What is Tax Basis and Why Does It Matter?

A member’s tax basis in his LLC interest plays a huge role in determining the tax consequences of a distribution made to that member. That means, any time cash is paid out to a member (and sometimes even when it’s not), that member’s basis in the LLC is going to determine how that distribution is taxed. For these purposes, an LLC and a Partnership are taxed in the same manner, and the description and calculations described below apply to LLCs and their members as well as Partnerships and their partners.

So how do you figure out what a member’s basis is?

A member’s initial basis in his LLC interest depends on how the member acquired the interest.

If a member received his interest in exchange for a contribution to the LLC when the LLC was formed, then his basis equals the amount he paid in to the LLC. If he contributed property instead of cash, then his basis would equal his adjusted basis in the property he contributed. If the property that he contributed had a debt, such as a mortgage, attached to it, then his basis would be reduced by the amount of debt that was assumed by the other members of the LLC.

If the member didn’t contribute cash or other assets in exchange for his contribution, but instead contributed services, then his basis would be the cash value of those services.

If the member purchased his LLC interest from another member for cash, then his basis would be equal to the cash he paid.

Once you’ve established what the member’s initial basis was when he joined the LLC, you can then track the member’s basis as it’s adjusted up and down to account for transactions that affect the LLC. The member’s basis will be increased by:

  • Any additional contributions the member makes to the LLC

  • Any amount the member pays for additional LLC interest

  • Any increase in the members’ share of LLC liabilities (these are treated as a deemed contribution to the LLC by the member)

  • The income of the LLC that is allocated to the member

The member’s basis will decrease (but not below zero) by:

  • The member’s adjusted basis in any LLC interest that is sold or transferred

  • Any decrease in his share of LLC liabilities (which are treated as a deemed distribution)

  • Cash or property distributions from the LLC

  • The member’s distributive share of losses of the LLC

  • Any nondeductible expenditures of the LLC that that are not properly chargeable to a capital account

  • The amount of the member’s depletion deduction for any LLC oil and gas property

Most of the rules determining basis adjustments are in Sections 705, 722, and 752 of the Internal Revenue Code. These rules are complicated, and a good tax lawyer or CPA should be following them to track each member’s basis in his LLC interest. If basis isn’t properly tracked, it can cause problems with annual tax reporting and transfers of LLC interests. It’s easier and less expensive to make sure these things are tracked from the beginning. And once an error is discovered, the more quickly the problem is remedied, the better.

If you don’t have a tax lawyer or CPA working with you on this, we recommend reaching out to a professional and at least learning what you can about how to prevent basis complications down the road.

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