An LLC is a popular entity for Australians investing, or carrying on business, in the US. What happens if your business has matured and you sell your interest in the LLC? What happens if you convert the LLC structure to a US corporate structure to do so? What are the US tax implications of doing so?
For US tax purposes, a sale could be subject to both capital gains and income tax, depending on the composition of the adjusted basis in the LLC interest.
Under the default classification rules for US tax purposes, an LLC is generally classified as a partnership in the absence of an election to be classified as a corporation.
A membership interest in an LLC is a capital asset. A sale of the interest would trigger a gain or loss on the difference between the amount received and the “adjusted basis” of the interest. Any resulting gain would be taxable at the long term capital gains tax rate (20%) if the interest was held for a period of more than one year prior to the Sale. To the extent the gain is attributable to inventory items and “unrealized receivables” (receivables that have not yet been included in income if accounted for on a cash basis) and recaptured depreciation of the LLC, it would be recognized as ordinary income instead of a capital gain.
The amount received includes cash, fair market value of property received, and the liabilities of the seller that are assumed or relieved.
The adjusted basis consists of the acquisition cost of the LLC interest adjusted for the member’s distributions from the LLC, contributions to the LLC, losses of the LLC, and debt and other allocable liabilities.
For an LLC member who is a non-resident alien for US tax purposes, your gain on the sale of your LLC interest would be “effectively connected income” of a “foreign Partner” and the Purchaser may have to withhold tax on the amount realized on the sale for that partnership interest if the partnership is engaged in a trade or business in the US.
The LLC operating agreement should be reviewed in order to determine the terms and conditions for selling a percentage interest in the LLC to ensure that any pre-emptive or approval rights of existing LLC members are appropriately addressed.
Transfer / Conversion
The process of converting an LLC interest was discussed in our previous blog on Restructuring Your US Operations: Why and How You Would Convert and LLC to an INC
A conversion would trigger similar capital gains tax implications in the US (as that of a sale).
However, if the IRC section 351 non-recognition rules for transfers to a corporation controlled by the transferor are satisfied, an LLC member would not recognize a gain or loss on the conversion. Further, the basis in the stock received would equal the basis of the property transferred and the holding period of the property transferred would carry over to the stock received, allowing the member to access the US Federal long term capital gains tax rate (20%) if the stock is subsequently sold.
If a conversion otherwise qualifies for non-recognition under IRC section 351, it would not be taxed in the US, even if the member is a nonresident alien (Treasury Regulations provide that the IRC provisions that tax the “effectively connected income of a non-resident alien does not override the non-recognition provisions of the IRC).
In order for the IRC section 351 non-recognition rules to apply, a conversion would need to satisfy the US anti-avoidance rules – see our prior blogs on Restructuring Your US Operations: Corporate Reorganization on Relief and Restructuring Your US Operations: Anti-Avoidance Rules in the Internal Revenue Code.
Further, if a conversion occurs as part of a broader restructure or planned sale of corporate stock, then, it is possible that it could be treated by the IRS / US courts as a taxable transaction under the “Step Transaction Doctrine” where a series of transactions designed to achieve an intended result could be viewed as a whole.
State taxes could also apply to a sale and conversion of an LLC interest if the business derives income sourced in that State.
If you are considering selling or restructuring your LLC interest, please contact:
Head, US-Australia Tax Desk