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election by an LLC that could involve obtains the requisite 80% control of proportion to the shareholders’ stock
the receipt of boot by the transferor for the corporation immediately after the ownership interest. Sec. 1366 provides
purposes of Sec. 351(b). Nevertheless, transfer. In the partnership context, Sec. that “there shall be taken into account
where the corporation assumes liabilities 72126 does not contain any such con- the shareholder’s pro rata share of the
of the transferor and the liabilities as- trol requirement. corporation’s (A) items of income (in-
sumed exceed the adjusted tax basis of cluding tax-exempt income), loss, deduc-
the assets transferred, gain is recognized Example 1: For example, assume tion, or credit the separate treatment of
to the transferor to the extent of such CPA firm XY LLC elected to be which could affect the liability for tax of
excess.24 treated as an S corporation. X and Y any shareholder, and (B) nonseparately
It is important to have a definitive each own 50%. Z has his own CPA computed income or loss.” (Emphasis
tax basis balance sheet before the LLC firm, a single-member LLC treated added.)
elects S status. Recognized partnership as a disregarded entity. XY LLC has The pro rata share is calculated on
gain could result if the liabilities of the offered to admit Z as a 10% member a per share, per day basis under Sec.
LLC exceed the tax basis of the assets in exchange for Z’s contribution or 1377(a). Possibly the nearest concept to
at the effective date of the S election. transfer of his clients (represented by a special allocation would be through
Recognized individual gain could result goodwill with no tax basis). XY LLC shareholder compensation adjustments;
if the liabilities of the disregarded entity does not want to own Z’s LLC or as- but there are limits to this technique,
exceed the tax basis at the effective date sume any of his liabilities. Immedi- including reasonableness tests.
of the S election. ately after the transfer to XY LLC, Z On the other hand, partnership
will only own 10% and thus fail the taxation offers greater flexibility in al-
Reason 3: Potential gain 80% control requirement. Z’s con- locating items of income and deduction.
recognition to new members tribution or transfer of clients to XY Provided that the allocations meet the
contributing property LLC will result in gain recognition substantial-economic-effect tests of Sec.

A new member that receives a member- to Z as though Z sold the clients, 704(b) and the regulations promulgated
ship interest in exchange for property with a potential zero tax basis, to XY thereunder, a partnership can allocate
contributed to an LLC that has elected LLC in exchange for a membership items of income and deduction among
S status may recognize taxable gain as interest. If XY LLC did not make its partners without regard to the part-
though the property were sold to the an S election and was classified as a ners’ ownership interest percentages. A
LLC. New members of the LLC who partnership for tax purposes, no gain comprehensive discussion of “substantial
contribute property to an LLC that has or loss to Z would result upon Z’s economic effect” is beyond the scope
elected S status will need to consider contribution or transfer of clients to of this article. Only the highlights are
the 80% control requirement of Sec. 351 XY LLC under Sec. 721(a).27 presented below.
rather than the more lenient require- Determining whether an allocation
ments of Sec. 721 under the partnership Reason 4: No special meets the substantial-economic-effect
provisions of Subchapter K. As refer- allocations test requires a two-part analysis. First,
enced above,25 a transferor(s) of prop- An S corporation offers no flexibil- the allocation must have economic ef-
erty to a corporation will generally not ity with respect to allocating items of fect, and second, the allocation must be
recognize gain or loss if the transferor(s) income and deduction that are not in substantial.28 The regulations provide

24. Sec. 357(c). Further, if the principal purpose of the taxpayer with respect to 26. “No gain or loss shall be recognized to a partnership or to any of its partners
an assumption of liabilities is tax avoidance of federal income tax or there in the case of a contribution of property to the partnership in exchange for
is no bona fide business purpose for the assumption of liabilities, the total an interest in the partnership” (Sec. 721(a)).
amount of the liabilities assumed (not merely the excess of liabilities over 27. As a potential workaround, Z can also elect S status for his LLC prior to the
tax basis of assets) is treated as boot for purposes of calculating gain under transaction, and merge his LLC/S corporation into XY LLC under the corpo-
Sec. 351(b). The burden of proof is on the taxpayer to prove by the clear rate reorganization provisions of Sec. 368. However, under this structure, XY
preponderance of the evidence that the principal purpose did not involve LLC would be succeeding to Z’s entity (including liabilities) rather than merely
the avoidance of federal income tax and that there was a bona fide business the assets. In addition, there is an issue whether the “pre-incorporation” step
purpose for the assumption of the liabilities (Sec. 357(b)). violates the “immediately after test” of Sec. 351 under a step-transaction
25. See fn. 22. analysis due to the existence of a preconceived plan of a merger into the
transferee S corporation.
28. Regs. Sec. 1.704-1(b)(2)(i).

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