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H/W LLC Converting to SMLLC by Gift

Technical topics regarding tax preparation.
#1
Chay  
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Client is a husband and wife LLC taxed as a partnership. On 12/15/2018, husband gives his entire ownership interest in the partnership to his wife, converting it to a disregarded entity.

I originally thought that I should show the wife's capital account moving to 100% of the company's capital, but then I stumbled across Revenue Ruling 99-6. Based on the ruling, it seems like anytime a partnership terminates, all partners are treated as receiving a liquidating distribution of their capital account, meaning that all capital accounts would always be at $0 when a partnership terminates regardless of the way it terminates.

Here is how I think the conversion should be treated:

  1. Transactions occurring on 12/15 are considered partnership transactions if they happen prior to the moment that the gift was made and go on the new Schedule C if they happen after that moment.
  2. Normal depreciation figures are multiplied by (11.5/12) before making it to the return.
  3. The Schedule C for the new SMLLC treats depreciable property as having been newly placed in service that year with the depreciable lives reset. Because there is no short year on the 1040, the mid quarter convention is applied.
  4. All property is shown in box 19 of Schedules K-1 as being distributed proportionately to husband and wife.
  5. Columns (c) and (d) of Schedule L and ending capital accounts on Schedule K-1 all have $0 due to everything being distributed.
Is this correct?

Anything else peculiar to this situation I may be missing?

Thanks in advance for your confirmation or your suggestions.
 

#2
Nilodop  
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I wrote this in response to your first version of this thread.
I can't help much on the forms and lines, etc., but I do want to raise two points, at least to get a discussion going.

First, and probably quite minor, I'm not sure that the moment a gift is made is the cutoff for transactions pre- and post-gift. I'll take a look, but my non-researched thought is that the cutoff is either the end of the day before the gift, or the end of the day of the gift. Probably of little to no significance, especially if they file MFJ.

The more intriguing question is whether there are any hot assets in. the partnership, particularly section 1245 assets, and whether there are any liabilities being assumed by W, maybe even liabilities that created negative capital. If there is negative capital of H, let's say (100k) and liabilities of H assumed by W of say 150k, there'd be a gain of 100k. Typically we don't worry about gain on transactions between spouses because section 1041 says it's not recognized, and that it's treated as a gift (which of course your transaction is anyway, but for section 1001 and reg. 1.1001-2(a).). But then we have the interaction among 731, 751, and 1245. 731(d) says that 731 does not apply to the extent otherwise provided by section 751. In turn, 751 says that hot assets include 1245 assets, and 1245 says it applies
notwithstanding any other provision of
Subtitle A. So does all this mean there's a recognized gain?

Also, upon re-reading, I don't see any description of the nature of the partnership and its assets. For instance, was it essentially a partnership that invested in marketable securities? If so, 731 has rules that might cause gain to be recognized, but probably that gain is excluded by 1041.

P.S. I just took a look at some regs., and I think income through the end of the date the partnership terminates (date of gift) is included in the final partnership return.
 

#3
Chay  
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Nilodop wrote:The more intriguing question is whether there are any hot assets in. the partnership, particularly section 1245 assets, and whether there are any liabilities being assumed by W, maybe even liabilities that created negative capital.

There are no liabilities held by the partnership. There were credit cards involved, but these were held by the individual partners and the partnership reimbursed the partners for the relevant expenses. There are plenty of section 1245 assets.

There's one thing I'm not clear on, however: is an asset expensed under the de minimis safe harbor that would otherwise be a 1245 asset considered to be a 1245 asset? Section 1245(a)(3) defines such property as "any property which is or has been property of a character subject to the allowance for depreciation provided in section 167", and section 167(a)(1), in turn, says the section applies to "property used in the trade or business". So either it stops there and the DMSH property is 1245 property, or else we go one step further and say that the DMSH has prevented the item from being treated as "property" for tax purposes (because it may not be capitalized) until and unless the item is actually sold, and that the ephemeral sale-only property cannot be subject to an allowance for depreciation. This second interpretation would be consistent with the 100% ordinary income treatment on sale.

Typically we don't worry about gain on transactions between spouses because section 1041 says it's not recognized, and that it's treated as a gift (which of course your transaction is anyway, but for section 1001 and reg. 1.1001-2(a).). But then we have the interaction among 731, 751, and 1245. 731(d) says that 731 does not apply to the extent otherwise provided by section 751. In turn, 751 says that hot assets include 1245 assets, and 1245 says it applies
notwithstanding any other provision of
Subtitle A. So does all this mean there's a recognized gain?

Section 1245(b)(1) provides that "Subsection (a) shall not apply to a disposition by gift", and subsection (a) is what defines section 1245 property. So if I'm reading this correctly, then property doesn't become "section 1245 property" until it is disposed of in a certain way, and so gifted property, even though used in a trade or business, cannot be section 1245 property and therefore cannot be subject to section 751.

There's still the issue of the liquidating distributions that happen to the partners. On further examination of Revenue Ruling 99-6, I've noticed that the liquidating distribution treatment only applies from the wife's perspective - from the husband's perspective there is a disposition of partnership interest. So I guess this only applies to the wife, and there are no distributions listed on the K-1 for the husband?

Anyways, it doesn't seem like the wife would have to recognize any income on distribution, since there is no exchange for other property and no redemption for partnership interest under section 751(b).

Also, upon re-reading, I don't see any description of the nature of the partnership and its assets. For instance, was it essentially a partnership that invested in marketable securities? If so, 731 has rules that might cause gain to be recognized, but probably that gain is excluded by 1041.

The assets consist of cash, 1245 property, and DMSH property. Section 179 was applied to one item of property. Partnership was in the trade or business of printing.

P.S. I just took a look at some regs., and I think income through the end of the date the partnership terminates (date of gift) is included in the final partnership return.

Which regs?
 

#4
Chay  
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I found these two opinions regarding the presentation on the 1065:

If your business is set up as a partnership, then whenever there is a change in who the partners are, there's technically a dissolution of the old partnership and a creation of a new partnership that includes the new partners. That raises the question of whether you have to zero out the balance sheet of the old partnership.

Tax regulations aren't clear, and there's disagreement on how best to account for this. Some zero out the balances as they would with any dissolution. Others prefer to keep the old account balances immediately prior to dissolution and transfer those numbers to the new partnership directly. In the absence of more definitive guidance from tax authorities, it's probably safest to go ahead and zero out balance sheets regardless.

https://www.fool.com/knowledge-center/d ... ar-re.aspx

The tax return of the old partnership should have the technical termination and final return boxes checked. Since, upon the technical termination of a partnership, it is deemed that the old partnership contributes all of its assets and liabilities to the new partnership, it is recommended that the ending balance sheet of the old partnership be zeroed out. A statement should be attached to the tax return explaining the transaction(s) that triggered the technical termination and showing what the ending balance sheet was immediately prior to the partnership termination. The Schedules K-1 of the partners of the old partnership should reflect zero ending capital accounts and should be marked final.

https://www.thetaxadviser.com/issues/20 ... erest.html

It seems there is some level of consensus for $0 on the Schedule L and capital accounts in the final year regardless of how the partnership terminated.

There's still a question on the "distributions" shown on Schdule K-1. Right now I'm thinking the wife shows her entire 52.5% share of the partnership's assets as distributed and the husband shows nothing due to the split treatment provided in Revenue Ruling 99-6.
 

#5
Nilodop  
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There's lots to discuss here, and I can't help much on the forms and lines, etc.

There's one thing I'm not clear on, however: is an asset expensed under the de minimis safe harbor that would otherwise be a 1245 asset considered to be a 1245 asset?. Here's an old thread that's on point but may not answer the question. viewtopic.php?f=8&t=8095

The tax return of the old partnership should have the technical termination and final return boxes checked. You have an actual termination.

Which regs?. 1.706-4, 1.704-1(b), 1.708-1(b), maybe more.
 

#6
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There was quite a bit of commentary on 99-6 when it came out. And it doesn’t address a non-taxable transfer, like a gift. The AICPA’s comments can be found here:

https://www.aicpa.org/content/dam/aicpa ... submit.pdf

The construct recommended by the AICPA is on Page 22.

In your case, it would work like this:

Husband (transferor) gifts his interest to his wife (transferee). Let’s say each has a $10k tax basis capital account. Since we are dealing with spouses, we don’t have to deal with “gain basis” and “loss basis” issues owing to 1041(b)(2):

(b)Transfer treated as gift; transferee has transferor’s basisIn the case of any transfer of property described in subsection (a)—
(1) for purposes of this subtitle, the property shall be treated as acquired by the transferee by gift, and
(2) the basis of the transferee in the property shall be the adjusted basis of the transferor.

This is consistent with 1.1041-1T:

This carryover basis rule applies whether the adjusted basis of the transferred property is less than, equal to, or greater than its fair market value at the time of transfer (or the value of any consideration provided by the transferee) and applies for purposes of determining loss as well as gain upon the subsequent disposition of the property by the transferee. Thus, this rule is different from the rule applied in section 1015(a) for determining the basis of property acquired by gift.

At this point, we have wife with a $20k basis in her interest. Then we treat 100% of the assets as having been distributed out by the partnership to wife. If the inside basis is also $20k, then you now have the basis of the individual assets in wife’s hands. The AICPA’s approach here largely mimics Situation 1 in the RR.

From a 1065 standpoint, you’d post a $10k “withdrawal” against the Husband’s capital account. You’d post a corresponding $10k increase to wife’s capital account. Then you’d show cash and/or property distributions, as the case may be, to wife of $20k. The capital of both spouses ends at zero.
 

#7
Chay  
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Nilodop wrote:There's one thing I'm not clear on, however: is an asset expensed under the de minimis safe harbor that would otherwise be a 1245 asset considered to be a 1245 asset?. Here's an old thread that's on point but may not answer the question. viewtopic.php?f=8&t=8095

The answer to the question wasn't stated outright, but based on the responses I think most of the contributors would agree that DMSH property is not considered 1245 property. It's unclear whether most of them would agree that the reason is that it isn't property at all, or that it is property, but wasn't ever "of a character subject to the allowance for depreciation provided in section 167".

My sense is that any other section of the code, outside of the capitalization, basis and depreciation rules, would treat it as property, so maybe the second interpretation is better. Maybe we should consider it "non-capitalized property".

And the point of this exercise is that if DMSH property really isn't 1245 property, then the de minimis election is a way to avoid the recognition of ordinary income under section 751.

Nilodop wrote:The tax return of the old partnership should have the technical termination and final return boxes checked. You have an actual termination.

Although it isn't called a technical termination, the termination I have is similar in that one of the partners retains her capital account within the LLC in a book sense even as the tax treatment changes. Because Schedule L is the "balance sheet per books", and there was never a set of books kept for this LLC that showed $0 for all assets, liabilities and equity, it seems strange to put $0.

In answering the question of whether to put $0 anyways, it makes sense to look at other similar situations such as technical terminations.

Nilodop wrote:Which regs?. 1.706-4, 1.704-1(b), 1.708-1(b), maybe more.

I've reviewed those and I agree that the transactions should cover the entire day. I also think it's reasonable to deem the transfer to have happened at the end of the end of the day as a result.

Jeff-Ohio wrote:There was quite a bit of commentary on 99-6 when it came out. And it doesn’t address a non-taxable transfer, like a gift. The AICPA’s comments can be found here:

https://www.aicpa.org/content/dam/aicpa ... submit.pdf

The construct recommended by the AICPA is on Page 22.

You know, I actually looked at those comments, but it somehow didn't occur to me that anyone was suggesting that non-taxable transfers should happen differently. After I read your post I re-examined RR 99-6 to see what the IRS' position was based on to begin with and whether it might not apply to gift transfers. Their reasoning seems largely based on McCauslen v. Commissioner, 45 T.C. 588, which held that the purchasing partner could not apply section 735(b) to the property that was acquired in a transaction that terminated the partnership. The purchase was held to reset the holding period in those assets.

In the case of a gift, there is no holding period issue, and thus no reason to apply the odd split-treatment "workaround" set forth in RR 99-6. So I agree that it should be disregarded in this case.

There's something a little odd about presenting the 100% distribution to the wife on the 1065, which is a transaction that occurs after the LLC is no longer a partnership. But I suppose this is consistent with showing $0 on Schedule L regardless of what the actual books of the LLC say.
 

#8
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There's something a little odd about presenting the 100% distribution to the wife on the 1065, which is a transaction that occurs after the LLC is no longer a partnership

That sounds kind of nit picky and might not even be entirely accurate. But it also sounds like it might be accurate and might also be fair.

Bear in mind that we need some construct to actually effect the full termination for all parties. And remember that we’re dealing with multiple parties and a lack of symmetry among them. So when we dive into the details of the construct, inconsistencies will be glaring. We’ll just have to accept those or do our best to explain them away.

With Situation #1, you could aptly describe it as an actual termination “involving” a deemed distribution of assets to A and B (or to C and D in the case of Situation #2). Maybe it’s not totally simultaneous, because the interest transfer is given effect first. But then again, maybe we’d say the partnership is terminated as to A’s tax consequence as a result of the sale, but not to B’s tax consequence, because B’s tax consequence involves deemed distributions to both A [as if A were still a partner] and to B. That’s my attempt to explain things away.

I would like to say that the following could aptly describe Situation #1: An actual termination “by way of” a deemed distribution of assets to A and B. That might be true for B, but not for A. The deemed distribution to A has no impact on A, because he was already out of the picture (as you note). Of course, this makes reporting a conundrum – Mr. A leaves not by a liquidating distribution, but because he sold his interest. Yet, for determining B’s tax consequence, Mr. A is very much a partner who got a liquidating distribution.

Just do your best with it. You have good judgement, so let that guide you.

And as I said before, a lot was written when this came out. One of those things was this:

https://www.nysba.org/Sections/Tax/Tax_ ... eport.html
 

#9
Chay  
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I'm posting a revised set of conclusions regarding this return for my own reference as well as that of anyone who happens to be interested:

  1. All transactions occurring on 12/15 are considered partnership transactions regardless of when the actual transfer happened. The calendar day convention under Regs. 1.706-4(c)(1)(i) applies.
  2. The partial month of December is treated as a full month for short year returns, and so normal depreciation figures are not prorated before making it to the return. Revenue Procedure 89-15 sections 3.01 and 4.03.
  3. The wife, on her new Schedule C, inherits all of the tax attributes of the property formerly held by the partnership. Section 168(i)(7) applies, and depreciation does not restart as it would have with a technical termination under the former sections 168(i)(7) and 708(b)(1)(B) before the TCJA was passed. Because the transferee is treated as the transferor under section 168(i)(7), and the transferor has already claimed a full year of depreciation, no depreciation is allowable on the new Schedule C for the current year with respect to assets that were distributed from the old partnership.
  4. The husband's capital account balance is transferred to the wife's, and then the cash and adjusted basis of all property of the partnership is shown in Line 19 of the wife's Schedule K-1 as being distributed to her.
  5. Columns (c) and (d) of Schedule L and the ending capital accounts on Schedules K-1 and M-2 all have $0 due to everything being transferred or distributed.
And Jeff, I get your point about constructs and lack of symmetry. Accounting for tax purposes has broken free from reality in a spiral of conventions, limitations and self-reference, and so my objection that partnership returns should describe partnership transactions does seem rather quaint.
 


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