There are five circumstances in which a distribution of property other than cash to a member can trigger gain recognition to a member or LLC. A ‘disguised exchange’ transaction can trigger one of the five circumstances where a member or LLC must recognize gain on a distribution of assets to a member.
In general, distributions of property other than cash from an LLC taxed as a partnership are tax-free to the members. This feature of an LLC is one reason why a business operating as an LLC may choose to be taxed as a partnership rather than a corporation.
‘Disguised exchange’ transactions occur between members of an LLC when (1) a member contributes property to the LLC with a built in gain and that same property is distributed to a different member; or (2) a member contributes property with a built in gain to an LLC and the same member receives a distribution of different non-cash property from the LLC within 7 years of the initial property contribution.
IRC Section 704(c) and 737 prevent disguised exchange transactions between LLC members. Pursuant to Section 704(c), when a member contributes property to an LLC with a tax basis different from its fair market value the contributing member will be allocated the unrealized gain or loss upon the sale of the property. If the same property is distributed to another LLC member within 7 years of the initial property contribution, instead of being sold, Section 704 requires the contributing member be allocated the gain equal to the lesser of the remaining Section 704(c) gain that would be allocated to the partner if the property had been sold or the excess of the fair market value of the property over its tax basis.
IRC Section 737 prevents a disguised exchange transaction by requiring a member to recognize gain if an LLC member contributes non-cash property to an LLC that has a value in excess of the member’s basis, then receives a distribution of other property not contributed by that member within 7 years of the initial property contribution. The amount of gain will be the lesser of the remaining 704(c) gain and the excess of the fair market value of the distributed property over the adjusted basis of the receiving member’s membership interest.