On January 1, 2002, John, Mary and Susan decided to organize an LLC (taxed, for federal tax purposes, as a partnership). John contributed $ 100,000 in cash in exchange for a 25% interest in the LLC. Mary contributed $ 50,000 in cash and accounts receivables with a basis of 0$ and a fair market value of $ 50,000 in exchange for a 25% interest in the LLC. Susan contributed $100,000 in cash and a capital asset having a basis of $60,000 and a fair market value of $100,000 in exchange for a 50% interest in the LLC.
The LLC had income from operations of $80,000 during the 2002 tax year. However, no distributions were made to John, Mary or Susan during 2012. The LLC had a loss from operations of $40,000 during the 2003 tax year. Again, no distributions were made during 2003. During 2003, the LLC acquired a building for $ 100,000 paying $40,000 in cash and obtaining a non-recourse loan to finance the remaining purchase price ($60,000) (the “Building Loan”). The lender for the Building Loan secured its loan with a mortgage on the building.
On January, 1, 2004, the LLC paid off the Building Loan and the mortgage on the building was released. On January 2, 2004, John sold his interest in the LLC to Therese for $110,000. At the time of the purchase and sale of John’s interests, the LLC had a valid IRC Code Section 754 election in Place with the IRS. The LLC has income from operations of $160,000 during the 2004 tax year. Again, no distributions were made to Mary, Susan or Therese during the 2004 tax year.
On January 1, 2005, the LLC sold the accounts receivables for $50,000 in cash and the building for $120,000 to separate third parties and dissolved. Upon the dissolution, the LLC distributed the capital asset to Mary. All other liquidation distributions are made in cash payments to the LLC members in accordance with the LLC’s operating agreement, which contains the following provisions:
1. Capital accounts. The LLC will maintain capital accounts pursuant to the provisions of Treas. Reg. § 1.704-1 (b) (2) (iv), as required by Treas. Reg. § 1.704-1(b)(2)(ii)(b)(1).
2. Liquidation. Upon liquidation of the LLC, liquidating distributions will be made according to the positive capital account balances of the members, as determined after taking into account all capital account adjustments for the LLC taxable year during which such liquidation occurs, by (i) the end of such taxable year, or (ii) within 90 days after the date of such liquidation.
3. Additional Capital Contributions Required. Each member shall be obligated to make up any deficit account balance existing at the end of any year or upon liquidation of the LLC.
Assume that (i) no cash distributions were made to any member, except as provided herein, (ii) all income and loss generated during the years of operation resulted from cash transactions, (iii) no depreciation occurred on the capital asset for any year and the fair market value of the asset remained the same at all times, and (iv) the agreement among the members of the LLC also include language that all allocation of income and loss were to be in accordance with the respective interests of the LLC members.
Discuss, in detail, the implications to all parties (inclusive of the LLC) of each transaction identified above, including the impact on each member’s basis in his LLC interest and his capital account at the end of each year.