Accountants constantly deal with the entity versus aggregate concept of partnerships. For real estate businesses, certain transactions have varying levels of sensitivity to consider, such as planning for 1031 exchanges, admitting owners in a joint venture for a development or redevelopment project, or attempts to avoid local or transfer taxes. Before closing the deal there are several federal and state tax considerations to carefully evaluate.
From a federal tax standpoint, single member limited liability companies (SMLLCs) usually do not have to file separate returns. The SMLLC’s activities are reported on its owner’s federal tax return. All states recognize limited liability companies (LLCs) as a legal entity, but SMLLCs may still have annual filings in certain states despite being disregarded for federal income tax purposes.
SMLLCs do not have the entity versus aggregate consideration; or at least not in the same way an LLC with two or more owners does. SMLLCs have only one owner, so the owner just looks through the entity when reporting the SMLLC’s activity for federal income tax purposes. A real estate fund might establish several SMLLCs for each to purchase, own, and operate as separate properties. Despite this, all SMLLCs are reported on the fund’s tax return, as though those SMLLCs did not even exist.
Sale of the business
Anyone who has dealt with the sale of a business has addressed the key question of asset sale versus “stock” sale. Asset sale means transacting the underlying assets, whereas “stock” sale means transacting in the LLC interests. In a business like a real estate enterprise, buyers may want to purchase assets rather than entity interests.
For income tax purposes, an asset purchase will give the buyer a step up in the asset purchase price, allowing them the benefits of depreciation or amortization tax deductions. From a non-tax standpoint, an entity purchase might carry unknown liabilities which either subject the buyer to economic harm or create artful drafting by the legal team representing either side of the deal. From a seller’s perspective, they are usually motivated to sell “stock” because they might be able to rid themselves of some unknown liabilities.
Consider the sale of 100% of an LLC. For legal purposes, this is a “stock” transaction; however, for income tax purposes, this is an asset transaction. The buyer is treated as purchasing assets and the seller is treated as selling assets. If the SMLLC’s assets consist of rental real estate, the buyer will get a step up based on purchase price and the seller will report the sale (and hopefully gain and/or recapture some ordinary income) on those assets.
The results can be very different where the subject LLC is 100% owned versus when it has more than one owner such as:
- If two buyers purchase an LLC that is 100% owned.
- The owner of a SMLLC only sells a portion of the LLC.
- The second owner contributes cash or property in exchange for an interest in the LLC.
The tax results are quite different in each of these cases than if that owner were to sell only a portion of an underlying piece of rental real estate, resulting in tenancy in common ownership. There are two IRS rulings that address sales/purchases involving SMLLCs:
- A contribution of property can be “income tax free” for the property contributing partner and the existing LLC member. Many exceptions apply here and contributing property introduces several key partnership tax issues requiring special calculations and tracking.
- Where part of the SMLLC is sold (that is, the existing member receives consideration for some or even all of its LLC interest), the seller reports a taxable transaction, and the buyer will be treated for federal income tax purposes as purchasing assets.
Each of these situations will likely result in differing tax basis, allocations and holding periods of the property and/or LLC interests, and potentially one set of tax attributes for the owners and a different set of tax attributes for the LLC.
State and local tax considerations
The states and localities typically follow the federal treatment for reporting, but there are different state treatments for depreciation deductions, section 1031 exchanges and other areas. Matters are further complicated when the LLC owns rental real estate in multiple states because the states are not consistent in determining how much income or loss are reported in each state.
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