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Enhancing Investment Returns by Addressing Book/Tax Differences

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| Legal Advisory

Many business entities are LLCs. Usually, LLCs are taxed as partnerships. Like all tax partnerships, LLCs are subject to partnership tax rules. Applying those rules to your advantage can greatly enhance investment returns. Ignoring those rules can cost you. 

This advisory addresses book/tax differences in LLC property. The key points of this advisory are:

  • Material book/tax differences can arise whenever someone contributes property to a tax partnership or when that partnership revalues property  
  • Book/tax differences can cause a mismatch between economic results and tax results, often to the detriment of one or more members/partners
  • Properly identifying, quantifying, and addressing book/tax differences can enhance your investment returns

Assume Sam contributes property with a built-in gain to an LLC. That property has a book basis (the fair market value) that is greater that its tax basis. In tax accounting jargon, the property has a book/tax difference. Here’s an example of a book/tax difference.

Example 1 - Sam contributes property worth $100 in which she has a tax basis of $75 to LLC. The LLC’s books will show that the property has a book basis of $100 and a tax basis of $75. In this case, there is a book/tax difference of $25. That $25 represents the built-in gain of that property.

This book/tax difference matters. Book income, deductions, gains, and losses for that property are based on the book basis, but tax income items are based on the tax basis. So, for example, if the LLC sells the property for $90 just after it is contributed, the LLC would have a $10 book loss ($90 minus $100) but a $15 tax gain ($90 minus $75). The LLC would therefore have an economic loss but a tax gain. To the degree that loss is borne by interest holders other than Sam, they have an economic loss without any corresponding tax loss from the LLC. Not a good result for those interest holders. 

The book/tax difference matters for other tax items, too. Depreciation is the most common operating income item that is affected by book/tax differences.

As noted, book/tax differences can arise when property is contributed to an LLC. The example above concerns a book/tax difference from property actually contributed to the LLC. Book/tax differences can also arise when property is deemed contributed to the LLC as well. Property is deemed contributed when an LLC adjusts the book values of its property. The LLC adjusts its book values any time it issues interests or redeems all of some of an interest holders’ interest. These book/tax differences create “reverse 704(c)” items. Here’s an example of a contribution that creates reverse 704(c) items:

Example 2 – On June 1, 2020, STU LLC acquires Land for $100 cash. Tom and Ursula are the only interest holders, each with a 50% interest. Each contributed $50 cash. On January 1, 2021, Sam contributes $100 cash for a one-third interest in STU LLC. When Sam contributes her interest, STU LLC adjusts the book value for Land to $200. The adjustment creates a book/tax difference for Land. Its book basis for Land is $200 and its tax basis for Land is $100. The difference ($100) represents the value of the reverse 704(c) item. 

In the example above, Sam is the potential victim of a book/tax difference. If she’s well advised, she’ll make sure that difference is addressed in the LLC’s operating agreement.

There are ways to successfully address book/tax differences. However, you need to address those differences when the book/tax difference arises, not after.

Addressing book/tax differences will likely benefit some of the interest holders at the expense of others. In other words, addressing book/tax differences will need to be negotiated. There are market norms, though. Negotiating leverage helps, too.       

If you have any questions about how to consider book/tax differences in your partnership transactions, please do not hesitate to reach out to anyone on the Nutter Tax Department.

This advisory was prepared by Nutter’s Tax Department. If you would like additional information, please contact one of the tax attorneys at Nutter at 617.439.2000. 

This update is for information purposes only and should not be construed as legal advice on any specific facts or circumstances. Under the rules of the Supreme Judicial Court of Massachusetts, this material may be considered as advertising.

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