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.