei- ther to begin operations or to

transform an existing sole propri- etorship into an LLC. It is irrel- evant for federal tax purposes whether the business is operated as a traditional sole proprietor- ship or as a single-member LLC, as the check-the-box regulations treat a single-member LLC as a sole proprietorship unless it spe- cifically elects to be taxed as a corporation. 4 It is, in tax parlance, a "tax nothing."

The question that goes begging, of course, is why form an LLC at all? Why not just form a traditional

James A. Fellows, Ph. D, CPA, is a Professor of Accountancy at the

University of South Florida in St. Petersburg, Florida.

Michael A. Yuhas, LL.M, CPA, is a

Professor at the Seidman School of

Business, Grand Valley State University

in Grand Rapids, Michigan

Ul

By James A. Fellows and Michael A. Yuhas

Life-Cycle Analysis of Single-Member Entities

corporation, and then make an S election? Doesn't this avenue, af- ter all, provide the dual benefits of passthrough taxation combined with limited liability? Certainly the S election does that. But there still remain fundamental differences between the tax accounting rules of S corporations and sole proprietorships. The purpose of this article is to analyze these differ- ences. A clear understanding of the tax accounting rules for these two entities is necessary to make an informed choice-to help us "look before we leap."

This article follows a life cycle approach. We first look at the dif- ferences between forming a single- member LLC and a single-share- holder S corporation. The analysis then turns to an examination of the dissimilarities encountered during the operation of each entity, includ- ing nonliquidating distributions to the sole owner. This is followed by a discussion of both the sale of the business to another party, and fi- nally by the tax rules surrounding a liquidation of the entity itself. There is not sufficient space to ad- dress at length every issue that may arise, but hopefully along the way we will succeed at pointing out those that primarily concern tax- payers and their tax advisors. The tax law surrounding a single-mem- ber LLC is not yet fully developed, and guidance from the IRS is sorely needed. Hopefully some of the is- sues we raise here will serve to spur them forward.

Formation of the Entity Better the devil you know than the one you don't-Aesop, The Fable of the Oxen and the Butchers

At the outset, we assume that no single-member LLC elects to be

taxed as a corporation, unless oth- erwise stated. The check-the-box regulations provide that a single- member LLC is, by default, a dis- regarded entity and not separate and apart from its owner, unless the owner specifically elects other- wise.' We shall change this as- sumption at the conclusion of the article when we briefly discuss the conversion of the passthrough en- tity into a C corporation.

We also assume that the single member of the LLC is an individual who is contemplating the choice between operating through the guise of an S corporation or an LLC. We do not discuss issues re- lating to corporate ownership of LLCs. These issues are many, in particular the variegated state tax rules facing corporate multistate operations through separate LLCs. But such a discussion is beyond the scope of this article. With these caveats in mind, we now turn to the first stage of our life- cycle discussion, which is the for- mation of the passthrough entity.

The discussion of creating a passthrough entity concentrates on the two general methods by which the entity can come into being. First, we look at an exist- ing sole proprietorship (and any other unincorporated activity, such as holding rental property) that is converting to either S cor- poration or LLC status. Next, we analyze the conversion from a C corporation to either S corpora- tion or LLC status. Under both scenarios, the tax consequences of switching to an S corporation differ from switching to an LLC.

Converting a Sole Proprietor- ship into a Single-Member LLC

If an existing unincorporated ac- tivity is converted into a single- member LLC, the individual owner must ensure that state law

requirements for creating an LLC are followed. 6 Other than this pre- caution, there are no tax conse- quences to forming the LLC, as long as the taxpayer does not elect to be taxed as a corporation. Because the check-the-box regu- lations treat the single-member LLC as a "tax nothing," it remains a sole proprietorship under federal tax law. Therefore, for federal tax purposes, the individual owner of the LLC is considered to own all the assets of the business. Any in- come, loss or business tax credits are considered earned directly by the individual and reported on his or her own individual income tax return. The formation of the LLC is treated as if nothing really hap- pened at all, hence, the use of the term "tax nothing" to describe a single-member LLC. The ease with which this is accomplished is cer- tainly superior to that by which the S corporation is formed.

Converting a Sole Proprietor- ship into a Single-Shareholder S Corporation

The general framework of Code Sec. 351 governs the tax conse- quences of incorporating a sole proprietorship. Generally, no gain on loss is recognized when the taxpayer transfers the assets of the business to the new legal en- tity. No gain is recognized by the corporation on the issuance of its stock to the shareholder and, un- der Code Sec. 362(a), the corpo- ration takes a carryover basis in the property from the share- holder, increased by any gain recognized by the shareholder. Under Code Sec. 358(a), the shareholder's basis in his stock is the same as the basis of the as- sets transferred, plus any gain recognized, less the fair market value of any boot, e.g., corporate debt, issued to the shareholder,

Passthrough Entities/May-June 2000

and less any liabilities that are transferred to the corporation.

Example. Leonard incorporates his sole proprietorship, and will make the election to be taxed as an S corporation. At the time of in- corporation, the only assets of the business are cash of $10,000 and inventory with a fair market value of $70,000 and a tax basis of $50,000. In addition, there is a $20,000 nonrecourse liability that is secured by the inventory. No gain is recognized by either Leonard or the corporation on the formation of the S corporation. The corporation takes a basis in the in- ventory of $50,000. Leonard's ba- sis in his corporate stock is $40,000, equal to the $10,000 cash plus the $50,000 tax basis in the inventory, less the $20,000 liability transferred to the corporation.

One potential pitfall of forming the S corporation is the potential for gain, which can occur in one of two ways. First, if the S corpo- ration issues any corporate debt to the shareholder in addition to stock, the fair market value of the debt is considered taxable boot, the tax equivalent of cash.8

Example. Sandy incorporates her sole proprietorship and makes an S election. At the time of incorporation, the fair market value of the assets was $500,000, and their tax basis was $350,000. There were no liabili- ties. In exchange for the assets, Sandy receives common stock worth $400,000 and a note pay- able of $100,000 from the cor- poration. Sandy must recognize $100,000 gain, equal to the tax- able boot (note payable) re- ceived. The corporation takes a basis in the assets of $450,000. Sandy's basis in her stock is $350,000, equal to the basis of the assets transferred, plus the recognized gain of $100,000,

less the $100,000 boot received. In view of this restriction, tax-

payers should incorporate the S corporation without the issuance of any debt. Loans can be made to the corporation at some later date, perhaps in an effort to build up "loss basis" under Code Sec. 1361 (d)(1)(B).

Recognized gain will also result at incorporation should the liabili- ties transferred to the corporation exceed the basis of all property transferred. Code Sec. 357(c) pro- vides that this excess is consid- ered gain to the shareholder. The gain is capital, ordinary or Code Sec. 1231 gain depending on the type of assets transferred.

Example. Patricia owns rental apartments as an unincorporated enterprise. She decides to form an S corporation to own the property. At incorporation, the properties have a fair market value of $500,000 and a tax basis of $200,000. They are secured by a nonrecourse mortgage of $300,000. This is the only property that is transferred to the new cor- poration. Because the mortgage transferred exceeds the property's basis by $100,000, Patricia must recognize $100,000 of Code Sec. 1231 capital gain. The corporation takes a basis in the rental proper- ties of $300,000, equal to Patricia's basis plus her recognized gain. Patricia's basis in her stock is 0, equal to the $200,000 basis of the properties transferred, plus her $100,000 recognized gain, less the $300,000 mortgage.

Note that if Patricia had formed a single-member LLC, instead of an S corporation, she would not have recognized this gain, as the single-member LLC would have been ignored for tax purposes. Moreover, if the rental properties are currently generating net op- erating losses, Patricia may not be

able to deduct any losses that are passed through from the S corpo- ration. This is because her initial stock basis in the corporation is 0, and Code Sec. 1366(d) prohib- its the deduction of any passthrough loss from an S cor- poration unless the shareholder has sufficient basis in the S cor- poration.9 No such limitation ex- ists for a single-member LLC. 10

Example. Continuing with the preceding example, assume that the rental properties generated a net tax loss of $50,000 for the corporation's first tax year and that Patricia had not made any further capital contributions or any loans to the corporation. Be- cause the tax basis in her stock is 0, she cannot deduct any of the losses on her personal tax return. The loss is suspended and may be deducted in future years should sufficient basis in the corporation be restored, either through addi- tional capital contributions, mak- ing loans to the corporation or through net taxable income of the operations passed through to Patricia. Had Patricia formed a single-member LLC to own and operate the rental properties, she would be able to currently deduct the $50,000 of losses because the LLC is ignored for tax purposes.

In summary, the single-member LLC, at least in terms of the in- corporation process, generally appears to provide a more attrac- tive alternative than the S corpo- ration. This attractive position does not apply, however, if the taxpayer is considering the con- version of an existing C corpora- tion to a passthrough entity.

Conversion of the C Corporation to a Singje-Member LLC

The conversion of an existing C corporation to a single-member LLC is treated for tax purposes asU

Life-Cycle Analysis of Single-Member Entities

a full liquidation of the corpora- tion with the business continuing to operate as an unincorporated entity (e.g., a sole proprietorship). The liquidation of a corporation is a fully taxable event to both the corporation and the shareholder. Code Sec. 336(a) provides for the recognition of gain and loss by a corporation on distributions of property to a shareholder during the liquidation process as if the property were sold by the corpo- ration at its fair market value. Moreover, Code Sec. 331 (a) pro- vides for the recognition of gain or loss to the shareholder upon the redemption of his corporate stock, in an amount equal to the cash and net fair market value of the property distributed over the shareholder's tax basis in his stock.1" Under Code Sec. 334(a), the shareholder will take a tax ba- sis in the distributed property equal to its fair market value.

Example. Jacob is the sole share- holder of a C corporation, whose only assets are $68,000 in cash and a commercial office building (with underlying land) that is being leased to a corporate tenant. There is no mortgage on the property. Seeking to avoid the double taxa- tion of corporate earnings while retaining limited liability, Jacob con- verts the C corporation to a single- member LLC. At the time of the conversion, the fair market value of the property is $500,000 and its tax basis is $300,000. Jacob's tax basis in his corporate stock is $100,000. The corporation's mar- ginal tax rate is 34 percent. The conversion is treated as a full liqui- dation of the corporation in redemp- tion of Jacob's stock. The corpora- tion distributes the land and build- ing to Jacob and must recognize $200,000 of gain in its last tax re- turn. 1 2 The corporate tax liability on the distribution is $68,000, so the

corporation's cash is just sufficient to pay the tax on the distribution and, thus, Jacob receives none of the cash. Jacob must also recog- nize $400,000 of capital gain on the redemption of his stock, equal to the fair market value of the building in excess of his $100,000 stock basis. Assuming this is all long-term capital gain, Jacob's tax liability is $400,000 x .20 = $80,000.13 Jacob takes a tax basis in the building of $500,000.

The total tax price on this con- version from C corporation status to single-member LLC status is the sum of the two tax liabilities, or $148,000, representing about 25 percent of the value of the corpo- ration. By any measure, this is a steep tax price to pay for simply changing the legal form of the same business enterprise. One positive side to the events described above is that Jacob is treated as if he had purchased new property for $500,000. However, he does not "step into the shoes" of the corpo- ration and continue to depreciate the building over its remaining use- ful life. Instead, the entire amount of basis properly allocated to the building is now recoverable on Jacob's personal tax return over a 39-year life.

Conversion of the C Corporation to an S Corporation

Unlike the conversion to a single-member LLC, the conver- sion of a C corporation to an S corporation is not treated as a liq- uidation of the C corporation. There is no constructive distribu- tion of assets to the shareholder and, thus, no subsequent Code Sec. 351 formation of the S cor- poration. Subject to the applica- bility, if any, of the three "pen- alty taxes" discussed below, as long as the sole shareholder of the C corporation makes the ap-

propriate election to become an S corporation, the changeover is a "smooth transition" with no rec- ognized gain to the C corporation or its shareholder. Once the last C corporation tax year has ex- pired, the corporation begins life anew as a passthrough entity, carrying over the same tax basis in the corporate assets as existed at the end of C corporation life. It should be noted, however, that any unexpired net operating losses, capital losses or tax credit carryforwards cannot be passed through to the S corporation shareholder. They can be used, however, by the S corporation in computing its own built-in-gains tax, discussed momentarily.

There are some caveats to this tax-free transformation. Code Sec. 1 363(d) requires any C corporation that accounts for inventory under the LIFO method to recognize in its final C corporation tax return any LIFO recapture amount. This re- capture is the excess of the hypo- thetical FIFO tax basis over the actual LIFO tax basis. The tax re- sulting from this conversion is paid in four equal annual installments, the first with the corporation's last C year return and the other install- ments with the corporation's first three S returns.

Any C corporation that converts to S corporation status is also re- sponsible for the built-in gains (BIG) tax under Code Sec. 1374. The BIG tax is a 35-percent tax assessed on the net unrealized built-in gains in corporate prop- erty on the first day of the S corporation's first tax year. How- ever, the tax is assessed only to the extent such property is sold within the first 10 years of S corporation's existence. The gain passed through to the share- holder is reduced by any BIG tax paid by the corporation. Any un-

Passthrough Entities/May-June 2000

expired net operating losses and capital losses from the C corpo- ration can reduce the BIG tax base, and any unexpired tax cred- its from C corporation years can offset the resulting BIG tax.

Example. Jacob is the sole share- holder of a C corporation, whose only assets are $68,000 in cash and a commercial office building (with underlying land) that is be- ing leased to a corporate tenant. There is no mortgage on the prop- erty. Seeking to avoid the double taxation of corporate earnings, while retaining limited liability, Jacob converts the C corporation to an S corporation. At the time of the conversion, the fair market value of the property is $500,000 and its tax basis is $300,000. Jacob's tax basis in his corporate stock is $100,000. There are no unexpired C corporation losses or tax credits. No gain is recognized by the corporation on the conver- sion to S corporation status. The S corporation's tax basis in the build- ing remains at $300,000, and it will continue to depreciate the build- ing over its remaining useful life. Jacob's tax basis in the S corpora- tion stock is $100,000. The S cor- poration is liable for the BIG tax over the next 10 years on a base not to exceed $200,000. If the prop- erty is held for over 10 years after the conversion to S corporation status, the exposure to the BIG tax disappears. However, assume the property is sold for a gain of $250,000 in five years. The BIG tax is $200,000 x .35 = $70,000. The amount of income passed through to Jacob for reporting in his own personal tax return is $250,000 - $70,000 = $180,000.

The last potential stumbling block on the conversion to S corporation status is where there are undistrib- uted C corporation earnings and profits at the end of the C

corporation's last tax year. In this case, the S corporation becomes potentially liable for the passive investment income (PIT) tax un- der Code Sec. 1375 if passive in- vestment income (e.g., interest, dividends and capital gains) ex- ceeds 25 percent of gross receipts. In addition, under Code Sec. 1 362(d)(3), S status is lost if the 25- percent threshold is flunked for three consecutive years.

A further burden to the S corpo- ration are the distribution rules un- der Code Sec. 1368(c) should C corporation earnings and profits still exist during the year a distri- bution is made to the shareholder. If distributions exceed the undis- tributed taxable income of the cor- poration since the beginning of its S corporation existence (its so- called "Accumulated Adjustments Account"), then the next part of the distribution is treated as ordinary dividend income to the share- holder, to the extent of the remain- ing C corporation earnings and profits.

Still, despite these three fore- going caveats, the conversion from C corporation status to S corporation status bears a smaller tax price than the con- version to a single-member LLC if there are significant appreci- ated assets in the corporation. The price to pay for the conver- sion to S status of a C corpora- tion having LIFO inventory sometimes is too steep to obtain passthrough status. However, where there is no LIFO inven- tory or the recapture tax is small, despite the existence of the BIG tax, the PIT tax, and the potential for dividend payments to the shareholders, these po- tential tax traps are manage- able and with careful planning, can even be eliminated totally. Their tax costs are problematic,

but they are not automatic, as is the case with the conversion from a C corporation to a single- member LLC.

Operating the Passthrough Entity Industry in itself is a treasure- Aesop, The Fable of the Farmer and his Sons

Granted, both the single-share- holder S corporation and the single-member LLC are pass- through entities and both provide the owner with limited liability. But differences exist nonetheless even in the tax accounting for the operational activities of the enti- ties. This section of our life-cycle analysis explores some of the more significant differences.

14

Tax Years and Tax Methods

Because the single-member LLC is a tax nothing, it must use the same year as that of its owner, which would be a calendar year for individuals. In this respect, the S corporation provides an advan- tage over the LLC. Even if the single shareholder of the S cor- poration is an individual, the S corporation is not required to use a calendar year as its tax year. This flexibility does provide some degree of tax deferral for the owner. However, Code Sec. 1 378(b) mandates that the S cor- poration can use only a "permit- ted year." This is defined as a cal- endar year or an accounting pe- riod for which the taxpayer es- tablishes a business purpose. A business purpose is established if the desired year corresponds to the corporation's "natural busi- ness year," generally defined as a 12-month period in which gross receipts during the last two months of the period are 25 per-

U

Life-Cycle Analysis of Single-Member Entities

cent or more of gross receipts for the entire 1 2-month period.

1 5

Even if no natural business year can be established, Code Sec. 444 allows an S corporation to use a tax year other than a calendar year, as long as the deferral pe- riod is not more than three months (i.e., a tax year ending no earlier than September 30). The advan- tage of this deferral is virtually eliminated, however, by the "re- quired payment" rule under Code Sec. 7519, requiring the corpora- tion to deposit with the IRS an amount roughly equal to the tax benefits derived by the share- holder from any tax deferral.

Concerning the use of account- ing methods, the LLC and S corpo- ration are virtually on equal foot- ing. If inventories are a material component of the business, both entities must use the accrual method to account for sales rev- enue and cost of goods sold .16 How- ever, beyond this restriction, the S corporation or LLC is free to use any accounting method available, in- cluding the cash method.1 7 The ac- crual method is permitted, even if the owner of the entity is a cash- method individual. For example, a service enterprise operated as a single-member LLC can use the ac- crual method for all of its transac- tions. The use of the accrual method for a sole proprietorship operated by a cash method individual pre- dates the advent of the LLC.

Self-Employment Taxes

Because the single-member LLC is a tax nothing treated as a sole pro- prietorship, the LLC member is sub- ject to self-employment taxes on the entity's net business earnings. Portfolio-type income (e.g., interest, dividends and capital gains) is not subject to the self-employment tax. Currently, only the first $76,200 (for Year 2000) of net earnings are sub-

Um

ject to the OASDI 1 2 .4-percent rate, while the entire net earnings are subject to the 2 .9-percent Medicare tax rate. The OASDI ceil- ing is increased annually.

S corporation shareholders, however, are not subject to self- employment tax on any passthrough of S corporation in- come. 8 On the surface, this ap- pears to provide substantial tax benefits over the single-member

Example. Jack is the sole shareholder of an S corporation. The net business income for the

year is $300,000 (all from active business operations) before con- sidering a $100,000 salary pay- ment to Jack. Taxable income for the corporation is therefore $200,000. Jack is not subject to self-employment tax on the $200,000 of taxable income passed through to him. The cor-

Figure 1

LLC status: OASDI: $ 76,200

Medicare: $ 277,050

Deduction for "employer" portion $17,483 x 1/2 x .40

Total

S Corporation status:

OASDI: $ 76,200

Medicare: $100,000

Deduction for "employer" portion $12,349 x 112 x .40

Total

LLC, but the tax benefits are miti- gated by the fact that a "reason- able salary" must be paid by the corporation to the shareholder for services rendered. Any attempt to distribute earnings of the S cor- poration as something other than a salary can potentially subject the portion of the distributions that should have been compensation to reclassification as such, sub- ject to FICA taxation at both the corporate and shareholder-em- ployee level. 19 Still, because the entire net business income of the S corporation is not subject to self- employment taxes, the S corpo- ration offers an advantage over the single-member LLC in this re- spect by permitting "returns on capital" to avoid FICA taxation. Consider the following scenario.

x .124

x .029

.124

.029

= $ 9,449 = 8,034

17,483

(3,497) $ 13,986

= $ 9,449

= 2,90 12,349

S (2,470) $ 9,879

poration and Jack are both sub- ject to the FICA tax on the $100,000 salary. If Jack is the sole member of an LLC, the tax- able income of the LLC, reported on Schedule C of Form 1040, is $300,000, as no deduction is al- lowed for any purported salary payments to the sole proprietor. Jack is subject to self-employ- ment tax on the entire $300,000.

The tax savings from S corpo- ration status in the preceding ex- ample is shown in Figure 1, as- suming the tax year is 2000 and that the salary payment to Jack is "reasonable" and not under- stated. Net earnings from self- employment under LLC status is 92.35 percent of the $300,000 taxable income of the LLC, or $300,000 x .9235 = $277,050. The

Passthrough Entities/May-June 2000

FICA tax for S corporation status is shared equally by Jack and the corporation through the tax with- holding process.

Because the OASDI part of the tax is only imposed up to an an- nual ceiling amount, the appar- ent advantage of the S corpora- tion is somewhat ameliorated. However, this ceiling continues to grow at a rather fast pace (e.g., from $72,600 in 1999 to $76,200 in 2000) so that the S corporation will continue to serve as an increased "tax shel- ter" for the self-employment tax.

In the area of employment taxes, there is one further disadvantage of the LLC to the S corporation. Al- though the single-member LLC of- fers limited liability to the owner for most purposes, the IRS has ruled that the individual owner of a single-member LLC is personally liable for any FICA or federal un- employment taxes that remain un- paid by the LLC. 20 This would not be the case with a single-share- holder S corporation.

The limited liability of the LLC thus applies only to legal actions not related to federal tax law. The concept of a tax nothing perme- ates all implications of federal tax law, not just the passthrough na- ture of income and loss.

The Passthrough of Losses: The Agony and Ecstasy of it All

Both the LLC and the S corpora- tion are passthrough entities that pass through losses to the respec- tive LLC member or S corpora- tion shareholder. However, de- pending on the type of entity cho- sen, there are restrictions on the deductibility of losses. The follow- ing discussion isolates the differ- ences between the single-mem- ber LLC and the single-share- holder S corporation in the areas of loss basis and at-risk amounts.

We ignore the passive loss rules, because the activities of the owner in a single-member LLC or single-shareholder S corporation would be subject to the same material participation standards mandated by Code Sec. 469.21

A Question of Loss Basis. The issue of so-called "loss basis" af- fects the S corporation but not the LLC. In particular, Code Sec. 1366(d) limits the S corporation shareholder's loss deduction for any one year to the sum of the shareholder's tax basis in his stock and his tax basis in any loans made directly to the S cor- poration by that shareholder. The mere guarantee of corporate debt by the shareholder does not increase the shareholder's debt basis and, therefore, does not in- crease loss basis. 22 Any current- year loss that cannot be de- ducted is carried forward indefi- nitely until sufficient loss basis in the corporation is restored.

This basis restriction on S cor- poration shareholders does not apply to the LLC member, be- cause the entity is a tax nothing. Thus, there is no separate basis in the entity held by the mem- ber. Only the at-risk rules, dis- cussed subsequently, could per- haps restrict loss deductibility for the LLC member.

Example. Ron is the sole share- holder of Aqua Corporation, a calendar-year S corporation that incurs a net operating loss of $25,000 in Year 2000. Ron's stock basis equals $10,000 be- fore considering the loss, and he has also loaned $5,000 to the corporation and has a $5,000 basis in that loan. The $25,000 loss is passed through to Ron and first reduces his stock basis to 0. Next, his loan basis is reduced to 0. The sum total of losses Ron can deduct on his personal tax

return in Year 2000 is $15,000 (subject to any at-risk limitations or passive activity limitations). The remaining $10,000 loss will be carried into Year 2001 and fu- ture years until Ron builds up suf- ficient loss basis in the corpora- tion, either by making additional contributions or loans or through the corporation earning income. If Ron operated the business as a single-member LLC, the entire $25,000 loss could be deducted on Ron's Year 2000 tax return (subject to any at-risk limitations or passive activity limitations).

A Question of At-Risk. Code Sec. 465 disallows a deduction of a loss from the taxpayer's passthrough business entity if the individual is not "at-risk" for these losses. The taxpayer's at- risk amount includes:

(1) the amount of money and property (as measured by the property's adjusted tax basis) contributed to the business activity; (2) any amounts borrowed with respect to the activity if the taxpayer is personally li- able for repayment; and (3) the adjusted tax basis of any property pledged as se- curity for taxpayer debt, but only if the property is not used in the activity in question.

A taxpayer's at-risk amount does not include any amounts for which the taxpayer is pro- tected against loss by nonre- course financing, debt guaran- tees, stop-loss agreements or similar arrangements. Despite the foregoing rules, Code Sec. 465(b)(6)(A) allows at-risk status for the taxpayer's share of any qualified nonrecourse financing that is secured by real property used in the activity. The follow- ing discussion does not apply to such debt.

2 1

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Life-Cycle Analysis of Single-Member Entities

On the surface, there appears to be very little difference, if any, be- tween the single-shareholder S corporation and the single-mem- ber LLC on this point. This conver- gence is due to the fact that, al- though the single-member LLC is a tax nothing, state law eliminates the member's liability for LLC debt to third parties. Thus, even if the LLC has borrowed money on a re- course basis, that debt is consid- ered nonrecourse to the LLC mem- ber. Because it is nonrecourse to the LLC member, there is no per- sonal liability on the debt and, thus, no at-risk amount.2 4 A simi- lar rule would apply to an S cor- poration that had borrowed funds on a recourse basis. The debt is nonrecourse to the shareholder, so no at-risk amount exists.

There is some debate about whether or not the guarantee of any debt by the owner of the entity pro- vides an amount at-risk. If it does, the single-member LLC provides a distinct advantage over a single- shareholder S corporation. This is because the S corporation share- holder does not receive any tax basis for losses for debt guarantees, only for direct loans made to the corporation by the shareholder. Thus, whether the shareholder re- ceives any amount at-risk for a debt guarantee is irrelevant.

Example. Melanie forms a single- member LLC to operate an equip- ment rental business, contributing $10,000 cash in exchange for all the interests in the LLC. In addition, the LLC borrows $400,000 on a re- course basis from a third-party creditor in order to acquire neces- sary inventory of rental equipment. Melanie personally guarantees this debt. In the first year of operations, the LLC has a $50,000 taxable loss from operations.

Can Melanie deduct the entire $50,000 on her personal tax re-

turn for this first year or is she limited to $10,000? Certainly if she had formed an S corpora- tion, the issue would not be in doubt, because Melanie only has a loss basis equal to her $10,000 cash contribution. No loss basis is granted her by her mere guarantee of debt. Thus, even if she is at-risk for the guar- anteed debt, the loss basis rules are given priority and, therefore, only $10,000 of the loss can be deducted in this first year.

But the issue is not so clear-cut in the LLC area. Because there are no loss basis rules to confront Melanie as an LLC member, she need concern herself with only the at-risk limitations. The Internal Revenue Code (the "Code") is si- lent on the issue of debt guaran- tees, but proposed tax regulations do address the problem.2 5 Basi- cally, the regulations provide that no at-risk amount is provided by a debt guarantee until the tax- payer pays the creditor any amounts borrowed by the entity and the taxpayer has exhausted all remaining legal rights against the primary obligor (i.e., the LLC).

Notwithstanding the proposed regulations, there is a line of case law that supports increasing at-risk amounts for loan guarantees if the taxpayer is economically at-risk with respect to the debt.26 Under this judicial doctrine, the taxpayer will be considered economically at-risk and, therefore, at-risk un- der Code Sec. 465 if the taxpayer has the ultimate liability to repay the debt if the business entity funds are not available for that purpose.

According to this doctrine, at- risk amounts are not delayed un- til the taxpayer ultimately makes good on the debt. It is irrelevant that the entity, the LLC, currently may be able to satisfy the debt. The economically at-risk doctrine

assumes a worst-case scenario. What is critical in obtaining at-risk amounts for the loan guarantee is that the taxpayer must not possess any right of reimbursement from the LLC and must bear the ultimate responsibility for the debt in case of LLC default. In a single-mem- ber LLC setting, this is a practical reality, so the doctrine may have substance here. Whether the IRS would agree with this position on audit is open to anybody's guess.

Code Secs. 1031 and 1033 Issues: Who is the Taxpayer?

The use of the single-member LLC to hold replacement property in a Code Sec. 1031 exchange of real estate has become increas- ingly popular in recent years. One of the critical elements of a bona fide Code Sec. 1031 tax-deferred exchange is that the owner of the relinquished property also must be the party that owns and holds the replacement property. Be- cause the single-member LLC is a tax nothing, an individual can form an LLC to hold legal and separate title to the replacement property, thus limiting the individual's own liability for legal actions relevant to this property.

The IRS has ruled that, for fed- eral tax purposes, the assets of a single-member LLC are consid- ered to be the assets of the indi- vidual member and, therefore, the LLC is the same taxpayer as the individual. This identity means that the LLC, acting as the alter ego of the single member, can own the replacement property received in a Code Sec. 1031 exchange.

Example. Madeline exchanges Whiteacre, which is undeveloped land, for replacement property in a qualifying like-kind exchange. The replacement property is a rental apartment complex. In order to shield herself from liabilities aris-

Passthrough Entities/May-June 2000

ing from the rental operations, Madeline forms a single-member LLC to own and operate the prop- erty. The exchange of Whiteacre for an interest in a single-member LLC holding the rental property qualifies as a tax-deferred ex- change under Code Sec. 1031.

Consistent with this tax noth- ing doctrine, the IRS has also es- tablished a similar rule that al- lows the single-member LLC to hold any replacement property acquired in a Code Sec. 1033 in- voluntary conversion.2 8

The use of the LLC to limit the owner's liability on the replace- ment property is an advantage not available for single-shareholder S corporations because S corpora- tions are not disregarded entities. Despite the passthrough nature of the S corporation, it is still a sepa- rate tax entity and, therefore, the receipt of the replacement prop- erty by the shareholder's S corpo- ration invalidates the Code Sec. 1031 exchange.29

Example. Madeline desires to exchange Whiteacre, which is undeveloped land, for replace- ment property in a qualifying like- kind exchange. The replacement property is a rental apartment complex. In order to shield her- self from liabilities arising from the rental operations, Madeline acquires the replacement prop- erty in a single-shareholder S cor- poration. The exchange does not qualify as a tax-deferred ex- change under Code Sec. 1031. Madeline must recognize any gain or loss on the exchange.

Note that in the preceding ex- ample if Whiteacre had been prop- erty with an unrealized loss, the for- mation of an S corporation, or a C corporation for that matter, to hold the replacement rental property, may be the best solution because Madeline may wish to use the capi-

tal loss on the exchange to offset capital gains from other sources.

3 0

The Constitutional Issue of States' Rights Redux

Taxpayers are keenly aware that each state in our federal system re- tains the right to tax individuals and business entities in its own man- ner. Thus, just because an S corpo- ration, or a single-member LLC, is treated as a passthrough entity for federal tax purposes does not make it so for each and every state. Most states, such as Florida, "piggy- back" federal tax law onto state law. Thus, a Florida-chartered S corporation or single-member LLC is not subject to the Florida corpo- rate income tax, and since Florida does not have a personal income tax, the passthrough of the income to the owners is effectively exempt from any Florida income tax.

This piggyback treatment is not available in all states, so taxpay- ers need to be cognizant of the position of individual states on this issue. For example, several states do not recognize the S election and, therefore, subject the S cor- poration to either an income tax or a franchise tax.3 1 The LLC, even a single-member one, is subject to income or franchise tax as a corporation in three states. 2

Nonliquidating Distributions to the Owner

The tax treatment of distributions to the individual owner of the en- tity is radically different for the LLC vis-a-vis the S corporation. Because the single-member LLC is a tax nothing, any distribution of cash or property from the en- tity to the owner has no tax con- sequences. Such is not the case for distributions to the S corpora- tion shareholder. Code Sec. 311 (b) requires the corporation to recognize gain, but not loss, on

the distribution of property to the shareholder. The gain is passed through to the shareholder, who receives a tax basis in the prop- erty equal to its fair market value. The shareholder's stock basis is in- creased by the amount of the gain and reduced by the fair market value of the property distributed. Should this fair market value ex- ceed the shareholder's tax basis in his stock (after the addition of the passed-through gain), the shareholder must recognize capi- tal gain on the excess. This rule is a tax trap for the unwary.

Example. George is the sole shareholder of an S corporation that has been an S corporation since inception. The corporation distributes appreciated inventory to George. The fair market value of the inventory is $100,000 and its tax basis is $60,000. At the time of the distribution, George's basis in his S corporation stock is $50,000. The S corporation recog- nizes $40,000 ordinary income from the distribution, and this is passed through to George. George increases his stock basis to $90,000. George also has to recognize $10,000 of capital gain because the fair market value of the inventory exceeds his adjusted stock basis by $10,000. George is left with a tax basis of 0 in his stock. If the entity had been a single-member LLC, no party would have recognized gain and George would retain a tax basis of $60,000 in the inventory.

Sale of the Business Those who are anxious to know how the world values them will seldom be happy with the price-Aesop, The Fable of Mer- cury and the Sculptor

At this stage of our life-cycle ap- proach, we have reached the point

U

Life-Cycle Analysis of Single-Member Entities

where the owner wishes to sell the business to another party. We will look at this in two respects. First, we will analyze the sale of a par- tial interest in the business, and then we will discuss a sale of the owner's entire interest in the busi- ness. As with the preceding analy- sis, we view these events compar- ing the LLC with the S corporation.

Sale of a Partial Interest: Part One An S corporation shareholder or an LLC member can bring in another investor while retaining an owner- ship interest himself in one of two ways. In the S corporation context, the second investor can simply be issued additional stock of the cor- poration. As long as the additional stock is not considered a second class of stock (e.g., preferred stock), the S election can be maintained." Even nonvoting stock can be issued to the new investor, as long as it is common stock. 4 In this manner, more funds can be pumped into the business without the loss of opera- tional control. Regardless of the type of common stock issued, the key point to note here is that the S corporation continues in existence, albeit with another shareholder. Note, however, there are limita- tions on who may be a shareholder of an S corporation (e.g., partner- ships, corporations and nonresident aliens are not eligible shareholders). On the other hand, there is no limi- tation on who may hold an owner- ship interest in an LLC.

In the LLC context, however, the addition of another member causes the LLC to be transformed from a tax nothing, a sole proprietorship, into a partnership. Rev. Rul. 99-5 provides the current tax treatment of such an event.3 5 In that ruling, Taxpayer A is the current single member of the LLC. Taxpayer B ac- quires a 50-percent interest in the

LLC by contributing cash to the LLC. The IRS ruled that B's contri- bution is considered a tax-free con- tribution of capital to a new part-. nership under Code Sec. 721. Tax- payer A, the original member of the LLC, is considered to have contrib- uted all of the net assets of the LLC, viz., the sole proprietorship, to the new partnership under Code Sec. 721. As long as the liabilities allo- cated under Code Sec. 752 to the new member, Taxpayer B, do not

recourse mortgage of $60,000. Mike contributes $40,000 cash for a one-half interest in the LLC, which is now considered a part- nership under tax law. No gain or loss is recognized by either Chuck or Mike on their respective contri- butions. The transaction is treated as if Mike had contributed $40,000 to the new partnership, taking a ba- sis in his partnership interest of $70,000, equal to his cash contri- bution plus his share of the mort-

Figure 2

Basis of building $100,000 Mortgage transfer (60,000) One-half of partnership mortgage 30,000 Initial basis $ 70,000

exceed the tax basis of property contributed by Taxpayer A to the new partnership, the original mem- ber of the LLC, Taxpayer A, does not recognize any gain. The part- ners will take a basis in their part- nership interest under Code Sec. 722 that is equal to their tax basis in the properties contributed plus their share of partnership liabilities. Under Code Sec. 752, any liabil- ity of the former LLC is treated as a distribution of money to the former single member of that LLC, which, net of any allocation back to that member as a new partner in the new partnership, could result in taxable gain as shown in the fol- lowing example. Code Sec. 723 provides that the new partnership takes a carryover basis in the prop- erty from the LLC.

Example. Chuck is the sole mem- ber of an LLC that leases a com- mercial building to a corporate ten- ant. At a time when Mike becomes a second member of the LLC, the business entity has one asset, the rental building with a fair market value and tax basis of $100,000. The building is secured by a non-

gage. Chuck's tax basis in his part- nership interest is also equal to $70,000, computed as set forth in Figure 2.

Example. Assume the same facts as in the previous example, except that the rental building has a tax basis of $20,000 and the financing is recourse in nature. Mike's tax ba- sis in the partnership remains at $70,000, but Chuck's will be zero and he will have $10,000 of Code Sec. 1231 gain to report. The gain is equal to the $30,000 mortgage allocation to Mike, less the $20,000 tax basis that Chuck had in the building. His zero basis in the part- nership interest is computed as set forth in Figure 3. (Note: If the fi- nancing had been nonrecourse, Chuck would not have retained at least $40,000 of the debt in basis undertiertwoof Reg. §1.752-3 and the gain would be recognized.)

One distinct problem that exists in the LLC context, but not the S corporation context, is the partner- ship allocation rules under Code Sec. 704(c). This section provides that if a partner contributes prop- erty that has any unrealized gain

Passthrough Entities/May-June 2000

or loss at the time of contribution, then any subsequent sale of the property by the partnership, or its

property to Clyde, would cause a recognition of the $300,000 gain by the S corporation, but the gain

Figure 3

Basis in building $20,000 Mortgage transfer (60,000) One-half share of mortgage 30,000 Code Sec. 1231 gain 10,000 Initial basis in partnership $ 0

distribution to another partner within seven years of the contribu- tion date, requires the allocation of recognized gain or loss to the con- tributing partner in an amount equal to the unrealized gain at the date of contribution. 36 This rule does not apply to contributions to S corporations.

37

Example. Jeremy is the sole owner of a single-member LLC, whose only asset is appreciated investment land with a fair market value of $500,000 and a tax basis of $200,000. There is no mortgage on the land. At this time Clyde ac- quires a 50-percent interest in the LLC by contributing $500,000 cash. Pursuant to Rev. Rul. 99-5, this is treated as a contribution to a new partnership, and Jeremy is also treated as having contributed the land to the partnership. Jeremy's tax basis in the partnership interest is $200,000. The unrealized gain of $300,000 on the land at the date of contribution is so-called "Code Sec. 704(c) gain." Assume that the land is sold six months later for $500,000. The entire gain is allo- cated to Jeremy. A recognized gain of $300,000 also would be allo- cated to Jeremy if the LLC simply distributed the land to Clyde six months later.

The tax results in this example would not apply in the S corpora- tion context. Any subsequent sale of the property by the S corpora- tion, or even a distribution of the

would be divided equally between both shareholders.

Sale of a Partial Interest: Part Two

The alternative method is for the owner to sell a partial interest in the entity to a new party. We will look at the S corporation context first. One disadvantage here is that the sale must be of the shareholder's existing stock, which presumably is all voting stock. Thus, the new investor must be given some voting rights in the organization. But, of course, the fundamental difference between selling stock to a new investor and simply issuing new stock to the latter is that the sale of the ex- isting stock is a recognized tax- able event. S corporation stock does not qualify for the Code Sec. 1202 exclusion of one half of gain, but any long-term gain is nonetheless taxed at favorable capital gains rates. Should the sale be at a loss, the shareholder may qualify for ordinary loss treat- ment under Code Sec. 1244.38

This tax treatment surrounding the sale of the S corporation stock prevails regardless of the charac- ter of the underlying assets of the corporation. The "pierced veil" of Code Sec. 751 does not apply to S corporations.

Example. For the past 10 years, Linda has been the sole share- holder of Kent Corporation, an S

corporation. The only assets of Kent are equipment with Code Sec. 1245 depreciation recapture potential of $50,000 and inven- tory with unrealized appreciation of $150,000. If Linda sells half of her stock for a $100,000 gain, the entire gain is long-term capital gain. However, there will be no step-up in the basis of the S corporation's assets to correspond to the gain reorganized by Linda.

What are the tax conse- quences if the sole member of the LLC sells one-half of his in- terest in the LLC to another party? Rev. Rul. 99-5 also dis- cusses this scenario. In the rul- ing, Taxpayer A is the sole mem- ber of an LLC. Taxpayer A sells 50 percent of his interest to Tax- payer B. None of the purchase price is subsequently contributed by Taxpayer A to the LLC. Be- cause the single-member LLC is a tax nothing, the sale is treated as a sale by Taxpayer A of a one- half interest in each of the assets of the LLC to Taxpayer B. Code Sec. 1001 (a) causes a recogni- tion of gain or loss by Taxpayer A. Both Taxpayers A and B are then deemed to have contrib- uted their proportionate share of the assets to the new partnership.

Example. Jim is the sole member of an LLC, whose only asset is ap- preciated real estate held as inven- tory, having a fair market value of $100,000 and a tax basis of $40,000. There are no liabilities in the LLC. Jim formed the LLC sev- eral years ago. Jim now sells 50 percent of his LLC interest to Mike for $50,000 cash. The sale results in a termination of the sole propri- etorship tax entity and a formation of a partnership tax entity. Mike is considered to have purchased a one-half interest in the real estate, resulting in a tax basis of $50,000 in his share of the property. Jim isU

Life-Cycle Analysis of Single-Member Entities

considered to have sold one-half of the property for $50,000. Because one-half of the property's basis was $20,000, Jim has recognized gain of $30,000. This gain is ordinary as it relates to a sale of inventory. Mike and Jim are then considered to have contributed the real estate to the tax partnership. Mike's tax ba- sis in his partnership interest is $50,000, while Jim's is $20,000, the tax basis in the property not sold to Mike. The tax partnership takes a basis in the property of $70,000, a carryover basis from Mike and Jim. The Code Sec. 704(c) rules will govern the built-in gain inherent in the property contributed by Jim.

There is a crucial difference be- tween the S corporation and the single-member LLC in this in- stance. If the business entity were an S corporation, all of Jim's gain on the sale of his stock would have been long-term capital gain, taxed at preferential rates. There is no piercing of the veil as with the sale of partnership interests under Code Sec. 751(a). The fact that the S corporation's only asset is an ordi- nary income asset is irrelevant.

Once again, an LLC must be concerned about Code Sec. 704(c), as depicted in the follow- ing example.

Example. Continuing with the preceding example, assume that the LLC sells all the realty the fol- lowing year for $100,000. Be- cause the LLC's tax basis in the realty is $70,000, there is $30,000 of recognized gain. The gain must all be allocated to Jim under Code Sec. 704(c). Jim would still have to recognize $30,000 of recog- nized gain, even if the LLC simply distributed the real estate to Mike, pursuant to the provisions of Code Sec. 704(c)(1)(B). If the business entity had been an S corporation, any gain must be equally allocated to Jim and Mike.

Sale of the Entire Interest in the S Corporation If an S corporation shareholder sells her entire stock in the S cor- poration at a gain, capital gain re- sults. If the stock has been held for more than one year, then the gain is taxed at preferential long-term capital gain rates. Should the stock be sold at a loss, some of the loss may be ordinary under Code Sec. 1244. The character of the underlying assets of the corpora- tion are irrelevant.

Example. For the past 10 years, Linda has been the sole shareholder of Kent Corporation, an S corpora- tion. The only assets of Kent are equipment with Code Sec. 1245 depreciation recapture potential of $50,000 and inventory with unre- alized appreciation of $150,000. If Linda sells all of her stock for a $200,000 gain, the entire gain is long-term capital gain.

Operating the business via S cor- poration status offers a distinct ad- vantage to the owner should she wish to report the sale of the stock on the installment method. A recent amendment to Code Sec. 453 dis- allows the use of the installment method to accrual-method taxpay- ers. 39 Because the typical S corpo- ration shareholder will almost al- ways be a cash-method individual, this new law presents no problem. The cash-method shareholder is still eligible for installment reporting, even if the corporation whose stock is owned is accrual-method.

Example. Assume that Linda sells all her stock in Kent Corporation, an accrual-basis taxpayer. The sales price is $500,000 and she has a basis of $300,000 in the stock sold. The terms of the sale require the buyer to pay Linda the entire $500,000 sales price in three years, together with annual interest pay- ments (at the applicable federal rate) on the unpaid balance. Un-

less Linda elects to report all of the gain in the year of the sale, she can use installment reporting and report the entire $200,000 gain three years later, when collection of the sales proceeds are made.

Under the new legislation, it is doubtful whether the use of the in- stallment method is available to the owner of the single-member LLC that uses the accrual method. As discussed, the LLC is a tax noth- ing, so that what is being sold, for tax purposes, is not an interest in a separate tax entity but the single member's direct interest in the un- derlying business assets. If the busi- ness is an accrual-method entity, then it can be argued, at least for purposes of this sale, the owner of the single-member LLC is also ac- crual-method and not eligible for installment reporting. The fact that the owner's overall method of ac- counting as an individual is cash- method may not be controlling. Whether or not this was the true intention of Congress in drafting the amendment to Code Sec. 453 will just have to wait until future inter- pretations of the law are promul- gated by the IRS.4 ° In the following discussion, we assume that the LLC member is not allowed to use the installment method.

Sale of the Entire Interest in the LLC

Rev. Rul. 99-5, discussed previ- ously, would also apply to the sale of an entire interest in the LLC. Because the LLC is a tax nothing, the sale is treated as an underlying sale by the sole mem- ber of the assets of a sole propri- etorship. The character of the gain or loss to the member depends on the type of assets sold.

Example. George has operated a successful retail operation for many years as a sole proprietor- ship that was converted recently

Passthrough Entities/May-June 2000

Figure 4

to a single-member LLC. Because inventories are a material factor in the business, it has always used the accrual method to report its sales. There are no liabilities, and the assets of the business are as set forth in Figure 4. The goodwill represents an internally gener- ated intangible asset, which is the result of George's "sweat equity."

If the business were operated as an S corporation and George's stock basis were $500,000, a sale of the corporate stock for $900,000 would generate a long-term capi- tal gain of $400,000, subject to a maximum tax rate of 20 percent. The tax that George pays on this gain is $400,000 x .20 = $80,000. Such is not the result if George sells his entire interest in the LLC for $900,000. George's gain is indeed still $400,000, but its character must be determined by looking at the underlying assets of the business. For example, the tax rate on the gain from the sale of the building will be 25 percent, as it represents so-called "unrecaptured Code Sec. 1250 gain." In summary, George has the amounts and character of gain to report as set forth in Figure 5. We shall assume for the moment that the entire sale was for cash and that George is in the 40-percent federal tax bracket for purposes of ordinary income.4 1

If George is in the 40-percent tax bracket, the total tax paid by

him is $31,000 higher than if the business had been sold by means of a sale of S corporation stock. In this instance, the single-mem- ber LLC represents a distinct dis- advantage compared to the S cor- poration. (However, the sale of S corporation stock does not pro- duce a basis step-up in assets to the buyer. A Code Sec. 338(h)(1 0) election could be made which would produce the same tax re- sults as the sale of the interest in the single-member LLC.)

There is another disadvantage to consider as well. Suppose that George had sold his entire inter- est in the LLC by means of an in- stallment sale rather than for $900,000 cash. The terms of the sale require the buyer to pay George a single payment of $900,000 in five years, with an- nual payments of interest (at the applicable federal rate) on the un- paid balance of the note. Before Code Sec. 453 was amended by P.L. 106-170, George could usethe installment method to report the $100,000 capital gain on the sale of the goodwill as well as the $180,000 total gain on the sale of the land and building. Even be- fore its recent amendment, Code Sec. 453 required, with certain exceptions, that ordinary income on the sale of the inventory and equipment be reported in the year of the sale.

As noted above, Code Sec. 453 no longer permits accrual-method taxpayers to use the installment method. Even though George is a cash-method individual, the busi- ness uses the accrual method. Al- though not entirely clear, George may be considered an accrual- method for purposes of the sale of the business assets. If such were the case, the entire gain of $400,000 must be reported in the year of the sale, even though cash collection of the sales price will not occur for five more years. This somewhat harsh treatment of George, if this is the correct inter- pretation of amended Code Sec. 453(a), represents another disad- vantage of the LLC as opposed to the S corporation.

Liquidation of the Entity The worth of money is not in its possession, but in its use-Aesop, The Fable of the Miser

The final stage of our life-cycle analysis is a discussion of the tax consequences of liquidating the S corporation or the LLC. In this context, the LLC appears to be the superior vehicle, especially if the corporation has appreci- ated assets to distribute at liqui- dation. This is because Code Sec. 336(a) requires the S corporation to recognize gain or loss on the distribution of property to its shareholders. This recognition, of course, flows through to the shareholder for reporting on the latter's own tax return. More- over, Code Sec. 331(a) requires the shareholder to recognize gain or loss on the redemption of his stock in exchange for the distributed property. We address only the more interesting sce- nario where gain is recognized.

Ul

Life-Cycle Analysis of Single-Member Entities

The passthrough of gain on the distribution of the property requires a corresponding increase to the shareholder's stock basis, which eliminates double taxation of this gain. Still, the redemption of the shareholder's stock at liquidation is yet another recognition event to the shareholder. The recognized gain or loss is equal to the fair market value of the property re- ceived less the shareholder's ba- sis in the corporate stock. Under Code Sec. 334(a), any noncash property received takes a basis in the shareholder's hands equal to the property's fair market value. The shareholder's holding period in the property begins anew. There is no tack on of the holding period from the corporation.

Example. Danny is the sole share- holder of an S corporation. The corporation's only asset is appreci- ated real estate, which is inventory to the corporation. The fair market value of the inventory is $200,000 and its tax basis is $120,000. When Danny decides to liquidate the S corporation, his tax basis in his S corporation stock is $90,000. In complete liquidation of the corpo- ration, Danny exchanges all his corporate stock for the real estate. The distribution causes the corpo- ration to recognize $80,000 of or- dinary income, as it involves the exchange of inventory. This $80,000 is passed through to Danny for reporting on his own tax return. The $80,000 gain also in-

creases Danny's stock basis from $90,000 to $170,000. At this point, he must now consider his own end of the exchange. He has received property with a fair market value of $200,000 in full redemption of his corporate stock, which has a tax basis of $170,000. Thus, Danny has $30,000 of capital gain to re- port from the redemption of his stock. Danny's tax basis in the dis- tributed real estate is $200,000. Danny's amount and character of gain would not be altered if the cor- poration sold the land to an unre- lated buyer for $200,000 cash and then distributed the cash to Danny in complete liquidation of this stock. The corporate gain of $80,000 would still pass through to him as ordinary income, in- creasing his stock basis to $170,000. The receipt of the $200,000 cash in exchange for his stock generates, again, $30,000 of capital gain.

Because a single-member LLC is a tax nothing, the liquidation of the LLC follows the same tax ac- counting pattern as the dissolution of a sole proprietorship. In other words, there is no liquidation to speak of, at least not in a tax ac- counting sense. The owner of the single-member LLC, being in es- sence a sole proprietor, has never actually been severed, tax-wise, from the ownership of the LLC as- sets. The formal ownership of title to all the assets being held by the LLC under state law is ignored for

tax purposes. The dissolution of the LLC under state law occurs, and the transfer of formal title to the assets to the LLC member does not cause any recognition of gain to anyone. The tax basis of any asset held by the LLC simply carries over to the owner and the holding period carries over as well. Con- sider the following example, which repeats the facts from the previous example, except that the business entity is now a single- member LLC.

Example. Danny is the sole owner of a single-member LLC. The LLC's only asset is appreci- ated real estate, which is inven- tory to the LLC. The fair market value of the inventory is $200,000 and its tax basis is $120,000. Danny decides to dis- solve the LLC. In a complete dis- solution of the LLC, Danny is dis- tributed the real estate. There is no recognized gain in this in- stance because it is treated as a termination of a tax nothing (i.e., a sole proprietorship). For tax purposes, Danny has always owned the assets of the LLC. Therefore, his tax basis in the real estate is $120,000, and his holding period in the real estate relates back to when the prop- erty was acquired by the LLC.

Changing to C Corporation Status

As a final note, a comment should be made on the tax consequences

Figure 5

Asset Gain Character Tax Rate on Gain Tax on Gain Inventory $ 80,000 Ordinary 40% $32,000 Land 40,000 Code Sec. 1231 20 8,000 Building 140,000 Code Sec. 1250 25 35,000 Equipment 40,000 Code Sec. 1245 40 16,000 Goodwill 100,000 Capital 20 20,000 Total $400,000 $111,000

Passthrough Entities/May-June 2000

of not terminating the business it- self but simply altering its legal form to that of a C corporation.

In some circumstances it may be advantageous not to operate as a passthrough entity. For ex- ample, if the taxpayer-owner is in the highest marginal tax bracket while the business entity is earn- ing less than $100,000 per year and all of the earnings are plowed back into the business rather than distributed to the owner, C corpo- ration status may generate more tax savings over the life cycle of the business. This is especially true if the owner never intends to bail out the corporate earnings, which would be taxed to him as divi- dends, but simply to hold the cor- porate stock until death and then pass it to his heirs who would re- ceive a step-up in the stock's tax basis to its fair market value un- der Code Sec. 1014(a). The heirs could then sell the stock generat- ing little if no gain, effectively getting the accumulated earnings out of the corporation at no in- come tax cost. There would, of course, be estate tax consider- ations to ponder.

For whatever reason the owner may have for changing to a C cor- poration, it would be advisable to know the tax consequences of the changeover from either S cor- poration status or LLC status. The switch from S corporation status merely requires that the owner

file a voluntary revocation of the S election with the IRS.42 The cor- poration continues with the same tax basis in its assets, and the shareholder continues with the same tax basis in his stock that he had with the S corporation. There is no implied liquidation of the S corporation with a par- allel transfer of the net assets to the C corporation.

On the other hand, the switch from a single-member LLC cur- rently regarded as a tax noth- ing to a single-member LLC taxed as a corporation does have tax consequences. The owner of the LLC does not have to dissolve the LLC and form a new legal entity under state law, however. The switch to C corporation status merely re- quires a literal checking of the box on Form 8832, Entity Clas- sification Election, and filing the form with the IRS.43 However, on the first day of the first C cor- poration year, the single mem- ber of the LLC is treated as hav- ing incorporated his sole propri- etorship under Code Sec. 351. As explained in the first part of our life-cycle analysis, there is potential for gain recognition if liabilities of the LLC exceed the tax basis of the property at the time of the conversion.

Example. Colleen operates a rental complex as a single-mem- ber LLC that elects to be taxed

as a C corporation. At the time of the election, the tax basis of the LLC's only asset, the rental property, is only $100,000, while the mortgage on the prop- erty is $150,000. Colleen will have to recognize $50,000 of gain due to the election.

Conclusion The best advice may come too late-Aesop, The Fable of the Doctor and his Patient

An individual owner's decision to operate as either a single- shareholder S corporation or as a single-member LLC must be based on all of the facts pertinent to that individual. Still, from the preceding discussion, it is diffi- cult to give the nod to the S cor- poration. Unless the owner is currently operating the business as a C corporation and is con- templating the switch to either an S corporation or an LLC, or wishes to form and operate a single-member LLC only until additional members can be brought in as investors, most of the issues discussed here show more flexibility and more advan- tageous tax consequences for a single-member LLC. Only the fu- ture can tell us if the single-mem- ber LLC begins to supplant the single-shareholder S corporation as a method of conducting busi- ness operations.

ENDNOTES

1 All quotations in this article are taken from THE FABLES OF AESOP (New York: The Book of the Month Club, Inc., 1995).

2 Respectful apologies to the great French philosopher of the 18th century who with- out question did not have U.S. tax law in mind. The two most recent states to allow single- member LLCs are Tennessee and Califor- nia. See Tenn. Code §48-203-102 and Cal. Corp. Code §17000 through §17705. The

California statute is effective beginning January 1, 2000. Tennessee law.was ef- fective as of June 14, 1999. As of this writ- ing, only Massachusetts and the District of Columbia specifically require that an LLC have at least two members. Reg. §301.7701-2(a). Reg. §301.7701-3(a). For example, in the state of Florida, the LLC must file articles of organization, which require a filing fee of $100. More-

over, an annual report must be filed with the state, with payment of an annual fee of $50. Fla. Stat. ch. 608.452. In Michi- gan, the LLC must also file articles of or- ganization with the state, along with a $50 filing fee. The annual report that must be filed with the state must be accompa- nied by a fee of just $5. Mich. Comp. Laws §450.5101.

7 If the activity is considered a sole propri- etorship, the taxpayer must report the op-

U7

Life-Cycle Analysis of Single-Member Entities

ENDNOTES

erations on Schedule C of Form 1040. If the operations constitute rental activity, then a Schedule E must be filed with the Form 1040.

8 Of course, cash itself is boot, but in the context of an incorporation of a single- shareholder corporation, it is unlikely that the corporation would be distributing any cash to the shareholder.

I Code Sec. 1366(d)(1)(B) also allows the shareholder to deduct losses to the extent the shareholder has made any loans di- rectly to the S corporation.

10 We are assuming here that the at-risk limi- tations of Code Sec. 465(a) do not come into play. As this example depicts a real estate operation securing a nonrecourse mortgage, Code Sec. 465(b)(6) should ap- ply. Code Sec. 465(b)(6) treats the mort- gage as qualified nonrecourse financing (assuming the funds were borrowed from a qualified lender), providing the taxpayer an at-risk amount for the entire financing.

11 To the extent the shareholder assumes a corporate liability or takes property sub- ject to a liability, the amount realized on the redemption of the stock, and thus the corresponding gain, is reduced.

11 Code Sec. 291(a) will cause up to 20 per- cent of prior depreciation on the building to be classified as ordinary income. The remainder of the gain is Code Sec. 1231 capital gain. If there are no capital losses to net against the Code Sec. 1231 capital gain, the Code Sec. 291 (a) rule is irrel- evant because corporations do not have any long-term capital gains tax prefer- ence.

13 If the stock qualifies as Code Sec. 1202 stock, only $200,000 of the gain is recog- nized, but it is taxed at 28 percent. The tax to Jacob in this instance is $200,000 x .28 = $56,000. Note, however, that 42 per- cent of the $200,000 excluded gain is a tax preference item.

14 The single shareholder of an S corpora- tion and the single member of an LLC are treated in virtually identical fashion when it comes to the issue of fringe ben- efits. This close proximity exists because Code Sec. 1372 treats a more than two- percent S corporation shareholder the same as a general partner. The tax ac- counting for partners (and the S corpo- ration shareholder) closely approximates the tax result that applies to sole propri- etors. For example, premiums paid for medical insurance are deductible by the S corporation but included in the income of the shareholder, who then can deduct a portion of the premiums (60 percent in Year 2000) in computing adjusted gross income on Form 1040. This generates the same result as a sole proprietorship,

which is allowed no deduction on Schedule C for the payment, but, of course, no inclusion of the payment in the sole proprietor's gross income. The sole proprietor can then deduct a por- tion of the payment (60 percent in Year 2000) in computing his or her adjusted gross income.

15 Rev. Proc. 74-33, 1974-2 CB 489. 16 Reg. §1.446-1(c)(1)(ii). 17 Note, however, the requirement of using

the accrual method, if the entity is a "tax shelter" under Code Sec. 461(i)(3). This definition goes well beyond whether in- terests in the entity have been offered to sale in any offering required to be regis- tered under federal or state security agen- cies and extends to entities generating losses where there are nonparticipating owners holding significant interests.

11 Rev. Rul. 59-221, 1959-1 CB 225. 19 J. Radtke, S.C, DC-Wis., 89-2 USTC !H9466,

712 FSupp 143, aff'd per curiam, CA-7, 90-1 USTC 950,113, 895 F2d 1196; Spicer Accounting, Inc., CA-9, 91-1 usTc 9 50,103, 918 F2d 90.

2 IRS Chief Counsel Advice 199922053. 1 See Reg. §1.469-5T for these standards.

See, e.g., D. Leavitt Est., CA-4, 89-1 usTc 19332, 875 F2d 420, aff'g 90 TC 206,

Dec. 44,557, cert. denied, 493 US 958, 110 SCt 376. Reg. §1.465-27(b)(5) provides an at-risk amount for the member of a single-mem- ber LLC, even if the LLC borrows money on a recourse basis to finance the real estate activity. Because the debt is nonre- course to the member, it is "qualified nonrecourse financing" for that member and provides an at-risk amount.

24 Code Sec. 465(b)(2)(A); Proposed Reg. §1 .465-24(a)(2); Proposed Reg. §1.465- 25(b)(1 )(I). Proposed Reg. §1.465-6(d).

2 M.W Melvin, 88 TC 63, Dec. 43,632, aff'd per curiam, CA-9, 90-1 USTC 950,052, 894 F2d 1072; S.H. Bennion; 88 TC 684, Dec. 43,801; S.J. Gefen, 87 TC 1471, Dec. 43,600.

1 LTR 199807013 (Nov. 13, 1997). Also, in LTR 199911033 (Dec. 18, 1998), the IRS ruled that a two-member LLC, act- ing as a bankruptcy-remote entity, could receive the replacement property. The LLC was established to protect the in- terest of the creditor that had advanced funds to acquire the replacement prop- erty. The second member of the LLC had no proprietary interest in the LLC and served as a member of the LLC direc- torship solely to safeguard the interest of the creditor. LTR 199945038 (Aug. 18, 1999).

Rev. Rul. 75-292, 1975-2 CB 333.

The IRS ruled, in LTR 199909054 (Dec.

3, 1998), that a qualified Subchapter S subsidiary (Qsub) is a "tax nothing" and, therefore, can hold the replacement property that its parent S corporation ac- quired in a Code Sec. 1031 exchange or Code Sec. 1033 involuntary conver- sion. Of course, the parent S corpora- tion could also form a single-member LLC to achieve the same purpose.

31 As of January 1, 2000, these states were New Hampshire, Tennessee, Texas, Wash- ington and Wyoming. As of January 1, 2000, these states are Michigan, Texas and Washington. Code Sec. 1361(b)(1)(D).

4 Code Sec. 1361 (c)(4). Rev. Rul. 99-5, IRB 1999-6. Code Sec. 704(c) also applies to any unre- alized losses at the time of contribution. Code Sec. 737(a), discussed in footnote 37, infra, applies to only unrealized gains.

' If the property is distributed to another part- ner more than seven years after the contri- bution, the precontribution taint is erased, and no allocation of recognized gain is made to the contributing partner. Code Sec. 737(a) also provides that if, within seven years of the contribution of the original prop- erty, any property is distributed to the con- tributing partner (as opposed to the origi- nally contributed property), recognized gain still must be reported by the contribut- ing partner. A full discussion of these issues is beyond the scope of this article.

' The assumption here, of course, is that the sale is not to a related party, as defined by Code Sec. 267(a). In that instance, the seller of the stock would not recognize the loss. Any suspended loss carries over to the related-party buyer, who may use the loss when the person sells the stock to an unrelated party. Code Sec. 453(a), as amended by Sec. 536(a) of the Tax Relief Extension Act of 1999 (P.L. 106-170).

' The IRS has issued Notice 2000-26, 2000- 17 IRB 1, which provides initial guidance on the new law.

41 The highest marginal rate has been rounded from 39.6 percent to 40 percent for the sake of simplicity. Still, this is not without practical application, as the phase-out of itemized deductions and ex- emptions for high-income taxpayers makes their effective marginal rate higher than the statutory rate.

4 Code Sec. 1362(d)(1). 41 Reg. §301.7701-3. The election is effec-

tive on the date filed. The taxpayer can choose another effective date, as long as the effective date is not earlier than 75 days before the election is filed, nor later than 12 months after the election is filed.