It may be preferable to create multiple LLCs or other entities to fulfill your objectives. There are three significant issues to consider – risk class of assets, basis of assets, and the diversification rules. Many people who create an LLC actually need more than one entity to accomplish all their goals.
Risk Class of Assets
Each asset has its own risk class. For example, marketable securities have almost no risk from a lawsuit standpoint. Marketable securities pose no real risk by just owning them. Real estate on the other hand poses a great risk. People can get physically injured when visiting or using real estate. When someone is hurt on real estate, the owner of the real estate receives a claim or lawsuit for damages. It is easy to see that real estate poses more lawsuit risk to the owner than marketable securities. It is important to try to classify risk classes and to limit liability in any situation to the least amount of assets possible. Different types of real estate pose different levels of risk. How much more risk depends on the real estate, where is it located, and the circumstances of its use. For example farmland poses a different risk level than an apartment building. Learn more about Wyoming LLCs here.
General Rule: Segregate different asset risk classes by using multiple entities. [Note, however, that some state laws do not offer charging order protection to single member LLCs.]
Basis of Assets
The basis of an asset is the amount paid for that asset or its cost. When you purchase an asset for $100, your cost basis is $100. When you sell that asset, the basis is subtracted from the sale price to determine the capital gain. You then pay taxes on the capital gain. There are factors that can cause the basis to increase (making capital improvements to an asset) or to decrease such as depreciation taken on an asset. When the basis of an asset is adjusted for various increases or decreases we refer to the basis as an adjusted basis.
When a gift of an asset is made to another person your basis, for determining gain on the sale of the asset, will transfer to that person. Thus, when they sell it at a gain they will calculate their capital gains tax by using your basis. But if the person sells the asset at a loss, they will use the lesser of your basis or the fair market value of the asset at the time of the gift, to determine their capital loss. But if a person inherits an asset, they will receive a step up (or down) in basis, equal to fair market value of that asset on the date of death or six months after the date of death in some cases. This means that when inherited property is sold in the future, gain or loss will be calculated by using this new fair market value basis.
When you contribute assets to an LLC, those assets have a basis. If members contribute many different assets in the LLC, each with a different basis, it can become an expensive administrative nightmare for the CPA. The LLCU you receive for contribution of the asset also has a basis of its own. Gifted LLC units transfer the LLCU basis to the gift recipient.
Remember that sales may not occur for years and may include multiple generations of family members. Some assets will receive a step up or down in basis following a member’s death. Some assets will retain the original basis. In some cases, an asset will be mixed with some of the asset receiving the step up in basis and some receiving a step down in basis. This can create complications such as additional accounting expense or increasing the chances of IRS attack.
General Rule: Be careful in mixing assets in an LLC or allowing future contributions of additional assets. Consider use of a different LLC for each basis class. It costs more money initially and a little more administratively to run each year, but can significantly reduce overall cost and complexity.
Diversification and Tax-Free Formation
Transferring assets into an LLC is not usually a taxable event. However, some transfers do trigger an immediate tax. Current law recognizes a taxable event when certain “diversification” occurs with securities, for example. The diversification rules are a trap for the unwary.
The 80% Rule
The first rule is sometimes called the 80% rule. If marketable securities that are contributed to the LLC make up more than 80% of its asset value, diversification could be a problem. Diversification does not occur if 20% or more of the value of the LLC is made up of real estate. When considering the value, keep in mind that any other discounts or valuation adjustments applying to assets must be considered before trying to satisfy this rule.
If more than 80% of the LLCs assets are stocks and securities, the LLC could be classified as an “investment company”. Transfers to an investment company can result in immediate recognition of gain on the transfer of appreciated securities if the transfer is to:
A regulated investment company; or
A real estate investment trust; or
A corporation, partnership or LLC if more than 80% of the value of its assets are held for investment and are cash, stocks, or securities. Under TRA ‘97, the definition of cash, stocks, and securities was greatly expanded. Stocks and securities include:
Marketable stocks and securities;
All corporate interests;
Evidences of indebtedness;
Forward or futures contracts;
Precious metals; or
Interests in any entity if 90% or more of its assets consist of any of the types of interests described above.
The Non-identical Assets Rule
Transfers of non-identical assets can cause diversification, unless the assets are already diversified. This rule is easy to trigger because if one person contributes stock A and another person contributes stock B, these are not identical assets. Thus, gain must be recognized on the transfer. There are some exceptions. For example, by definition, mutual funds are diversified already and therefore the contribution of mutual funds should not cause diversification. The transfer of identical assets, however, does not cause diversification. Therefore, if one or more persons transfer the identical security the anti-diversification rule is not violated.
Learn about Wyoming LLC Privacy here.
The De Minimis Exception
The de minimis exception avoids application of the rule when an insignificant contribution is made that would technically trigger the rule. The IRS has accepted a 1% contribution as an insignificant amount, but has rejected an 11% contribution as being insignificant. The area between 1% and 11% is a no-man’s land.
The 25% Test and the 50% Test
Diversification does not occur if the transferors transfer a diversified portfolio of stocks and securities to the LLC, provided the 25% and 50% tests are met.
A portfolio of assets is treated as diversified if not more than 25% of value of total assets is invested in the stock and securities of any one issuer; and
A portfolio of assets is treated as diversified if not more than 50% of value of total assets is invested in the stock and securities of five or fewer issuers.
The diversification rules are one more factor to help determine how many LLCs or other entities to use in a given case. As a practical matter, careful consideration of the assets being contributed avoids this problem. Trying to do too much with one LLC can create a lot of diversification problems.
Examples of Diversification (a summary of the above)
Will the contribution diversify the contributing person’s assets? If the contribution does not diversify the contributors’ assets, the investment company taxation rules do not apply.
Diversification results if two or more persons contribute non-identical assets to the LLC.
The same diversification rule may apply to contributions from spouses in non-community property states. In non-community property states, diversification does not result if husband and wife contribute assets jointly owned in the same proportion as their interests in the LLC. Therefore, spouses should transfer title to joint tenancy or tenants in common before transferring the assets to the LLC.
In community property states, spouses may contribute different community property assets as the sole LLC assets. Diversification does not result when husband and wife contribute community property assets, even if those assets are the sole assets used to fund the entity. Thus, when spouses contribute community property assets to fund an LLC, taxation of appreciated assets is rarely an issue.
If one party contributes almost all of the assets to form an LLC other than de minimis contributions by other members, there is no diversification. If an individual contributes assets worth less than 1% of the LLC, the de minimis exception applies. De minimis contributions are not considered for purposes of determining diversification.
If several individuals contribute identical assets to form an LLC, diversification does not occur.
Contributing an already “diversified” portfolio of stocks and securities does not cause diversification. A portfolio is diversified if not more that 25% of the value of the contributed securities is from one issuer; and not more than 50% of the value of the assets are the securities of 5 or fewer issuers.
Mutual funds are diversified by definition. Thus, contributing mutual fund shares to an LLC should not cause diversification.
If the contribution is “stocks and securities” (see below), which are not identical in both type and ratio to the assets already in the LLC, and “marketable securities” comprise over 80% of the value of the LLC, investment company taxation rules will apply. An entity not diversified at its formation can become diversified by later contributions, retroactively creating a taxable event. With other than husbands and wives contributing community property, the contributors should own the assets to be contributed as joint tenants or tenants in common in proportion to their ownership interest in the entity before transferring the assets to the entity.
If the contribution causes diversification, are more than 80% of the assets “stocks and securities?” If so, the entity will be treated as an investment company.
Analyze the assets to be contributed to an LLC. Are they “stocks and securities” as defined by IRC 351(e), which includes:
__ stock or securities of any private or public corporation;
__ forward or future contracts;
__ precious metals;
__ foreign currency;
__ interests in publicly traded partnerships or LLCs;
__ any interest in a REIT, registered investment company, or common trust fund;
__ bonds and personal notes; and
__ interests in any entity if 90% or more of its assets consist of any of the types of interests described above.
If more than 20% of the total value in an LLC is investment real property or other assets that are not classified as “stocks and securities,” the entity will not be treated as an investment company. If possible, contribute at least 20% investment real property to prevent the LLC from being considered an investment company.
Exercise extreme caution when contributing assets to an already funded LLC.