Committee on LLCs , Partnerships and Unincorporated Entities, Section of Business Law, ABA

Committee on LLCs, Partnerships and Unincorporated Entities, Section of Business Law, ABA

UNWINDING THE MYTH OF THE CAPITAL ACCOUNT

Capital Accounts & Basis


Understanding the Importance

● Legal Practitioners, Accountants and lastly and most importantly, Clients.

● Beginning and Middle and End of the Partnership’s Existence

● Triggers:Contribution, Sale, Exit, Death of a Partner, Dissolution

● Partnerships (& LLCs classified as partnerships) are pass-through entities for federal income tax purposes



What is a Capital Account?

● Member’s capital account is a “Book” concept that tracks the member’s investment in the LLC

● Generally, capital accounts are created at the inception of the LLC

● Sample Language: “3.01 Capital Accounts. For each Member (and each permitted assignee), the LLC shall establish and maintain a separate Capital Account, which shall be maintained in accordance with Treas. Reg. Sec. 1.704-1(b)(2)(iv)(b).”



Primary Issues

1. Confusing capital accounts with pure capital investment.

2. Capital account maintenance is not just an accounting issue.

3. Misconception that a member’s capital account is equal to a member’s “basis” in the LLC.



1. Capital Accounts ≠

PURE Capital Investment

Myth: “Capital Account” refers to the amount of ACTUAL capital invested in the LLC.

Reality: Capital Accounts take into account the increase & decrease of subsequent contributions (whether cash and property) as well as distributions & allocations.



Contributions & Allocations

● Each member’s capital account is increased by:

(1) the amount of money contributed by him to the LLC;

(2) the fair market value of property contributed by him to the LLC; and

(3) allocations to him of LLC income and gain (or items thereof),including income and gain exempt from tax and income and gain.



Distributions and Allocations

● and each member’s capital account is decreased by:

(4) the amount of money distributed to him by the LLC;

(5) the fair market value of property distributed to him by the LLC;

(6) allocations to him of expenditures of the LLC described in [Code] § 705(a)(2)(B);

(7) allocations of LLC loss and deduction (or item thereof); and

(8) and is otherwise adjusted in accordance with the additional rules set forth in [Treas. Reg. § 1.704-1(b)(2)(iv)].



In a nutshell…. Creation = when s/he/it becomes a member in the LLC

Increased = by the net value of capital contributions made to the LLC and allocations of LLC income and gain to such member

Decreased = by the net value of distributions made to the member and allocations of LLC loss and deductions to such member



Caution:Not all payments to a member are considered “distributions” that decrease the capital account. If the payment is made to the member in a capacity other than as a payment with respect to the LLC interest, then it isn’t a distribution for partnership tax purposes. For example, “disguised sales” and “guaranteed payments” are not distributions.



Disguised Sale: A wants to sell half of Blackacre to B. AB form an LLC where A contributes Blackacre with a basis of $50 and a value of $300 and B contributes $150 cash and the LLC immediately distributes the $150 cash to A. Assuming the LLC would not have made the distribution to A but for the contribution of Blackacre, the transaction would be characterized for tax purposes as a sale of 50% of Blackacre by A to B for $150, and a contribution to the LLC by each of A and B of their respective halves of Blackacre. A would recognize $125 gain on the half sold to B. The members’ respective bases in AB would be $25 for A and $150 for B. The LLC’s inside basis in Blackacre would be $175. The distribution to A of $150 does not separately decrease A’s capital account.



Guaranteed Payments: C performs services for CD, LLC. The operating agreement provides for payment to C in an amount equal to $100 per month as payment for services. These payments are not linked to whether or not the LLC produces income. These payments are treated as “guaranteed payments” to C and not as distributions with respect to his LLC interest. The payments are compensation income to C and deductible compensation expenses of the LLC. The distribution to C of $100 each month does not separately decrease C’s capital account.



2. Capital Account maintenance….is EVERYONE’S job WHY is it important?

WHEN is it relevant?

Beginning Capital Contribution delineation

Middle Increase of contribution by member Distributions & Allocations

End Triggers: Death Dissolution New member Exiting member



(1) For the determination and maintenance of the members’ capital accounts in accordance with the rules of Treas. Reg. § 1.704-1(b)(2)(iv);

(2) Upon liquidation of the LLC (or any member’s interest in the LLC);

(3) If such member has a deficit balance in his capital account following the liquidation of his interest in the LLC…. he is unconditionally obligated to restore the amount of such deficit balance to the LLC by the end of such taxable year, which amount shall, upon liquidation of the LLC, be paid to creditors of the LLC or distributed to other members in accordance with their positive capital account balances.



3. BASIS….is NOT your Capital Account!

Capital Account

A member’s capital account is a “book” concept and tracks the member’s investment in the LLC for internal allocation purposes.

Basis

The member’s “basis” in the LLC (also referred to as “outside basis”) is a “tax” concept and tracks the after-tax investment the member has in the LLC interest.



Outside Basis

A member’s outside basis in the LLC = original cost of the LLC interest (and carryover basis of contributed property) PLUS

any income and gain allocated to the member MINUS losses allocated to the member and distributions made to the member.

------------------------------------------------------------------------

Example: “A contributes property with an adjusted basis to him of $400 (and a value of $1,000) to a LLC. B contributes $1,000 cash. While under their LLC agreement each may have a ‘capital account’ in the LLC of $1,000, the adjusted basis of A’s interest is $400 and B’s interest $1,000.”



Inside Basis

An LLC’s inside basis is the LLC’s basis in assets owned by the LLC, as determined using general Code §§ 1011 through 1023 principles, i.e., cost or carryover basis with adjustments.

Although these are clearly different concepts, as a general rule, the aggregate of the members’ outside bases equals the aggregate of their inside bases.



Liabilities

Liabilities $0

Capital Accounts

BookA $1,000B $1,000

Assets

BookCash $2,000

Example 1: A and B form an LLC; each contributes $1,000. They will share the profits and losses equally.



INITIAL TRANSACTIONS

Assets

Book Cash $1,200Stock 300Building 2,000

$3,500

Liabilities

Mortgage $1,500

Capital Accounts

BookA $1,000B $1,000

Example 1: The LLC immediately buys an apartment building for $2,000, paying $500 cash and providing a $1,500 mortgage for the balance. The

LLC also purchases stock for $300.



Example 1: In year one, the building depreciates ($100), the LLC earns dividend income of $30, tax exempt income of $20, and rental income from the building of $150, for a total net income of $100. The stock

increases in value to $400.

YEAR ONE OPERATIONS

Assets

BookCash $1,400Stock 300Building 1,900

$3,600

Liabilities

Mortgage $1,500

Capital Accounts

BookA $1,050B $1,050



Example 1: At the end of the year, the LLC distributes the stock to A and $400 cash to B.

YEAR-END CAPITAL ACCOUNTS

A BOpening Balance $1,050 $1,050Book gain on stock - $100 50 50Distribution (400) stock (400) cash*

Closing Balance $700 $700


* Note that this gain only occurs for book purposes and not for tax purposes. There is no gain to the LLC upon the distribution of the stock to A. A and B both receive distributions worth $400, but A has a carryover basis of $300 in the stock and would recognize $100 gain on the disposition of the stock if he sold it the same day. However, this basis disparity is also reflected in the outside bases of A and B in their LLC interests – A’s basis is reduced by $300 on the distribution and B’s basis is reduced by $400, so on a sale of A’s LLC interest, he would have $100 less gain than before the distribution.

Example 1: After the year-end transactions, the LLC’s balance sheet would look as follows:

YEAR-END BALANCE SHEET

Assets

Book Cash $1,000Building 1,900

$2,900

Liabilities

Mortgage $1,500

Capital Accounts

BookA $700B $700



Example 2: X and Y form a 50/50 LLC to which X contributes land with a value of $300 and a basis of $200, and Y contributes cash of $300.

Assets

Book Cash $300Land 300

$600

Liabilities

Liabilities $0

Capital Accounts

Book X $300 Y 300

$600



Example 2: For tax purposes, the LLC will inherit X’s basis in the land, $200. Thus, the LLC’s inside basis in the land for tax purposes is $200.

This creates a book-tax disparity, addressed in Code § 704(c).

Assets

Basis BookCash $300 $300Land 200 300

$500 $600

Liabilities

Liabilities $0

Capital Accounts

Tax BookX $200 $300Y 300 300

$500 $600




Allocating Voting and Economic Rights in LLCs:An Invitation to Confusion



“Don’t believe everything you think”



State Law LLC Act ≠ Federal Income Tax Code

“We have really everything in common with America nowadays, except, of course, language.”

-- OSCAR WILDE, THE CANTERVILLE GHOST



Unless otherwise provided in the operating agreement, profits and losses must be allocated on the basis of the agreed value, as stated in the records of the [LLC], of the contributions made by each member to the extent the contributions have been received by the [LLC] and not previously returned.



Capital Account

Initial Contribution

+ Income+Gain- Loss- Depreciation- Credit



Are Contributions:

► Increased by allocations of income and gain? (if there is an LLC Act that says that, I have not seen it) ► Decreased by allocations of loss, depreciation and credit?(if there is an LLC Act that says that, I have not seen it)



Ergo:

The default rules set forth in the various LLC Acts for how allocations are to be made to the members DO NOT satisfy the requirements imposed by the Internal Revenue Code for the maintenance of capital accounts and the QIOP requirement that liquidating distributions be made in accordance with positive capital accounts

*** That means you have to draft around state law to comply with the tax code ***



Fine, then we will simply write an operating agreement that says that we will do everything in accordance with the capital account rules of the Internal Revenue Code.



For every problem there is an answer

That is Simple,

That is Obvious, and

That is Wrong



Where else do LLC Acts utilize contributed capital?

► Sharing ratios of interim distributions ► Sharing ratios of liquidating distributions ► Allocation of relative voting authority



Two Important Principles to Keep in Mind

(1) Capital accounts adjust to account for non-

economic items (e.g., depreciation)

(2) Capital accounts can be reduced to zero and even less



Charlsey contributes 10-year property to LLC, FMV $1,000. Micah contributes $1,000 cash.

Day 1 Capital Accounts:Micah Charlsey

$1,000 $1,000

Operating Agreement provides for all allocations and distributions to be made in accordance with positive capital accounts, but all depreciation of property contributed by Charlsey to be specially allocated to Charlsey.



At the end of year 1 the LLC has allocable income of $200 and no other tax items except $100 of depreciation. $100 of income is allocated to each capital account and the depreciation is all allocated to Charlsey. Capital accounts are now:

Micah Charlsey$ 1,000 $ 1,000 Initial+ 100 100 Year 1 Income- 100 Depreciation$ 1,100 $ 1,000 Total

If you now vote in proportion to capital accounts, and it is a majority vote, Micah always wins. Charlsey is not happy, and you don’t want to be around Charlsey when she is not happy.



Leah, Emily and Sarah each contribute $1,000 cash to LLC; all allocations are to be made in accordance with capital accounts. Also, each member votes in proportion to capital accounts. Day 1 capital accounts:

Leah Emily Sarah$1,000 $1,000 $1,000



Over the course of the first year of operations the LLC loses $4,000; as of the last day of Year 1 capital accounts are as follows:

Leah Emily Sarah$ 0 $ 0 $ 0

Each member gets to 0/0 percent of the total vote. Obviously a ridiculous outcome, but that can happen.


Committee on LLCs , Partnerships and Unincorporated Entities, Section of Business Law, ABA

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Transcript of Committee on LLCs , Partnerships and Unincorporated Entities, Section of Business Law, ABA