Introduction

Individuals who want to start a business have several options for structuring their enterprise. As individuals explore the various possibilities, they often weigh factors like tax implications, liability protection and potential for business growth. One option is a limited liability company (LLC), which combines the pass-through taxation status of a partnership along with the liability protection afforded to C corporations. This limited liability protection helps shield personal assets from business debts and obligations, which provides some financial security.

LLCs have grown in popularity over recent decades. The owners of LLC interests, known as members, may elect at the outset whether the LLC will be taxed as a partnership or as a corporation using IRS Form 8832. All LLC discussions in this article will assume that partnership taxation was elected. In this two-part series, we will provide options to consider for charitably minded LLC members. The first installment will cover the basics of LLC taxation, outright gifts, gift to donor advised funds and bargain sales. The next installment will discuss the benefits of using a charitable remainder trust with LLCs, unrelated business taxable income, prearranged sales and disqualified person rules.

LLC Interests

While many LLCs have more than one owner or member, some states allow single-member LLCs. For tax purposes, single-member LLCs are not recognized as separate from the owner. The members of an LLC must include their share of the LLC's income, deductions and credits on their personal tax returns, even if that income is not actually distributed.

Most gain or loss on the sale of an LLC interest will be treated the same as if a capital asset were sold. IRC Sec. 741. Because the sale of LLC interests triggers capital gain tax, an LLC member will be subject to capital gains recognition on the sale of a partnership interest in the same manner as if the member sold a capital asset. This is called pass-through taxation because the LLC passes its income, deductions and credits through to its members. Partnerships and S corporations may also be treated as pass-through entities.

When contributed to a nonprofit, capital gain LLC interests will generate favorable treatment for purposes of a charitable income tax deduction to the donor. Certain LLC interests, however, such as short-term capital gain assets, which would include LLC interests held for less than a year, will not qualify for favorable capital gain treatment.

Under Sec. 751, any amount received from the transfer of unrealized receivables or inventory "shall be considered as an amount realized from the sale or exchange of property other than a capital asset." These are often referred to as "hot assets," and are treated as ordinary income assets. Inventory assets, which generate ordinary income when sold by the taxpayer, are not deductible at fair market value (FMV) as a charitable contribution. Sec. 170(e). If a donor wishes to use ordinary income assets for charitable purposes, the charitable income tax deduction will be limited to the donor's basis in the asset.

There are exceptions to the general inventory rules. The exceptions, however, pertain only to C corporations and apply only in narrow circumstances. For example, an exception exists for gifts that are used in relation to the nonprofit's exempt purpose and are solely for the care of the ill, the needy or infants. Sec. 170(e)(3) and Reg. 1.170-4A(b)(2)(ii). There is also an exception for gifts of certain scientific equipment to educational institutions or scientific research organizations. Sec. 170(e)(4).

Typically, if the asset is tangible personal property (TPP) and the nonprofit intends to use the asset in a manner related to the nonprofit's exempt purpose, the donor may claim a deduction for the fair market value of the property. A gift of inventory does not produce a fair market value deduction, even if there is an intended related use. Reg. 1.170A-1(c)(4).

Determining the Donor

Either the LLC or a member of the LLC can be the donor. If the LLC is the donor, the underlying assets of the LLC will be the contributed property. The determination of the assets owned by the LLC as long-term capital gain or as inventory assets will impact the valuation of the charitable contribution. The deduction for LLC asset donations passes through to the LLC members pro rata according to the ownership interests. Sec. 702.

If the member of the LLC is the donor, the donor will be contributing the LLC interest. In addition to the reduction for any "hot assets," gifts of closely held business interests may be subject to valuation discounts for minority interests and lack of marketability. These discounts have the potential to reach between 20% and 40% of the donated interest, which will decrease the charitable deduction. If the LLC has restrictions on transferability, the qualified appraisal may reflect a reduction to value.

Regardless of the type of business interest the owner holds, his or her attorney should take the time to examine the articles of incorporation, operating agreement, partnership agreement or other organizational documents. These documents may impose restrictions on the transfer of an ownership interest. Often, such restrictions may be removed prior to the charitable transfer, but may require additional legal legwork before completing the gift.

Charitable Gift Options

Noncash assets contributed to nonprofits require substantiation if the donor wants to claim a charitable deduction. If the value of the noncash asset is more than $500, the donor is required to file Form 8283. Reg. 1.170A-16(c)(1). If the noncash asset's value exceeds $5,000 ($10,000 for closely held stock), the donor is required to obtain a qualified appraisal in order to substantiate the deduction. The appraisal will value the asset as of the date it is contributed to the nonprofit and can be obtained 60 days prior to the gift or up to the tax return's due date, including extensions. Reg. 1.170A-17(a)(4). Because most LLC gifts are in excess of $5,000, acquiring a qualified appraisal is an essential aspect when contributing to a nonprofit. Without a qualified appraisal, the IRS may deny the donor's charitable deduction in full.

Outright Gifts

An outright gift of a portion of an LLC interest will provide the donor with a charitable income tax deduction. The gift must be a percentage or fraction of the donor's overall ownership interest and not a partial interest gift. If certain rights are retained, while others are donated, it could result in a partial interest gift. The LLC member must donate a portion or fractional share of all rights in the LLC to be eligible for a charitable deduction. An outright gift could be made to the nonprofit or to a donor advised fund (DAF) held by a nonprofit.

Example 1

Annie is ready to sell her long-term held LLC membership interest that she has owned for many years. The LLC operates a retail store in the community and is owned by a small group of investors. When she meets with her advisor, she is surprised to learn that selling her LLC interest will result in a hefty tax bill. The LLC interest is a capital asset and is appraised at $650,000. With a federal capital gains tax of 23.8%, Annie could end up with a $154,700 capital gains tax bill. Annie's state capital gains tax is 8%, increasing her tax bill by an additional $52,000 in state taxes. Her total tax bill on the sale could reach over $200,000.

Her advisor suggests that she consider a charitable contribution of an undivided percentage of the LLC interest to generate an income tax deduction. Annie could then sell the remaining LLC interest she retains to a third-party buyer and the charitable income tax deduction would help offset part of the capital gains recognized on the sale. The advisor cautions Annie, however, that there are factors that may reduce the charitable income tax benefit she will receive. Since the store's inventory and unrealized receivables will be considered "hot assets," the value of the deduction will limit the value attributed to those assets to cost basis. The value of her deduction will be subject to discounts applied by the qualified appraiser based on minority ownership and lack of marketability. Annie is pleased to leverage a charitable income tax deduction to reduce her tax bill.

Bargain Sales

A bargain sale occurs when a property is sold to a nonprofit for a price below fair market value. The donor executing a bargain sale will receive cash for the sale price and will be entitled to a charitable income tax deduction based on the difference between the asset's FMV and the nonprofit's sale price. The charity will purchase the LLC interest at a discounted value, with the hope that the charity will recover the purchase price in a sale to a third-party buyer. It is important to note here that the donor's basis in the asset must be properly allocated between the sale and gift portions of the transaction. Sec. 1011(b). Without this rule, the basis allocation would be all to the sale portion, bypassing capital gains altogether.

Example 2

Bart and his nephew Cedrick created an LLC approximately 7 years ago. Bart is ready to move on to other ventures and is confident that Cedrick can continue the thriving business. After consulting with his attorney and accountant, Bart negotiates a bargain sale of his LLC interest to his favorite charity. The qualified appraisal set the value at $250,000 for the LLC interest. Bart agrees to accept $175,000 in cash from the charity and will receive a charitable income tax deduction of $75,000.

Bart must allocate 70% of his basis in the LLC to the sale portion. Cedrick has indicated to the charity that he would be interested in purchasing the LLC interest at fair market value. After the bargain sale is completed, the nonprofit can negotiate a sale with Cedrick to recover the purchase price. Through this gift, Bart receives cash, bypasses a portion of his capital gain and receives a charitable income tax deduction.

Effect of Debt on Outright Gifts

Debt financing within the LLC can also cause unrelated business taxable income to be triggered. Sec. 514. Additionally, if a member's transfer of an LLC interest to a nonprofit results in a relief of indebtedness to the member, it is treated as a distribution to the LLC member. Sec. 752(d). Therefore, if the LLC has debt and a member makes an outright charitable donation, the member's share of the debt is treated as taxable income to the donor.

With a single-member LLC, the donor may be encouraged to pay off the debt in the LLC before making the donation. Where there are additional LLC members, this may be a less desirable option. When debt exists, the donor's charitable deduction may offset some or all of the taxes due. The offset of capital gains tax is an important consideration to note when speaking to donors about gifts of debt-encumbered LLCs.

Conclusion

There are charitable strategies that can be used when selling a business or transferring a business to the next generation. Using charitable gifts, LLC members can align their objectives for exiting their business with their philanthropic efforts, all while realizing tax savings. By understanding the tax implications that come with the pass-through taxation of LLCs and the tax advantages offered by charitable gift strategies, professional advisors will be well equipped to guide and support business owners through their wind-down process.