Tom Talks Taxes - July 13, 2021

How to calculate basis after an LLC S corporation election

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Electing S Corporation Treatment for an LLC, Part 2

In my last edition, I covered some basics regarding an LLC making an election to be taxed as an S corporation.

Here’s the high-level summary: a single-member LLC (SMLLC) taxed as a disregarded entity or a multi-member (MMLLC) taxed as a partnership that elects to be taxed as a corporation for federal tax purposes makes a tax-deferred §351 exchange of its assets and liabilities for stock in the new corporation. The stock exists for federal tax purposes only.

It is essential to correctly track the taxpayer’s basis in his or her S corporation stock. For example, a taxpayer must have sufficient basis for both tax-free distributions from the S corporation and full use of any pass-through losses and deductions.

When an LLC makes the corporation election, its stock basis is not arbitrarily determined, or simply started at $0. The taxpayer’s basis in his or her stock received in the exchange is generally equal to the adjusted basis of the assets exchanged for the stock plus any gain recognized in the exchange less the fair market value (FMV) of any money or other property received in the exchange (i.e. boot).

In a §351 exchange, a taxpayer only recognizes gain to the extent of the FMV of boot received in the exchange. Since a taxpayer generally typically does not receive boot upon the LLC making the corporation election, there is generally no gain recognition to the taxpayer; however, the transfer of liabilities to the new S corporation can generate boot in some circumstances and, thus, cause gain recognition to the taxpayer.

The transfer of liabilities complicates the exchange in two ways:

  1. The taxpayer’s basis in the stock received in the exchange decreases by liabilities assumed by any other parties to the exchange unless payment of the liability would give rise to a deduction (for example, an account payable of a cash-basis taxpayer).

  2. If the taxpayer transfers liabilities in excess of the adjusted basis of the other assets transferred, then the excess amount is boot. If payment of the liability would give rise to a deduction, then it is not considered in this calculation. If the transfer of the liability had a principal purposes of tax avoidance or not a bona fide business purpose, then the amount transferred is boot, regardless of the adjusted basis of the other property transferred in the exchange.

The corporation will take the adjusted basis of the property transferred to it, increased by any gain recognized by the taxpayer in the exchange.

Example. On December 31, Steam, LLC, a single member LLC owned by Kevin, had the following assets and liabilities:

  • $25,000 cash

  • $5,000 unpaid business credit card balance

  • $15,000 in §1245 assets fully depreciated with bonus depreciation

Effective January 1, Steam, LLC elected to be taxed as a S corporation by timely filing Form 2553. Kevin’s basis in his S corporation stock effective January 1 is $20,000:

  • $25,000 adjusted basis of cash transferred, plus

  • $0 adjusted basis of assets transferred, less

  • $5,000 credit card liability transferred.

Since Kevin did not recognize gain in the exchange, the corporation has a $0 adjusted basis in the depreciated assets transferred by Kevin.

This assumes the business credit card was used solely for bona fide business purposes. If the taxpayer co-mingled personal expenses on the business credit card, then it is likely the portion that constitutes personal expenses would be boot, and would generate taxable gain to the taxpayer.

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