Capital Account Webinar David Tingstad June 7 2013

Report
Capital Accounts & Basis
Committee on LLCs, Partnerships and Unincorporated
Entities, Section of Business Law, ABA
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 passthrough entities for federal income tax purposes
Committee on LLCs, Partnerships and Unincorporated
Entities, Section of Business Law, ABA
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).”
Committee on LLCs, Partnerships and Unincorporated
Entities, Section of Business Law, ABA
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.
Committee on LLCs, Partnerships and Unincorporated
Entities, Section of Business Law, ABA
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.
Committee on LLCs, Partnerships and Unincorporated
Entities, Section of Business Law, ABA
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.
Committee on LLCs, Partnerships and Unincorporated
Entities, Section of Business Law, ABA
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)].
Committee on LLCs, Partnerships and Unincorporated
Entities, Section of Business Law, ABA
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
Committee on LLCs, Partnerships and Unincorporated
Entities, Section of Business Law, ABA
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.
Committee on LLCs, Partnerships and Unincorporated
Entities, Section of Business Law, ABA
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.
Committee on LLCs, Partnerships and Unincorporated
Entities, Section of Business Law, ABA
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.
Committee on LLCs, Partnerships and Unincorporated
Entities, Section of Business Law, ABA
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
Committee on LLCs, Partnerships and Unincorporated
Entities, Section of Business Law, ABA
 (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.
Committee on LLCs, Partnerships and Unincorporated
Entities, Section of Business Law, ABA
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 aftertax investment the member
has in the LLC interest.
Committee on LLCs, Partnerships and Unincorporated
Entities, Section of Business Law, ABA
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.”
Committee on LLCs, Partnerships and Unincorporated
Entities, Section of Business Law, ABA
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.
Committee on LLCs, Partnerships and Unincorporated
Entities, Section of Business Law, ABA
Example 1: A and B form an LLC; each contributes $1,000. They will
share the profits and losses equally.
Assets
Cash
Liabilities
Book
$2,000
Liabilities
$0
Capital Accounts
A
B
Book
$1,000
$1,000
Committee on LLCs, Partnerships and Unincorporated
Entities, Section of Business Law, ABA
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.
INITIAL TRANSACTIONS
Liabilities
Assets
Cash
Stock
Building
Book
$1,200
300
2,000
$3,500
Mortgage
$1,500
Capital Accounts
A
B
Book
$1,000
$1,000
Committee on LLCs, Partnerships and Unincorporated
Entities, Section of Business Law, ABA
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
Cash
Stock
Building
Liabilities
Book
$1,400
300
1,900
$3,600
Mortgage
$1,500
Capital Accounts
A
B
Book
$1,050
$1,050
Committee on LLCs, Partnerships and Unincorporated
Entities, Section of Business Law, ABA
Example 1: At the end of the year, the LLC distributes the stock to A and
$400 cash to B.
YEAR-END CAPITAL ACCOUNTS
Opening Balance
Book gain on stock - $100
Distribution
Closing Balance
A
$1,050
50
(400) stock
$700
B
$1,050
50
(400) cash*
$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.
Committee on LLCs, Partnerships and Unincorporated
Entities, Section of Business Law, ABA
Example 1: After the year-end transactions, the LLC’s balance sheet
would look as follows:
YEAR-END BALANCE SHEET
Assets
Cash
Building
Liabilities
Book
$1,000
1,900
$2,900
Mortgage
$1,500
Capital Accounts
A
B
Book
$700
$700
Committee on LLCs, Partnerships and Unincorporated
Entities, Section of Business Law, ABA
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.
Liabilities
Assets
Liabilities
Cash
Land
Book
$300
300
$600
$0
Capital Accounts
X
Y
Book
$300
300
$600
Committee on LLCs, Partnerships and Unincorporated
Entities, Section of Business Law, ABA
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).
Liabilities
Assets
Liabilities
Cash
Land
Basis
$300
200
$500
Book
$300
300
$600
$0
Capital Accounts
X
Y
Tax
$200
300
$500
Book
$300
300
$600
Committee on LLCs, Partnerships and Unincorporated
Entities, Section of Business Law, ABA
Allocating Voting and
Economic Rights in LLCs:
An Invitation to Confusion
Committee on LLCs, Partnerships and Unincorporated
Entities, Section of Business Law, ABA
“Don’t believe everything you think”
Committee on LLCs, Partnerships and Unincorporated
Entities, Section of Business Law, ABA
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
Committee on LLCs, Partnerships and Unincorporated
Entities, Section of Business Law, ABA
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.
Committee on LLCs, Partnerships and Unincorporated
Entities, Section of Business Law, ABA
Capital Account
Initial Contribution
+ Income
+Gain
- Loss
- Depreciation
- Credit
Committee on LLCs, Partnerships and Unincorporated
Entities, Section of Business Law, ABA
Committee on LLCs, Partnerships and Unincorporated
Entities, Section of Business Law, ABA
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)
Committee on LLCs, Partnerships and Unincorporated
Entities, Section of Business Law, ABA
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 ***
Committee on LLCs, Partnerships and Unincorporated
Entities, Section of Business Law, ABA
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.
Committee on LLCs, Partnerships and Unincorporated
Entities, Section of Business Law, ABA
For every problem there is an answer
That is Simple,
That is Obvious, and
That is Wrong
Committee on LLCs, Partnerships and Unincorporated
Entities, Section of Business Law, ABA
Where else do LLC Acts utilize
contributed capital?
►
Sharing ratios of interim distributions
►
Sharing ratios of liquidating distributions
►
Allocation of relative voting authority
Committee on LLCs, Partnerships and Unincorporated
Entities, Section of Business Law, ABA
Two Important Principles to Keep in Mind
(1) Capital accounts adjust to account for noneconomic items (e.g., depreciation)
(2) Capital accounts can be reduced to zero
and even less
Committee on LLCs, Partnerships and Unincorporated
Entities, Section of Business Law, ABA
Charlsey contributes 10-year property to LLC, FMV $1,000. Micah
contributes $1,000 cash.
Day 1 Capital Accounts:
Micah
$1,000
Charlsey
$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.
Committee on LLCs, Partnerships and Unincorporated
Entities, Section of Business Law, ABA
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
$ 1,000
+ 100
$ 1,100
Charlsey
$ 1,000
100
100
$ 1,000
Initial
Year 1 Income
Depreciation
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.
Committee on LLCs, Partnerships and Unincorporated
Entities, Section of Business Law, ABA
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
$1,000
Emily
$1,000
Sarah
$1,000
Committee on LLCs, Partnerships and Unincorporated
Entities, Section of Business Law, ABA
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
$0
Emily
$0
Sarah
$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
Committee on LLCs, Partnerships and Unincorporated
Entities, Section of Business Law, ABA

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