Contributed Property to LLC

[Randall]

Father contributes a rental property to LLC with children as other LLC members. Father will own 95% of LLC. Renat property is fully depreciated (building portion).

I'm confused on how to treat. Everything I'm reading says the original basis is the partnership basis. Then I read that the FMV is booked but both depreciation for book purposes (on FMW) and tax purposes must be maintained.

Do you show the FMV on the LLC books and balance sheet, then show a book/tax difference in depreciation? Does this then flow to the K-1. I'm thinking the Item M must be checked for the father's K-1 and show built in gain.

Then when he dies, how do children get the stepped up basis? I'm thinking thru inheriting his LLC interest. But if his interest has the built in gain, then would they too have to report gain on a future sale?

[OldJack]

Think partnership accounting with a multi-member LLC (unless they have elected corp status). There are a lot of but-if's in partnership accounting!

Therefore, in simple general terms, depreciation deductible and depr tax basis by the partnership-LLC is the same as it would have been to the person contributing the asset (in your case zero depr). The difference in depr tax basis and FMV is an asset that cannot be deducted or depreciated for tax purposes, but is normally carried on the books like it was a separate asset or land tied to the tax basis asset.

The reason for FMV is to give FMV to the members equity account for purposes such as distribution of profits and ownership. If the LLC, for book and financial purposes, depreciates the asset at FMV, then there is a non-deductible amount of depreciation (all in your case) that must not be deducted for tax purposes and becomes the "reconciling item" on the tax return balance sheet every year.

When you say father will own 95% of LLC for 100% of assets contributed you have a question that must be determined. Is the 95% for profit/income allocation or is it ownership of capital? If it is ownership, there is the question of gifts to others and/or income to others for value received. Or 100% must be shown for the father until profits are distributed to capital accounts. Profits can be distributed on a basis other than capital if spelled out in the LLC agreement.

There is no "built-in gain" on value of a partnership LLC, that is only on a Sub-S corp that previously was a C-corp. Inheritance is at fair market value on the date of death based on ownership interest and beneficiary would receive a step-up to such FMV. For simple reasoning of such things, I usually have the LLC issue "Units of Ownership" certificates so that everyone things like stock in a corp.

[kcjenkins]

The father's basis at the time of transfer is the partnership basis. The original cost is booked and then the accumulated depreciation is booked as well. So now, the asset continues on just as it was on the father's books.

[Randall]

Thanks OldJack. That's basically where my reading has brought me. But my reading also gave me the impression that for the father's K-1, the item M should be checked for built in gain with a statement attached. I got the impression that for contributed property with a FMV greater than tax basis, item M should be checked 'yes'.

A side question, which is preferable on the K-1 schedules, to check tax basis or 704 book? If the balance sheet (Sch L) is presented on book basis, should I be consistent and show the K-1s as 704 book?

Another side question, some of my reading brings up 754. I don't think that applies this year as there are no distributions. But in the future, when father dies, his interest is distributed to children, would this constitue a 754 adjustment in basis to the children to step up their interests to FMV at that time?

[Randall]

Thanks KC. So are you saying the original cost should be listed with accumulated depreciation? Then separate line item for excess of FMV over original cost listed and depreciated for book purposes (but not tax purposes)?

On the original assets, in ATX, would you list acquisition date as beginning LLC date to be consistent. But then show prior depreciaton, would that be a problem with ATX?

I'm thinking of duplicating the return in ATX to show the excess FMV portion and having a depreciation schedule for these that will not flow thru to a deductible tax item on the actual return. Does that sound like a good way to track things.

I'm still trying to get a handle on why this book depreciaton needs to be maintained on the FMV excess if it is not deductible for tax purposes and doesn't pertain to tax basis. I guess for book capital purposes for the members.

[kcjenkins]

Well, partnership accounting, as Jack mentioned, is nutty, frankly. So it's hard to explain the odd things that result. Basically, over the years, accountants tried a lot of things in partnership books to improve the tax bottom line and then the Congress and the IRS passed laws and regs to defeat those tricks, and we ended up with our current crazy mix of rules and restrictions. You could, since the building in this case is fully depreciated, take a short cut and enter the thing at FMV, with a note in there on the original cost and ac dep, and just select 'nondepreciable' for the asset type. There is no logical benefit to calculating what the dep could have been, as far as I can see. But that is your call, and maybe Jack will chime in again if he sees a reason for you to calculate it anyway.

[OldJack]

>> maybe Jack will chime in again if he sees a reason for you to calculate it anyway. <<

There is no reason to depr from a tax return prospective or tax accounting method. However, if the entity is preparing audited financial statements for public or financial institutions they should be presented in accordance with Generally Accepted Accounting Principals which would require depreciation reflecting the decrease in fair market value of a used asset over a useful life of the asset. I agree with KC's statements regarding partnership accounting as nutty and would add that it can also be extremely complicated.

[OldJack]

A side question, which is preferable on the K-1 schedules, to check tax basis or 704 book? If the balance sheet (Sch L) is presented on book basis, should I be consistent and show the K-1s as 704 book?

Code sec 704( b ):

>>( b ) Determination of distributive share

A partner's distributive share of income, gain, loss, deduction,

or credit (or item thereof) shall be determined in accordance with

the partner's interest in the partnership (determined by taking

into account all facts and circumstances), if -

(1) the partnership agreement does not provide as to the

partner's distributive share of income, gain, loss, deduction, or

credit (or item thereof), or

(2) the allocation to a partner under the agreement of income,

gain, loss, deduction, or credit (or item thereof) does not have

substantial economic effect.

<<

If you check this box [704( b )] on the K-1 you are declaring that distribution of profits is in accordance with the "partners interest" in the LLC which could be different than the LLC book value. How profits are distributed/allocated should be written in a LLC operating agreement.

[Randall]

Thanks KC and OldJack. This helps to sort out my thoughts out a bit.

[Randall]

OldJack, do you have any comment on my question about Item M on Sch K-1 regarding the built in gain of FMV excess over adjusted basis?

[OldJack]

Another side question, some of my reading brings up 754. I don't think that applies this year as there are no distributions. But in the future, when father dies, his interest is distributed to children, would this constitute a 754 adjustment in basis to the children to step up their interests to FMV at that time?

A sec. 754 election applies only to sales or exchanges of partnership interest and to distributions. It does not apply to contributions of property, including money, to a partnership. [small Business Quickfinder Handbook] Sec.754 adjusts for the difference the inside basis of a partner that has "purchased a partnership interest" at an outside cost tax basis different than the inside basis.

ie: 3 equal partners in a partnership with only one asset having a tax basis of $6,000 and a FMV of $9,000. New Partner purchases Selling Partner's interest for $3,000. If the partnership sells the only asset for $9,000 the New Partner has a tax gain of $1,000 (9,000-6000 x 1/3 interest = $1000 New Partner k-1 gain). New Partner reports $1,000 k-1 taxable income on 1040 and increases his/her outside partnership tax basis by $1,000. If sec. 754 had been elected at the time of purchase, the partnership account for New Partner would have been adjusted to $3,000 ($2,000 plus $1,000 special 754 allocation) and New Partner would have zero tax gain on the k-1.

I don't see that you have a reason to elect 754 until and unless the heirs become partners and facts change. Like I said, partnership accounting is complicated and you should do more research.

When father dies his heirs get a step-up tax basis to FMV for his interest (outside tax basis) in the partnership. Generally, fathers "outside tax basis" is his tax basis when he contributed the property plus/minus his profits/losses/allocations to him in the partnership plus any other contributions, less distributions to him.

[OldJack]

OldJack, do you have any comment on my question about Item M on Sch K-1 regarding the built in gain of FMV excess over adjusted basis?

Question M on the K-1 is new starting in 2009 and I have no experience with what they are looking for with that question. It would appear that you would have to declare the facts of the Partner's property outside tax basis v. FMV booked in the LLC. I really don't know, hope someone else will give us the answer.

[Randall]

Thanks again. That's what I thought on 754. I'll look more regarding Question M. I did read something about reporting this as built in gain that the contributing partner would have to report if the contributed property were distribtued to another partner other than the contributing partner within 7 years. If that took place, the contributing partner would then have to report a gain. There's no intention right now of distributing the property to anyone but it does seem like I need to check yes on Item M and included a statement of the built in gain amount. But I'm wondering if this just goes away after 7 years or if father dies before then, does it go away.

[OldJack]

>> if father dies before then, does it go away. <<

I would think so as it is father's tax basis item and not anyone elses. Remember it is only on father's k1.

[BulldogTom]

Now I remember why I hated my Partnership Tax Classes. This stuff sucks.

Tom

Hollister, CA

[kcjenkins]

Very true. It's the worst area in the entire code. When I was teaching it, my students often got hung up on the unfairness of many of the quirks in the code. Almost always, if you look back into the discussion on the passing of a particular part of the code, you would find it was a reaction to some 'creative' partnership deal that a smart accountant had come up with to save a client money. And like any law based on a particular case, there were always 'unintended consequences' that screwed up legit partnership agreements. Plus, back before LLCs, partnerships were really the only alternative to corporations, so they were used to try to fit agreements between groups of investors who did not want the restrictions of the corporate form. Indeed, many of those odd quirks began before the Sub S was created. I hated teaching that section myself, just because it was so full of complexities that were really unexplainable through the use of logic or fairness.