In An Attempt to Avoid Identity Theft, The California Franchise Tax Board (FTB) is Sending Out Additional Forms to Taxpayers and Tax Professionals

By: Tamara B. Pow, Esq.

Due to a dramatic increase in tax returns that appear to be related to possible identity thefts, the Franchise Tax Board “FTB” is sending out additional forms for taxpayers to fill out, in order to ensure that these refunds do not fall into the wrong hands and that all personal information, is correct. The increase in returns may have resulted from the higher volume of employer data breaches and breaches in the data of tax professionals as well, leading to these precautionary steps from the FTB.

The FTB is issuing forms FTB 3904, Request to Confirm Tax Return Filing. This form simply means that the FTB needs you to confirm if you filed a specific personal income tax return. These forms are sent out when the FTB highly suspects the likelihood of identity theft. The FTB recommends calling the phone number listed on the form immediately at (916) 845-7088, rather than sending or faxing your information, due to the time-sensitive nature and gravity of this issue. An employee at FTB may be able to ask certain questions over the phone in order to validate that the taxpayer filed the return so that the tax refund may be appropriately received. If an FTB employee is unable to verify the taxpayer over the phone, then the FTB may require the form to be filled out and sent back. However you should avoid sending this information by mail, due to the time lag in mail correspondence.

The FTB is also issuing forms FTB 4734D, Request for Tax Information and Documents. This form means that additional information is needed to approve your tax refund, as it serves to determine the taxpayer’s identity. If you or your client receives this form, you are advised to call the phone number listed on the form 916-845-7088. Do not call the practitioner hotline or the toll free number for either form 3904 or 4734D.

Beware of the New Form W-2 Email Phishing Scam

By: Tamara Pow , Esq.

On February 2 nd , 2017, the Internal Revenue Service, state tax agencies, and the tax industry sent out an urgent alert to all employers regarding a recent spike in cases of the Form W-2 email phishing scam that is now spreading beyond the corporate world, affecting school districts, nonprofit organizations, tribal casinos and organizations, chain restaurants, temporary staffing agencies, healthcare, and numerous other sectors.

In addition to this recent, dangerously updated scam, the W-2 scammers are combining their scheme to steal employee W-2 information with an older scheme on wire transfers that is attacking some organizations more than once.

“This is one of the most dangerous email phishing scams we’ve seen in a long time. It can result in large-scale theft of sensitive data that criminals can use to commit various crimes, including filing fraudulent tax returns. We need everyone’s help to turn the tide against this scheme,” said IRS Commissioner John Koskinen.

The Form W-2 phishing scam works through cyber criminals using various spoofing techniques to disguise an email to appear as if it is from an organization executive or corporate officer, using their name. This email is sent to an employee in the Payroll or Human Resources departments, requesting a list of all employees and their Forms W-2. The details within these emails may look like this:

  • Kindly send me the individual 2016 W-2 (PDF) and earnings summary of all W-2 of our company staff for a quick review
  • Can you send me the updated list of employees with full details (Name, SSN, Date of Birth, Home Address, Salary)
  • I want you to send me the list of W-2 copy of employees wage and tax statement for 2016, I need them in PDF file type, you can send it as an attachment. Kindly prepare the lists and email them to me asap

In the latest twist, cyber criminals are following up with emails from an “executive” to the payroll or comptroller asking that a wire transfer also be made to a certain account. As a result, some companies have lost both employees’ W-2 information and thousands of dollars due to wire transfers. Various businesses that had received this specific version of email phishing scam last year, when it first appeared, are reportedly receiving it again this year.

Employers should immediately report W-2 thefts to the IRS. This will allow the IRS to take steps to help protect employees from tax- related identity theft. The Security Summit, a partnering of federal and state tax agencies, have enacted numerous safeguards in 2016 and 2017 to identify fraudulent returns filed through scams. As the Security Summit partners make progress, cyber criminals need more data to mimic real tax returns.

Company payroll officials should confirm in person any executive-level requests or generally unusual requests for lists of Forms W-2 or Social Security numbers. Organizations that have received a W-2 scam should forward it to both phishing@irs.gov and state tax agencies at StateAlert@taxadmin.org . Companies that have received or fallen victim should file a complaint with the Internet Crime Complaint Center (IC3), which is operated by the FBI. We urge all employers to share information with their Payroll, Finance, and Human Resources employees about this W-2 scam and wire transfer scam. Employers should have an internal policy, regarding the distribution of employee W-2 information and conducting wire transfers.

Employees whose Forms W-2 have been stolen should review recommended actions by the Federal Trade Commission at www.identitytheft.gov or the IRS at www.irs.gov/identitytheft . Employees should file a Form 14039, Identity Theft Affidavit, if their tax return is rejected due to a duplicate social security number or if instructed to do so by the IRS.

The Security Summit, a partnering of Federal and state tax agencies supports a national taxpayer awareness campaign called “Taxes.Security.Together.” and a national tax professional awareness effort called “Protect Your Clients: Protect Yourself.” Both offer simple tips that can help make data more secure. Employees, employers, and individual taxpayers and tax professionals may also check out:

  • IRS Security Awareness Tax Tips
  • Publication 4524, Security Awareness for Taxpayers
  • Publication 4557, Safeguarding Taxpayer Data
  • The Security Summits’ Fact Sheet 2016-21
  • The Social Security Administration

How to Beat Real Estate Passive Loss Rules and Deduct Rental Losses

By: Tamara Pow, Esq.

For anyone who is currently invested in real estate or is considering doing so, whether you intend on moonlighting as a real estate professional simultaneously with your day job, or transmitting away from your current profession into the field of real estate full-time, you may want to consider the impact of two tax cases recently decided this year by the U.S. Tax Court for how you conduct your real estate activity.

In order to qualify for tax deductions, real estate professionals often have to deal with overcoming passive loss rules by proving that they are indeed real estate professionals for tax purposes. This means that they spent over half of their “work hours” materially participating in their real estate trade or business during a taxable year, no less than 750 hours during a single, taxable year. In order to qualify as a real estate professional, one would have to satisfy any one of several tests that determine material participation first.

According to Section 469(h)(1) of the Internal Revenue code, “[M]aterial participation is regular, continuous, and substantial involvement in business operations.” A passive activity loss is defined in §469(d)(1) as “[t]he excess of the aggregate losses from all passive activities for the taxable year over the aggregate income from all passive activities for that year.” And a passive activity itself is defined by §469(c)(1) as “[a]ny trade or business or activity for the production of income in which the taxpayer does not materially participate.” According to the same section of the Internal Revenue code, rental activity is generally treated as passive, regardless of whether the taxpayer materially participates. In essence, being a real estate professional and materially participating in real estate go hand in hand: you must materially participate in order to be considered a real estate pro, or you are doing neither if the hours do not add up.

In the case of Jones v. Commissioner of Internal Revenue, Docket no. 19645-14S, whose summary opinion was filed on February 7, 2017, it was determined that §469(c)(7) of the Internal Revenue code was not applicable to the petitioner, Alvin Jones, so he was not qualified as a real estate professional and therefore was not entitled to deduct losses from his rental real estate activity. Mr. Jones was a resident of the state of Georgia, owned and operated Georgia First Insurance, LLC (“Georgia First”), and owned 10 rental real estate properties in 2011, and 11 in 2012.

Payroll records for Georgia First indicated that he was paid for 519.99 hours of work in 2011 and 173.33 hours in 2012. However, the hours on the payroll record for 2011 only reflected May to December and did not necessarily show the total time that he spent performing personal services for Georgia First, but rather just the extent of his compensation. Also not included were the working hours in connection to the reported business miles driven on behalf of Georgia First. In regards to the times spent on his rental real estate activity, the petitioner maintained contemporaneous time logs, claiming 951 hours in 2011 and 1,040 in 2012. However, despite these logs and the petitioner’s general testimony, the Court found that the petitioner failed to establish his total hours performing services for Georgia First due to the holes in the payroll records and the lack of other evidence to determine otherwise, making his claim to have spent more than half of his working hours on his rental real estate activity inconclusive, therefore sustaining the IRS’ disallowance of loss deductions, per §469(a).

Six days later, a similar case was decided with a different outcome in the same Court. In Zarrinnegar v. Commissioner of Internal Revenue, Docket nos. 23183-14, 15989-15 , the petitioner was a dentist who owned a dental practice with his wife. The petitioner’s contemporaneous time logs for both the dental practice and his rental real estate activity, as well as the testimony of several witnesses, including the petitioner’s wife, and the general testimony of the petitioner himself, were consistent in proving that the petitioner’s part-time schedule at the dental practice easily amounted to less than half of the petitioner’s working hours, while satisfying the condition that the petitioner work more than 750 hours on his real estate business during the year in question. Among other findings for additional questions presented to the Court in this case, the Tax Court determined that §469 of the Internal Revenue code did not disallow the petitioner’s deductions for losses from rental properties, reversing the original finding from the IRS in that matter.

So, consider your time commitment requirements carefully if you want to deduct your losses from investment in real estate. Passive loss rules can be beaten and rental losses can be deducted under the right circumstances, which may become easier as you reduce hours in your regular profession over time.

California Conforms to New Tax Due Dates – Update your Agreements!

By: Tamara B. Pow, Esq.

On December 8, 2015 I published a blog about new federal partnership tax return filing deadlines . At that time, the IRS had just announced that partnership and S corporation returns will be due 2 ½ months after year end, or on March 15 th if the partnership is on the calendar tax year. C corporation returns will be due 3 ½ months after year end, or on April 15 th for calendar year corporations. California has now conformed to these due dates (AB 1775, Ch. 16-348). (Note: California has not conformed to the federal delay in changing the due date for C corporations with fiscal years ending on June 30 th .)

Federal extensions (based on requests) of time to file partnership returns have changed – from five months to six months, same as S corporations. C corporation extensions depend on the taxable year, with some being reduced from six months to five months. California (automatic) extensions of time to file may change as well from the current six months for partnerships and seven months for corporations to six months for both ( Spidell’s California Taxletter, Volume 38.10, p.4).

Don’t forget to update LLC operating agreements and LP and LLP partnership agreements, as well as corporate shareholder agreements if necessary to make sure the requirements are in line with these new deadlines. Often these agreements have particular time periods for management to provide tax reporting documents to owners, which may need to be changed. For example, the partnership tax return deadline for a calendar year partnership is now March 15 th . If your partnership agreement still says the managing partner shall prepare tax information by the 90 th day of the tax year, it should be changed to the 60 th day (or thereabouts) to meet the new requirements.

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 limited liability company and other business entity formations, operations, transfers, conversions and dissolutions. 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 stay apprised of these items when advising owners of LLCs 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.

Limitations on Deductibility of LLC Member’s Share of Losses

By: Tamara B. Pow

Will you be denied a deduction for your share of LLC losses?

You may have pass through losses from your LLC membership interes t , but that does not mean you can deduct them against your personal taxes this year. Understanding the limitations on deductibility of your share of LLC losses is critical if you don’t want a bad tax surprise.

Limited liability companies are pass-through entities, meaning the profit and loss of the company are passed through to the members to be reported on their individual tax returns. However, not all LLC losses are deductible on a member’s tax return. The deductibility of losses is impacted by the member’s basis, the at risk limitation and the passive loss limitation. This is a very complex area of tax law, which is also affected by statutory changes such as NOL limitations in certain tax years. This analysis is best left to a qualified experienced tax accountant, rather than trying to figure it out yourself by answering simplified questions on tax reporting software. However, here are the basic issues to be aware of, so you know what to ask your accountant.

Basis : An LLC member’s share of losses from the company are only deductible to the extent of the member’s adjusted basis in the membership interest as of the end of the LLC’s taxable year. However, a loss that is disallowed in one year may be carried over to a subsequent year when the member’s adjusted basis is sufficient and then deducted.

At-Risk : An LLC member can deduct her share of LLC losses only to the extent the member is at risk for at least the amount of the loss. A member is at risk to the extent she has contributed money or (the adjusted basis of) property to the LLC, and her share of amounts borrowed by the LLC (unless borrowed from a member). Nonrecourse debt does not put a member at risk, but qualified nonrecourse financing of real estate does put a member at risk for the member’s proportionate share.

Passive Losses : Passive losses can only be used against passive income, not ordinary income. If an LLC member does not materially participate or meet an exception to the participation rules, a loss is considered passive. An LLC member is generally considered to be materially participating if he participates for more than 500 hours in a tax year or has materially participated for 5 out of the last 10 years.

Make sure to plan for these loss limitations and discuss them with your CPA. Just because your LLC has tax losses this year, it doesn’t mean that you get to take those loss deductions.

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 limited liability company formations, operations, transfers, conversions and dissolutions. 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 spot issues like these when advising owners of LLCs 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.

LLC Owners – Don’t forget to pay your LLC’s 2016 gross receipts fee by June 15!

By: Tamara B. Pow

Even though we are not even halfway through the year, it is already time to pay your LLC gross receipts fee. LLCs classified as partnerships or disregarded entities are required to estimate their total annual income, and pay an estimated LLC fee by the 15 th day of the 6 th month of their taxable year (June 15 for calendar year LLCs). If you underestimate the fee, there is an underpayment penalty equal to 10% of the difference between the amount you paid and the amount actually due. There is no reasonable cause exception, but there is an exception for timely paying an amount equal to or greater than the LLC’s fee for the previous year. The LLC should use FTB Form 3536, Estimated Fee to remit the estimated fee payment.

The LLC Annual Fee is in addition to the $800 per year franchise tax. The amount of the Annual Fee is based on gross revenue of the LLC:

Gross Receipts

Annual Fee

Less than $250,000

$0

More than $250,000 but less than $500,000

$900

More than $500,000 but less than $1,000,000

$2,500

More than $1,000,000 but less than $5,000,000

$6,000

More than $5,000,000

$11,790

Make Sure You Understand Pass Through Entities Before Forming a Limited Liability Company

By: Tamara Pow

One of the major considerations in determining the right entity for a business is how it is taxed. There are major differences in the taxation of owners in corporations that pay their own corporate income taxes and owners in pass through entities. Like general partnerships, limited partnerships, limited liability partnerships and S corporations, the LLC is a pass through entity for tax purposes. This means that it is not a separate taxpaying entity for income tax purposes. Instead, the members of the LLC, like partners in a partnership, report their share of LLC income, gain, loss, deductions and credits on their personal tax returns by using the numbers from a Form K-1 received from the LLC, and attaching the Form K-1 to their individual tax returns. The LLC is treated as a partnership for tax purposes and files a Federal Partnership Tax Return on Form 565.

The Form 565 filed by an LLC is an information return which shows the taxable income of the LLC and each Member’s share of that income. Certain deductions are disallowed on the LLC information return, usually to avoid a double deduction (doubling up with deductions that can be taken on a Member’s personal return). Also, certain income and deduction items are separately stated, rather than being lumped into overall income or expenses, so that the character of that particular item can be passed through and treated correctly on the Member’s tax return. Some examples of separately stated items include short and long-term capital gains and losses, charitable contributions, medical and dental expenses and nonbusiness expenses. This means that if an LLC owned by two Members donates $1,000 to charity, and the Members share profits and losses equally, each Member’s Form K-1 will show a $500 charitable donation attributable to that Member. This $500 donation will flow through to be included with any other personal charitable donations that Member made in that taxable year, and will be jointly subject to any limitation on deduction of that person’s total donations.

Because the LLC is a pass through entity, it usually must have the same tax year as its Members. If the LLC Members are individuals, this typically means a calendar year, but not always. The general rule is that an LLC must have the same taxable year as members who own, in total, more than 50% of LLC profits and capital. If there are no majority owner(s) with the same taxable year, then the LLC must use the same taxable year as all of its principal Members (a principal member owns five percent or more of profits and capital of the LLC). If the principal Members have different taxable years, or if there are no principal Members, then the LLC must default to using the calendar year as its taxable year. There is a limited exception to this rule. If an LLC can establish a sufficient business purpose for adopting a different taxable year, or if a different taxable year will not cause more than 3 months’ deferral of recognition of income for its Members, the IRS will allow it.

In addition to the taxable year, the LLC can make certain tax elections which will affect the tax treatment of LLC items, such as methods of depreciation for LLC property, the choice of inventory method, the choice to adjust the basis of LLC assets on the transfer of an LLC interest or on certain distributions from the LLC, and others. There are also some elections that may be made by the individual Members, such as credits for foreign taxes paid.

Although the LLC itself may not pay any income tax, the information reporting of the LLC tax items directly affects the taxation of the Members, and should be planned for well in advance of the tax reporting deadline.

If you are forming a limited liability company, or investing in any partnership or other pass-through entity, be sure to talk to your tax advisor and ask all the questions you can think of until you understand what the tax implications will be for your personal tax return so that you don’t get a surprise next April.

Tamara B. Pow is a founding partner of Strategy Law, LLP (a pass-through entity) in downtown San Jose. She has been forming LLCs and partnerships and helping business founders with the choice of entity decision for 20 years. She has also invested in numerous partnerships and LLCs personally and prefers not to get surprised by what is on any Form K-1 she receives.

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.

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.

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.

Beware Of Income Taxes On Member Contributions To An LLC Taxed As A Partnership

By: Tamara Pow

Before you make a contribution to an LLC in exchange for a membership interest, beware that some member contributions to LLCs are taxable. For a limited liabilty company (“LLC”) taxed as a partnership, the general rule is that members do not recognize any tax gain or loss on their contributions to the LLC in exchange for a membership interest. After the contribution to the LLC, the member will get a basis in her membership interest equal to the basis she had in the contributed property and any pre-contribution gain or loss she had on the property will be allocated to her. However, watch out for these six exceptions to the rule of a member not recognizing gain or loss on a contribution of property to an LLC:

  1. Contribution of Services
    Although the non-recognition rule is true for the contribution of property or cash to an LLC, the contribution of services to an LLC in exchange for a membership interest may be taxable depending on how the LLC agreement is drafted. This is a very complex tax analysis, that I will attempt to simplify here, but if you are considering contributing services to an LLC it is critical that you get the advice of a good lawyer or CPA that understands these complexities. Generally, if the service member receives a capital interest in the LLC (a right to receive money or property on the LLC’s dissolution), the member will immediately recognize ordinary income on the value of the capital interest received in exchange for the services. This recognition may be delayed until any contingency or substantial risk of forfeiture is satisfied. On the other hand, if the service member receives a profits interest, dependent on the LLC’s future profits, this will usually not cause recognition, unless the profits interest brings with it a substantially certain and predictable stream of income, or the member sells it within two years, or the profits interest is in a publicly traded partnership. Either way, an LLC generally recognizes no gain or loss on the issuance (or later vesting) of a membership interest provided in exchange for contributed services.
  2. Disguised Sale
    If the contribution of property to the LLC is really a disguised sale restructured to look like a contribution in exchange for a membership interest, the member transferring the property will recognize gain. For example, if a member transfers property or money to an LLC and, within two years, gets property or money back, the transaction will be treated as a taxable exchange either between the member and the LLC or between the member and another member.
  3. Acquisition of Stock of a Corporate Partner
    An LLC’s acquisition of stock of a corporate member in exchange for property may be taxable.
  4. Contribution of Property subject to Liabilities
    If a member contributes property subject to liabilities and the LLC assumes the liabilities, or takes the property subject to them, the transfer of the property may cause tax recognition for the contributing member. The member is treated as receiving a distribution of cash equal to the amount of the liability assumed, if the member does not have enough basis to cover the deemed distribution, the member will recognize taxable gain.
  5. Investment Company LLC
    If the LLC is classified as an investment company, the contributing member may recognize gain or loss on the contribution of property.
  6. “Boot” Received
    If the contributing member receives some property in addition to the membership interest, this property is known as boot and will be treated as either a distribution from the LLC or a partial sale.

If all the members are contributing cash to an LLC, taxes on contributions are not a concern. However, if members are contributing services or property, or may fall into any of the exceptions above, be sure to check with your tax advisor prior to finalizing the structure and language of your operating agreement.

As an LLC attorney in the Bay Area, Tamara is often asked about the tax consequences LLC members face when making contributions to an LLC. Tamara uses her MBA, California real estate broker’s license and experience in public accounting, to consider all possible tax consequences when choosing the best form of business entity or structuring a member contribution to an LLC.

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.