Exam No. 4884

Upon formation of the LLC, the contribution by L & M of 50K each of cash is treated as a non-taxable event under § 721 to L & M. The receipt of the contribution is also non-taxable as to the LLC. Under § 722 the outside basis in the LLC that L & M have is equal to the basis of the property contributed. Here, each gave 50K of cash so they have 50K of outside bases in the LLC. The LLC has an inside basis under § 723 equal to the basis of the money contributed by the members. The LLC's inside basis is 100K.

When the debt is borrowed by the LLC it is unsecured. Although referred to in the facts as recourse as to LM it is a loan to an LLC and is non-recourse. However, Mort has personally guaranteed the debt and it is recourse as to him. Under the recourse regs at 1.752-2 the test to determine which partner shares in the recourse liability is based on a "doomsday" scenario. The partner that hears the economic risk of loss for a psp liability to the extent that if the partnership constructively liquidated, the partner would be obligated to make a payment to any person and the partner would not be entitled to reimbursement. Under a scenario of constructive liquidation all of the following occur:

• All psp liab. become payable in full
• All the psp assets, including cash, have no value
• The psp disposes of all prop in a taxable transaction for no consideration
• All items of income, gain, loss and ded. are allocated among the partners and
• The partnership liquidates.

Under the agreement Lil is required to turn over any funds received in exchange for personal services they have performed in the past, present, or future. In order to avoid any shifting of income to the other partner of the LLC for earnings prior to her agreement, when she receives and signs over she will be making a § 721 tax free contribution to the partnership. She will get a basis in the LLC for an additional 5K. The LLC is not considered to have any income because it was earned prior to Lil becoming a member. Lil, individually will be taxed, as ordinary income, on the 5K payment. The capital contribution will increase her basis and capital account and raises her interest on liquidation. Since the agreement specifies the sharing of income and loss items this added capital will not affect. The split will be honored since the agreement has the two economic effect requirements and the QIO and the 50/50 split will be treated as substantial. To allow the LLC to take the income would violate the assignment of income doctrine. The treatment as income on LM's books is not appropriate. Unlike in the Schneer case, this income was earned prior to the assignment of income to LM.

After the first year of operation the "LM" has $150,000 of losses from operations. The agreement calls for the losses to be split 50/50 and under § 702 the losses will pass out to each member. Each member's basis will decrease under § 705. Lil, however, only has 50K of basis in the partnership. She does not have a negative basis restoration agreement - only a QIO. Accordingly, she only will receive 50K of deductions and the balance or 100K will go to Mort who has all of the debt basis.

Even though the allocations pass through to the partners. An LLC is potentially (still open) a per se passive entity and the passive activity rules under § 465 may limit the loss being passed to the two members. Potentially they can argue they materially participate in the LLC and are involved on a regular, continuing and substantial basis and that it is not passive but it is still a risk to be aware of.
 

Created by:  bojack@lclark.edu
Update: 31 May 03
Expires: 31 Aug 04