Beware – Your Gift of LLC Interests to a Family Member May Be Disallowed

By: Tamara Pow

Your gift or sale of an LLC interest to a family member may be disallowed for tax purposes.

If you are gifting or selling a limited liability company (“LLC”) interest to a family member, you must keep in mind the requirements of Internal Revenue Code Section 704(e). IRC (section sign) 704(e) provides that a gift or sale to a spouse, ancestor or lineal descent (or trust for their benefit) must meet certain requirements. If not, the donee will not be considered a member of the LLC for tax purposes, the gift will not be a completed gift for estate planning purposes, and the donee’s distributive share of LLC items will be subject to reallocation.

Your LLC interest gift must satisfy five conditions to qualify the donee as a member for tax purposes:

  1. Capital must be a material income producing factor for the LLC. In other words, the LLC’s income must be based on a business that requires substantial capital, such as inventories or equipment, and not a pure service based business resulting in commissions or fees.
  2. The donee must own a capital interest. You can’t simply gift an interest in profits. If the LLC were to distribute its assets, the LLC operating agreement must provide for the donee to receive a share of the assets on dissolution or if the donee withdraws from the LLC.
  3. If the donor provides services to the LLC, she must be reasonably compensated.
  4. The donor and donee’s share of LLC income should be relative to each of their capital interests in the LLC.
  5. The transfer (whether by gift or sale) must not be a sham. This is a facts and circumstances test that is based on several factors.

The factors that the IRS considers when determining whether or not the transfer is a sham center around whether or not the donee actually got control over the LLC membership interest. The treasury regulations tell us that the donor has too much control if she retained a unilateral right to withhold LLC distributions (other than for reasonable needs of the LLC business), she retained control over the essential assets of the building (e.g. by leasing them to the LLC), she retains more-than-usual management powers, there is a limitation on the donee’s right to sell or liquidate, or the donee is a minor. On the other hand, the donee has enough control if he has substantial participation in the management of the business of the LLC, he receives distributions of all or most of his distributive share of LLC income for his sole use and benefit, and he is really treated as a member for things like bank account control, filing tax returns, and in the LLC operating agreement.

Making a gift of an LLC interest is a transaction that involves expertise in both estate planning and LLC membership interests. To prevent unintended and potentially expensive estate consequences due to incomplete gifts, make sure your LLC attorney is coordinating with your estate planning attorney to ensure compliance with IRC Section 704(e).

Tamara B. Pow is a founding partner of Strategy Law, LLP in downtown San Jose, California where she practices business and real estate law including formations, operations, transfers, conversions and dissolutions of both family LLCs and non-family LLCs. Her tax background, including time as a tax consultant at Price Waterhouse, LLP, as well as her MBA and real estate brokers license help her in advising owners of limited liability companies and other business entities.

The information appearing in this blog does not constitute legal advice or opinion. Such advice and opinions are provided by the firm only upon engagement with respect to specific factual situations. Specific questions relating to this article should be addressed directly to Strategy Law, LLP.

Creatively Covering Customers Catastrophes: The Exciting World of IP Infringement Indemnification

By: Robert Hawn

As a business attorney in Silicon Valley practicing in our firm’s office in San Jose, I spend a lot of time creating license agreements for our licensor clients. In creating and negotiating licenses, a number of risks need to be allocated. One of the most important of these goes by the fancy name of intellectual property infringement indemnification.

So, what is intellectual property infringement indemnification? In plain English, this means if you license something you don’t own, then you have to cover your licensee against a claim from the real owner. But, wait, you say: “I created this stuff on my own. What’s the problem?”

Remember, a license is nothing more than a licensee giving you money in exchange for you giving it the right to use your intellectual property. The rub here is that we are dealing with intellectual property. Unlike tangible property, such as a house, where you can run a title report and see who owns it, the ability to see if there are others that have superior rights to intellectual property can be difficult. Patent searches, for example, can be expensive and time consuming, and they don’t uncover patents in process that have yet to be published. Copyright, which is one of the key protective schemes for software, is rarely registered. Trade secrets are, by their very nature, secret.

Because of this uncertainty, or risk, a licensee will look at you and say “What happens if you don’t own this stuff?” Because you want the deal, you’ll say, “I’ll cover you if someone says ‘my stuff is their stuff’”. At this point, your attorney is saying “Are you crazy? If you get hit with an infringement suit, the costs alone in fighting it will kill your company!” So, why do you ignore your attorney’s advice? Because few if any licensees will buy your stuff if you don’t cover them against this risk. In other words, if you don’t provide this protection, you won’t have a company left to kill.

Now, there are some exceptions to offering intellectual property infringement in licensing deals. Often, in “direct consumer” licensing, particularly with downloads where few if any customers actually read the license to which they are agreeing, a licensor will not only leave out infringement protection, a licensor will affirmatively disclaim it, often in all capital letters. In other situations, a licensor may have sufficient market power to refuse to offer this protection. In others, the use of certain types of technology are understood to be a shared risk.

So what’s a young start-up, or even a sophisticated multi-national company, to do? First, you can close your eyes and jump, and this seems to be the most common choice. It is also one of the worst. Second, you can employ lots of high priced attorneys and other advisors to conduct searches and reviews of current technology to determine if what you are doing will infringe on anybody else’s technology. The problem with this approach, putting aside the expense, is that this type of broad approach is best suited to patented technology, and still can’t account for technology that is not yet publicly disclosed, e.g., in an unpublished patent application or if the owner has maintained it as a trade secret. Third, you can take a look at your technology, and the technology of your competitors or active trolls, and ask yourself what is the key item that would lead your competitor to sue you. You can then perform an analysis, using your developers and attorneys, to determine the risk you face in covering your customers against lawsuits. Although this method has many of the disadvantages of the second method discussed above, it is more directed and based on a practical assessment of where your exposure may exist.

As you might guess, provisions dealing with coverage against infringement risk tend to be highly complex and heavily negotiated. In upcoming blogs, we’ll explain some of these moving parts and how you, as a businessperson, can work through them.

The information appearing in this blog does not constitute legal advice or opinion. Such advice and opinions are provided by the firm only upon engagement with respect to specific factual situations. Specific questions relating to this article should be addressed directly to Strategy Law, LLP.

The Basics of Basis: Ten Things All LLC Members Should Understand About Basis

By: Tamara Pow

Limited Liability Companies (LLCs) are complex entities for tax purposes. Generally, for LLCs choosing to be taxed as a partnership, the taxation of independent members depends on the profits or losses of the entity, and the basis of the LLC Member. Even though the calculation of basis is usually left to the company’s tax accountant, all LLC members, and partners in partnerships, should at least understand the basics of basis .

  1. What is basis? Basis is generally the amount of the member’s investment in the LLC for tax purposes, and the amount of the basis (as adjusted) is used to figure out any gain or loss on sale, exchange, and certain distributions. Certain things that happen during a member’s ownership of an LLC interest will increase or decrease the basis, resulting in an “adjusted basis.”
  2. What is the initial basis of an LLC member? The initial basis of an LLC member who acquires an LLC interest in exchange for a contribution is equal to the amount of cash contributed, plus the member’s adjusted basis in any property contributed, plus any gain recognized on the contribution of property to the LLC.

    Note: if an LLC member buys their interest with a note, the LLC member usually does not get any initial basis for the amount of the promissory note. The member, however, will get basis when the member makes payments under the note.

  3. What is the initial basis of an LLC member who buys an LLC interest from another member? If a member buys an interest from another member, the initial basis is the amount paid for the membership interest.
  4. What if a member got an LLC interest by gift? If someone is gifted a membership interest in an LLC, their initial basis is equal to the adjusted basis in the membership interest of the person who gifted them the interest, plus any gift taxes paid on the gift.
  5. What if a member received the LLC interest through inheritance? If a member acquired the LLC membership interest through inheritance, their basis is the fair market value of the LLC interest for estate tax purposes.
  6. What causes the basis in an LLC interest to go up? The main factors that increase the basis in an LLC membership interest are the member’s share of LLC income, additional cash contributed to the LLC by the member, the adjusted basis in additional property contributed to the LLC by the member, and any increase in the member’s share of LLC liabilities.
  7. What causes the basis in an LLC interest to go down? The main factors that decrease the basis in an LLC membership interest include the member’s share of LLC losses, share of nondeductible LLC expenses, cash distributed to the member from the LLC, the adjusted basis of property the LLC distributes to the member, and any decrease in the member’s share of LLC liabilities.
  8. How do LLC liabilities affect basis? If your LLC incurs a debt or makes payment on a debt, it has a direct effect on the members’ basis. Any increase in a member’s share of liabilities counts as a contribution by that member to the LLC, increasing the member’s basis. Any decrease in a member’s share of liabilities counts as a distribution by the LLC to that member, decreasing the member’s basis. The member’s share of liabilities depends on whether the debt is a recourse or a nonrecourse liability.
  9. What is a recourse liability? A recourse liability is a liability where, the member legally bears all or part of the risk of loss. In other words, the member would have to pay the LLC’s liability if the LLC could not.
  10. What is a nonrecourse liability? A nonrecourse liability is a liability where, the member, does not bear any risk of loss – the creditor would only be able to go after the assets of the LLC for repayment, not the assets of the members.

Understanding the basis in your LLC interest is critical, but it is only the first step in planning for tax consequences of LLC membership. This information is intended to assist you in understanding the conversation with your tax advisor.

Tamara B. Pow worked as a tax consultant at Price Waterhouse, LLP in San Francisco and San Jose prior to practicing law. She is a founding partner of Strategy Law, LLP in downtown San Jose where she practices business and real estate law including formation and representation of LLCs.

The information appearing in this blog does not constitute legal advice or opinion. Such advice and opinions are provided by the firm only upon engagement with respect to specific factual situations. Specific questions relating to this article should be addressed directly to Strategy Law, LLP.

You Must Understand Taxation of Member Contributions to an LLC to Anticipate Tax Considerations for the LLC

By: Tamara Pow

In two of my previous blogs I have discussed the individual tax consequences to members when they make contributions to an LLC taxed as a partnership or contributions to an LLC taxed as a corporation . When contributing property or services to a limited liability company (“LLC”), members need to be careful about possible tax recognition rules. However, what about the LLC? What taxes will it potentially face based on the contributions made by members? The general rule is that the LLC itself will not recognize gain on the receipt of contributed property, cash or services in exchange for an LLC membership interest. This is true whether the LLC is taxed as a partnership (IRC 721(a)) or if the LLC is taxed as a corporation (IRC 1032). However, the LLC must understand the tax consequences to the members in order to determine its basis in the contributed property.

LLC Taxed as a Partnership

For an LLC taxed as a partnership, the LLC’s tax basis in the contributed assets is the same as the basis of the member that contributed such property, unless the contribution is a disguised sale, in which case the LLC’s basis in the contributed assets is the cost of such assets to the LLC.

LLC Taxed as a Corporation

For an LLC taxed as a corporation, the LLC’s basis in the contributed assets is the same as the basis of the member that contributed such property if the contribution was tax free under IRC Section 351. If the contribution was not tax free under IRC Section 351, then the LLC taxed as a corporation gets a stepped up basis in the assets.

Because of the tax implications, LLCs can be more complicated than many expect. Make sure to structure your limited liability company contributions for the best tax consequences for the members and the entity, or at least be aware of the tax consequences so that you are not surprised when it comes time to report the transactions.

Tamara B. Pow is a founding partner at Strategy Law, LLP in San Jose, California. She has been practicing LLC, partnership and real estate law in California for 20 years. As an LLC attorney with an MBA, a California real estate broker’s license and experience in public accounting, she overemphasizes the importance of tax planning and consulting with a lawyer or CPA who is knowledgeable about member contributions to LLCs before the contribution is made.

The information appearing in this blog does not constitute legal advice or opinion. Such advice and opinions are provided by the firm only upon engagement with respect to specific factual situations. Specific questions relating to this article should be addressed directly to Strategy Law, LLP.