Case Study: Tax Implications of Funding Decisions

April 13, 2006

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John, Peter and Amy form a limited liability company (LLC). John contributes a building with a tax basis of $80,000 and a fair market value of $170,000. The contributed property was subject to a liability, and the LLC assumes this $60,000 mortgage liability on the building.

John's tax basis in the LLC normally would be the basis of the property he contributed--$80,000. This would have been his original cost for the building, plus the cost of any capital improvements he made to the building, such as a new roof, minus any depreciation he took on the building. Depreciation will only be an issue where the asset has been used for business purposes prior to the contribution.

However, the $60,000 liability assumed by the LLC must be allocated among all the owners, including John. Thus, the tax bases of John, Peter and Amy in the LLC will be increased by $20,000 each.

In addition, John's basis must be decreased by the other owner's allocable share of the liability ($40,000). Thus, John's final basis in the LLC is $60,000 ($80,000 + $20,000 - $40,000).

Note that John would have recognized a gain on the contribution if, and to the extent, the mortgage liability exceeded John's basis in the building. Here, no gain is recognized because the liability of $60,000 is less than John's basis of $80,000 in the building.

Remember Peter and Amy would each increase their tax basis for their investment in the LLC, by $20,000 each. The LLC would have a carryover basis of $80,000 for the building on its books.

Finally, if this were a corporation, John's tax basis for his ownership interest would be $20,000 ($80,000 tax basis for contributed asset less liability of $60,000). Note how, in the corporation, when the entity assumes the liability, there are no adjustments to the bases of the other owners.

Note that the building has a fair market value of $170,000. This would be determined by an appraisal or any other reasonable estimation of its current value based on estimated selling price or, perhaps, replacement value.

Had John contributed $170,000 of cash, or services with a value of $170,000, the tax basis of his owner's equity interest would be the same as the fair market value contributed--$170,000.

The fair market value John contributed, and thus the fair market value of the owner's equity interest, is $110,000 ($170,000 less $60,000). Note how this differs from John's tax basis of the owner's equity interest, which is $80,000 before adjustment and $60,000 after adjustment.

This difference can lead to misunderstandings when profits are divided among the owners because John really contributed something of value to the LLC worth $110,000.

It wouldn't be fair to give him credit, for purposes of division of profits or voting, for only the $60,000 tax basis he will have in his ownership interest.

So his owner's equity account, in the LLC's accounting system, should be credited for the fair market value contributed.

The building has a value of $170,000, and the liability assumed by the LLC amounts to $60,000. Thus, the entry for the accounting system would be:

Building FMV	$170,000
John's Owner's Equity for Contribution	$110,000
Liability on Contribution	$60,000

This way of recording requires that a separate tax record for the building be established, as the LLC's tax basis for the building will be $60,000 (i.e., the carryover basis from John). This is the amount that must be used for purposes of depreciation, and calculation of gains or losses on the sale of the building by the LLC.

A separate record of the owner's capital accounts, based on tax basis, also will be maintained outside the accounting system. This record will reflect only the following adjustments: an increase in John's account for $80,000, his tax basis after adjustment, and an increase in the accounts for each of the two co-owners of $10,000 based on the liability adjustment.

Thus, the entry would be:

Building	$80,000
John's Owner's Equity for Contribution	$60,000
Peter's Additional Owner's Equity	$10,000
Amy's Additional Owner's Equity	$10,000

This way of recordkeeping ensures that the building is recorded for the amount that can be depreciated (i.e., the carryover basis from John). However, in this tax-based approach to recording, the liability is not recorded, as it is accounted for as an adjustment to the owner's equity accounts. This makes it difficult to account for the payments by the LLC on the liability, in the LLC's accounting system.

This separate record will not dictate division of profits and voting in the LLC.

A separate record of the owner's capital accounts, based on fair market value, would be maintained outside the accounting system. This record will reflect only one adjustment: an increase in John's account for $110,000, the real value he contributed. No adjustments are made here for the co-owners, as the $60,000 liability is simply subtracted from the value of the building, $170,000, and John is given credit for only the true value contributed, $110,000.

This separate record will dictate division of profits and voting in the LLC.

Finally, for the sake of simplicity, the business could forego keeping the separate set of records based on fair market value, as these are not required for tax purposes. Division of profits and voting in the LLC could then be based on the relative tax basis of the owner's equity interests. As previously discussed, this is usually not desirable, as it produces inequitable results.

The one exception might be where present and planned future contributions will only be in the form of cash or services. There, of course, the tax basis of the owner's equity interest and fair market value of the owner's equity interest will be equal. Even here, however, because of the possibility of future non-cash contributions, the best alternative will usually be to record, and allocate income and voting, based on fair market value.

Moreover, keeping records in the accounting system based on the fair market value of the owner's equity interest is a better approach from an asset protection perspective, too. The net amount of the asset recorded (asset minus liability) in the LLC's accounting system is $110,000, which is the true value of John's contribution.

This amount also is much larger than the $80,000 that would be recorded, under the tax basis alternative.

The additional amount of net assets has a beneficial effect on the calculation of liquidity and solvency. This additional amount will make it less likely that transfers from the business will be deemed fraudulent.

This fair market value approach also is consistent with generally accepted accounting principles.