LLCs: the tax tail wagging the investor.

• Author: Koppel, Michael D.
• Position: LLCs & LLPs

As the first generation of limited liability companies (LLCs) ages, individuals are frequently called on to invest funds in an existing LLC in exchange for an ownership interest. This brings with it the question of what exactly the new investor owns. If an investor is not cautious, he could possibly lose out. LLCs are generally taxed as partnerships. As a result, they are governed by partnership tax law. This law is exceedingly important, because every well-drafted LLC document references and incorporates partnership tax law.

Two Fundamental Concepts

Partnership tax law sets forth the concepts of a capital account and of a revaluation.

Capital accounts. An owner has a capital account. The capital account is the accumulation of the owner's investment plus income and less losses and distributions. The capital account represents the dollar amount that the owner would receive if the entity were liquidated.

If an owner's capital account is zero or negative, he cannot receive any cash at liquidation and would be forced to recognize income if the entity were liquidated.

Revaluations. When new equity interests are issued, an LLC can adjust capital accounts either up or down to reflect the increase or decrease in the LLC's value. This is a revaluation, a book-up or book-down. For instance, self-created goodwill and earnings potential of patents would be candidates for a book-up.

The existing owners' capital accounts are increased or decreased to reflect the appreciation or depreciation in the LLC'S value. As a result of the change to the owners' capital accounts, the existing owners would receive an increased or decreased right to future cash distributions.

Capital accounts and revaluations ensure that each owner eventually receives in distributions the amount the LLC earned or lost while the person was an owner. In a world accustomed to S corporation structures and their rigid adherence to doing everything pro rata, the concept of capital accounts and revaluations is exceedingly foreign. A problem arises when taxpayers try to apply S rules to LLCs.

Example: U, an LLC, is a startup technology company. An electronics company is currently negotiating for a license of U's next-generation technology. U requires working capital to operate properly. Due to the expenditures related to development efforts, U's assets equal its liabilities. Therefore, the existing equity and the existing owners' capital accounts are zero.

K, an investor, believes that the...