Taxable Disguised Sales

April 13, 2006

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Certain contributions made for ownership interests may be taxable events.

Normally, the owner acquires an equity interest in the entity by contributing money, other property or services to the entity through strategic funding practices. In return, he receives only his equity interest.

If in addition to his equity interest he receives cash or other property, he really has made a taxable sale of the property to the entity (what the IRS terms a "disguised sale"). This ordinarily should not affect the small business owner, as it would be unusual for an owner to take back anything except the equity interest itself.

In addition, the IRS has a "safe harbor" rule for partnerships, which provides that a contribution will not be treated as a disguised sale when a distribution is made to the owner more than two years after a contribution. This exception also should apply to limited liability companies (LLCs).

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If the owner of an LLC receives a distribution within two years after his contribution, he must be able to prove it was not consideration paid for a sale of the asset to the entity. This can be done by showing the distribution was for compensation, lease or loan payments, etc.