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Tax Effects of Transferring Assets to an LLC

Several readers have written to ask what happens to business assets when a sole proprietorship becomes a Limited Liability Company (LLC). Last time I wrote about the legal aspects of transferring non-cash assets from the individual sole proprietor’s name into the name of the LLC. Today I would like to discuss the tax effects of the transfer.

Since the single member LLC with no election to be taxed as a corporation is the simplest situation, I would like to talk about the one-person, disregarded entity first. In a later article, I’ll look at more complex situations where a single-member LLC elects to be taxed as a corporation, or where two or more members contribute non-cash assets.

There are different ways the owner of the LLC can transfer an asset, say a computer, into the LLC.  One is to make a capital contribution. This is a tax-free transaction that requires no more paperwork than an adjusting entry in the LLC’s financial books. I sometimes advise clients to add a memo or resolution to the company file, noting that the individual and LLC have both agreed to the transaction. The LLC will use a “carryover” basis for the computer – that is, the LLC’s basis for depreciation will be the same as the individual’s. If the sole proprietor has already written off the entire cost of the computer, the LLC’s basis will be zero. If the sole proprietor bought the computer for $2000 and has taken depreciation deductions of $1000, the LLC’s basis will be $1000. Since the LLC will report its taxes on the owner’s Schedule C, for tax purposes it will be business as usual, as though nothing has changed.

A second way of transferring the sole proprietor’s computer to the LLC would be a sale and purchase. Say the sole proprietor bought the computer for $2000 and has written off the entire cost. He sells the computer to the LLC for $1000. When an asset is depreciated, its basis is adjusted by the amount of the depreciation taken, so the sole proprietor’s basis is zero. Therefore, he has a $1000 taxable gain from the sale of the computer to the LLC. The LLC now has a depreciable basis of $1000. A business owner might choose to sell an asset to his LLC rather than making a tax-free contribution of capital if, for example, he had a net operating loss in the year of the sale but expects to have income in the following years. A $1000 computer would not make much difference one way or the other, but a $50,000 flatbed truck.

But would IRS allow the sale of an asset from an individual owner to his single-member LLC?  After all, a person cannot sell an asset to himself. Courts have held that state law controls legal aspects of LLC’s such as property law. Since the LLC is a separate legal entity under state law, it can purchase assets from its owner.