When a client requests the preparation of a purchase or sale agreement for limited liability company (LLC) interests, counsel should always gather additional information prior to the preparation of such an agreement to obtain a complete picture of the exchange.
Sale Versus Redemption
The primary reason is that counsel needs to determine whether the transaction will be structured as a sale of membership interests from the departing member (“Departing Member”) to a remaining member, or a redemption (or “liquidation distribution”) of Departing Member’s interest by the LLC. Counsel should also look to the LLC operating agreement for provisions setting forth transfer restrictions, procedures, and notice requirements. Additional requirements often apply if the transaction is a sale as opposed to a redemption. A transfer in contravention of the operating agreement can be deemed invalid, so counsel should review the operating agreement in its entirety to advise clients of the relevant provisions of the operating agreement and the California Revised Limited Liability Company Act.
Tax Treatment Factors
Assuming that the LLC is treated as a partnership for federal income tax purposes, the Departing Member transfers the entire interest, and the partnership status of the LLC continues with two or more members (“Remaining Members”) after the transaction, then the following tax consequences may apply.
Under the relevant statutory provisions in Subchapter K of the Internal Revenue Code (“IRC”), the LLC members are afforded some flexibility in allocating their tax burdens by structuring the transaction as a sale or a redemption. The tax differences between a sale and a redemption can be substantial, as Departing Member’s gain and Remaining Members’ tax basis will be treated differently. Additional factors affecting tax treatment may include whether the LLC assets include the so-called “hot assets” as defined by IRC Section 751 (i.e. inventory and unrealized receivables), whether the payments to Departing Member are made in installments, whether the LLC distributes property instead of cash (or a mixture of both) to Departing Member, whether goodwill is considered as part of the LLC assets, whether the redemption of Departing Member’s interest is funded by a promissory note from the LLC, and whether Departing Member’s contribution to the LLC was in the form of service instead of cash and property.
In Foxman v. Commissioner, 41 T.C. 535, 550-51 (1964), aff’d, 352 F.2d 466 (3d Cir. 1965), a departing partner entered into an agreement to sell his entire partnership interest to the two remaining partners. In the individual tax return following this transaction, the departing partner treated the transaction as a sale and reported a capital gain. However, the two remaining partners treated the transaction as a redemption, which resulted in a substantial reduction of their distributive shares of partnership income, and therefore a more favorable tax result to the two of them.
When this matter eventually proceeded to the Tax Court, the two remaining partners contended that the transaction was in essence a liquidation of interests (redemption) under IRC Section 736, while the departing partner maintained that the transaction was, as previously agreed, a sale under IRC Section 741.
In short, the Tax Court held that the transaction was unambiguously a sale, as evidenced by the agreement precisely prepared by the parties’ attorney. The Tax Court found that the records unequivocally indicated that the partners intended to take the sale route in their negotiations, and the final agreement prepared by their attorney accurately reflected such intentions with no ambiguity. The Court of Appeals affirmed the decision of the Tax Court.
The Foxman case illustrates the flexibility among LLC members to allocate their tax burdens to some extent, and the importance of consistent unambiguous documentation. The parties’ choice of sale or redemption will generally be respected by tax authorities as long as the supporting documentation is consistent with the members’ intentions.
There are instances where the IRS can look behind the parties’ chosen form and recharacterize the transaction. One such instance is when the redemption appears to be funded by a Remaining Member’s contribution to the LLC. Another is when the Remaining Members’ interests do not increase pro rata after the transaction. In these circumstances, a rebuttable presumption of a disguised sale can arise under IRC Section 707. To avoid unintended consequences, counsel should carefully review all relevant facts and circumstances, including the cash situation of the LLC, when structuring the transaction.
It is also important for Counsel to realize that the interest of Departing Member does not necessarily align with the interest of Remaining Members when choosing between sale and redemption. Counsel needs to advise all parties, including the LLC, to consult with their own tax advisors for a comparison of different tax scenarios before initiating any negotiations, so that the parties can reach an informed, consistent, and reasonable decision.
In conclusion, intentional structuring and proper documentation will serve all parties and their attorneys well. A buyer’s or seller’s remorse caused by “hindsight” tax planning and failure to comply with the LLC operating agreement can result in disruption of business operations and costly lengthy legal disputes. To prevent unintended adverse consequences, counsel should make sure the client’s transaction complies with the LLC operating agreement, and take care to prepare documentation consistent with the parties’ intentions and informed decision.
This eBulletin was prepared by Monica Lin at CEO Law (lin@CEOFirm.com).