LLC Tax Trap: Deemed Distributions

Generally, when members of a Limited Liability Company (LLC) transfer assets into the LLC in exchange for membership, no gain or loss is recognized for tax purposes. But this can become more complicated when debt or liability is involved.

A frequent tax trap that LLC members fall into is a deemed distribution that occurs because of a shift in liabilities. This happens when a member contributes an asset that has debt attached to it to the LLC. Before transferring the asset, the member had been responsible for the entire debt attached to the asset. But after transferring the asset to the LLC, the member has been relieved of at least a portion of the debt on that asset. This reduction in liability (known as a “liability shift”) is treated as a cash distribution to the member who made the contribution, and that member will be responsible for paying tax on the amount of his debt reduction.

Let’s look at an example: consider a two-member LLC. Member A transfers a piece of property to the LLC and the property has a mortgage of $50,000 attached to it. Member A is the sole guarantor of that mortgage. If the members decide to refinance the property in order to add Member B as a guarantor, there will be no tax effect on the entity, but there will be a significant tax implication for Member A. Because of the refinancing, Member A has reduced his debt by $25,000. He has essentially transferred half of his debt to Member B. The IRS views this as a $25,000 cash distribution to Member A, and Member A will be responsible for paying tax on the $25,000 distribution, even though he never actually received any cash (I.R.C. § 752(b); Treas. Reg. § 1.752-1(c)).

This is just an example of the many complications that can occur when LLCs are formed or have contributions made. There are ways to avoid these types of traps, but they take planning. Having a business lawyer and a tax lawyer or CPA work with you to establish an LLC formation plan, or to deal with transactions that transfer property in and out of the LLC, is important.