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Family Limited Liability Companies (FLLCs) and Family Limited Partnerships (FLPs) are a mainstay in the estate planning toolbox. They may be created for several purposes, such as to hold a family operating business or to centralize the management of investment activities. At some point, however, a family’s objectives may change. When the FLLC or FLP has outlived its usefulness, planning expertise is essential to avoid the many tax traps associated with dissolving the entity.
All Good Things Come to an End
There are a myriad of reasons why a family may want to dissolve an FLLC/FLP, the more common of which include:
Dissolution Options and Tax Impact
There are three options for dissolving a FLLC/FLP: (1) sell the entity's assets and distribute the cash (net of debts) to the owners; (2) distribute the entity's assets in-kind to the owners, or; (3) a combination thereof.
Selling the Entity Assets
If the partners choose to fully liquidate the FLLC/FLP by selling the entity’s assets and distributing the cash, gains or losses are generally passed through to the partners. A partner must recognize gain to the extent that the money distributed exceeds his or her basis in the partnership interest, referred as “outside” basis.1 A partner’s outside basis is then increased or decreased by the partner’s share of the entity’s gains or losses, distributions or contributions, as well as the partner’s share of partnership liabilities. By contrast, “inside basis” is the entity’s basis in its assets, initially equal to the asset’s FMV or, if purchased by the entity, the purchase price of the asset.
In general, a partner recognizes loss from a distribution only if it is a complete liquidation of his or her interest and only to the extent there is excess basis over and above the money distributed.2
Distributing the Entity Assets
If the owners decide to dissolve the entity by distributing the assets in-kind, there are two options: (1) each owner receives a share of every asset according to their ownership interest, or; (2) entire assets are distributed in-kind, either individually or as tenants in common.
An owner generally does not realize any gain or loss on a liquidating distribution of assets. Rather, the gain or loss is added to the basis of the distributed property and will be realized when the owner ultimately sells the property. Basis planning can thus mitigate this future income tax impact. However, different rules apply to property that was contributed before or after the seven year mark following the original contribution of the property, as discussed below.
Gain that is recognized in a liquidation or distribution is typically a capital gain. A notable exception applies to certain “hot assets”, which will not escape ordinary income taxation in either scenario.3 Such ordinary income assets include inventory and unrealized receivables.4 This adverse tax consequence may be mitigated by advance planning with your team of advisors.
The Seven Year Mixing Bowl Rule and Built-In Gain
To prevent tax avoidance schemes, the “mixing bowl” rules apply when property that was originally contributed to the entity by one owner is distributed to a different owner within seven years of its original contribution. This rule is highly problematic for property that had built-in gain at the time of contribution.5
While, normally, gain or loss from the sale of an asset is allocated according to each owner’s proportionate interest, an exception arises when an asset has built-in gain at the time of contribution. This gain must be attributed back to the contributing owner.6 (Future appreciation may be allocated in proportion to the owner’s interest or as the owners otherwise agree.7) This built-in gain taint will follow the entity interest to any future owners of that interest as well.8
If Partner A contributed Whiteacre with a FMV of $500,000 and a basis of $200,000 to an FLP, and if Whiteacre was then distributed to Partner B in year five, Partner A must still recognize the $300,000 built-in gain at the time of distribution.9
A similar surprise can arise for a contributor of built-in gain property if they receive a distribution of some other non-cash property during the seven year mixing bowl period.10 In the preceding example, if Partner A received a different parcel of land (Blackacre) in year five, Partner A must still recognize the $300,000 built-in gain on Whiteacre (or the lesser of, (i) the value of Blackacre less (ii) Partner A’s basis).
These results can be avoided if built-in gain property is distributed back to the original contributor or if all owners have a proportionate share of built-in gain. Additionally, along with simply waiting out the mixing bowl period, the built-in gain taint can also be eliminated by a sale of the contributing owner’s interest in the entity. This results in a taxable event; however, immediate recognition of gain can be buffered by utilization of the installment sale rules allowing gain recognition to be deferred over the term of an installment note.11
The Cash/Marketable Securities Caveat
As stated, when cash distributed to an owner exceeds their basis in the entity, the excess distribution is taxable gain. While most family entities are not heavy with cash, many taxpayers are surprised to learn that, in many instances, marketable securities are treated as cash for these purposes.12
There are several key exceptions that avoid this cash treatment, including distributing the same securities back to the contributing owner.13 This scenario can also be mitigated by making proportionate distributions of marketable securities so that each owner can apply their basis to offset their pro-rata portion of the securities. Other exceptions are beyond the scope of this article.14
Another surprise can occur with distributions of encumbered assets when the debt is an obligation of the entity itself (i.e. a recourse debt). When an entity is relieved of a liability, so too are the owners on a pro-rata basis. This reduction in each owner’s proportionate share of the liability is treated as a distribution of cash. Notably, this “deemed distribution” occurs for all owners, pro-rata, even for the owners who do not receive the underlying property.15 Hence, specific planning for encumbered assets is necessary to mitigate this often undesirable scenario.
The Intersection with Estate Planning
With a distribution of assets, certain estate planning opportunities may arise. By distributing low basis assets to a senior generation, such assets may receive a windfall of basis step-up when the assets pass at death to the next generation. Additionally, consideration should be given to the loss of any valuation discounts on the FLLC/FLP interest and the impact on a family’s comprehensive estate plan. Collaboration between tax and estate planning advisors is essential for optimal results.
The liquidation of a family entity is riddled with tax traps for the unwary. Additionally, non-tax issues should not be overlooked, including potential family discord caused by unequal tax burdens or distributions of assets with disparate appreciation potential. Pre-planning and collaboration with your entire team of tax and estate planning advisors is essential. Your Oxford team stands ready to guide you through the complexities of your ever changing wealth planning needs.
The above commentary represent the opinions of the author as of 6.20.17 and are subject to change at any time due to market or economic conditions or other factors.
1IRC Section 731(a)(1); See, generally, IRC Sections 731-735.
2IRC 731(a)(2)(Excess basis must actually exceed cash distributed plus the basis of any inventory or unrealized receivables).
3IRC Sections 751(a) and (b).
4See, generally, IRC Section 751(c) and (d).
8Treas. Reg. 1.704-3(a)(7)
10IRC Section 737; Treas. Reg. 1.737-1(c)(2)(iii) (The recipient must recognize the lesser of their original built-in gain or the excess value of the distributed property over the partner’s outside basis.)
11See, generally, IRC Section 453.
12For these purposes, marketable securities are defined as financial instruments and foreign currencies that are, as of the date of the distribution, actively traded.
15IRC Section 752(b).