When a taxpayer forms an LLC and contributes appreciated property to the LLC, the taxpayer generally does not recognize gain on the transfer. The IRS does not force taxpayers to recognize gain on property contributions to LLCs because taxpayers didn’t sell or exchange the property; they continue to own an interest in the contributed property, albeit through a business entity. Naturally, there are exceptions to this rule where gain can be recognized such as where debt encumbered property is transferred to the LLC or investments are transferred to an investment LLC.
On the other hand, when a taxpayer performs services (i.e., sweat equity) in exchange for an interest in an LLC, the taxpayer will usually recognize compensation income equal to the fair market value of the LLC interest received. The IRS treats the transaction as if the taxpayer received cash compensation (which is taxable), and then used the cash to purchase the LLC interest at fair market value.
There are two forms of ownership interests in an LLC—a capital interest and a profits interest. A capital interest gives the owner a claim to assets when the LLC is dissolved. A profits interest is defined as an interest other than a capital interest. Helpful. Basically, a profits interest does not entitle the owner to assets upon the LLC’s liquidation, but instead entitles the owner to a share of the LLC’s profits (if any).
A taxpayer who performs services in exchange for a capital interest recognizes income in the amount of the fair market value of the capital interest. However, a taxpayer who performs services in exchange for a profits interest will not recognize income on receipt of the profits interest. This is because the profits interest holder is not entitled to liquidation proceeds of the LLC, but is instead entitled solely to LLC profits (if any). Profits interests holders therefore have an speculative value in their interests and will not recognize income upon receipt of the interest, but will instead pay tax on any profits that are allocated to them.
Example 1: Thelma and Louise form an LLC. Thelma contributes land that is currently worth $50,000 and was originally purchased for $20,000 for a 50% capital interest. Louise will perform real estate advisory services for a 50% capital interest. Since both parties own a 50% capital interest, each would be entitled to 50% of the assets upon liquidation—Thelma and Louise would each own 50% of the land upon liquidation. Thelma does not recognize income upon her contribution because it is a contribution of property. Louise will recognize income of $25,000 because she contributed services in exchange for a capital interest.
Example 2: Same as above except that Louise received a profits interest instead of a capital interest. If the LLC liquidates, Louise will not share in the liquidation assets. Instead, Thelma will receive 100% of the land. Louise will not be taxed on her contribution of services because she received only a profits interest. However, Louise will recognize income for any profits that are allocated to her in the future.
While a profits interest is generally not subject to tax because of their unascertainable value, there are circumstances where their value is ascertainable. In these circumstances, the profits interests will be taxable upon receipt. These circumstances include:
- the profits interest relates to a substantially certain and predictable stream of income from the partnership assets (such as a net lease);
- the partner disposes of the profits interest within two years of receipt; or
- the profits interest is a limited partner interest in a publicly traded partnership.
While a capital interest received in exchange for services usually is taxable, it is not immediately taxable if the capital interest is subject to a substantial risk of forfeiture. Property is subject to a substantial risk of forfeiture if the rights to its full enjoyment are conditioned (directly or indirectly) upon either of the following:
- Future Performance of Substantial Services. A requirement of future performance (or refraining from performance) of substantial services by the recipient is a substantial risk of forfeiture. The regularity of the performance of services and the time spent in performing them tend to indicate whether the required services are substantial.
- Occurrence of a Condition Related to a Purpose of the Transfer. For example, a requirement that the recipient complete an advanced educational degree, obtain a professional designation, or attain a certain job position within the company to receive unrestricted access to the property would likely be a substantial risk of forfeiture, which would exist until that condition was met.
When the capital interest is subject to a substantial risk of forfeiture, the service provider will not recognize gain until the substantial risk of forfeiture is eliminated.
Example: Same as Example 1 above except that Louise’s capital interest will be forfeited if Louise does not provide 5 years of services to the LLC. Since Louise’s capital interest is subject to a substantial risk of forfeiture, it is not taxable in the year of receipt. Instead, it will be taxable after Louise completes 5 years of service and her capital interest is fully vested.
If you need help with small business taxes,
sign up for a FREE tax consultation.
Buzzkill Disclaimer: This post contains general tax information that may or may not apply in your specific tax situation. Please consult a tax professional before relying on any information contained in this post.