Tax Basis of the Owner's Equity Interest

April 13, 2006

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How taxable allocations of income and interests are figured depends on a number of factors when strategically funding the business.

Where only cash or services are contributed to an entity, in return for an equity interest, the tax basis of the owner's equity interest will be the same as the fair market value of the equity interest. In other cases, the two amounts will be different. The differences can have important ramifications, especially when dividing income among the owners.

The initial tax basis of the owner's equity interest is equal to the initial cash plus the tax basis of non-cash property contributed to the entity, subject to adjustments when non-cash property with a liability is contributed to a limited liability company (LLC).

Note that, when non-cash property is contributed, the tax basis of the owner's equity interest is based on the owner's tax basis in the asset contributed. This tax basis is carried over. It is equal to the owner's original cost in the asset, plus the cost of any capital improvements the owner made to the asset, minus any depreciation he took on the asset. With property that has appreciated (or depreciated) in value, or that has been depreciated, this tax basis will usually be different from the fair market value of the property.

The entity also uses this same carryover tax basis in the acquired property for purposes of determining its depreciation, and gain or loss. Also, the holding period for the property, for capital gains purposes, includes the contributing owner's holding period.

If the owner sells his business interest, the gain or loss is determined by subtracting the tax basis for the equity interest from the proceeds received from the sale.