How did Texas treat a sale of 90% of LLC interests followed by a federal Section 754 basis adjustment under the former franchise tax?

Plain-English summary

The seller's unitary gain was sourced as an intangible sale, while the LLC's basis adjustment affected only the buyer's share of income or loss.

The sellers transferred assets and liabilities to an LLC treated as a federal partnership. A buyer then acquired about 90% of the LLC interests, and the LLC elected under Section 754 to adjust asset basis under Section 743.

Texas agreed that, if the seller's gain was unitary income, the sale of LLC interests was an intangible sale sourced by the payor's location for both former franchise-tax components.

The LLC did not recognize gain from the members' interest sale. It used the adjusted basis to compute depreciation and gain or loss, but the adjustment affected only the buyer's taxable income or loss reported through Schedule K-1.

What this means for you

Buyers and sellers of LLC interests

The member's interest sale and the partnership's inside-basis adjustment had separate tax consequences.

Tax professionals

Keep seller gain, LLC-level recognition, sourcing, and the transferee-specific basis adjustment separate; also establish whether the gain is unitary before applying this sourcing answer.

Common questions

Q: Did the LLC recognize gain when its interests were sold?
A: No.

Q: How was the seller's gain sourced?
A: By the payor's location, if the gain was unitary income.

Q: Who received the benefit or burden of the basis adjustment?
A: The buyer, through its share of LLC income or loss.

Citations and references

• I.R.C. Secs. 754 and 743

Source

• STAR search: https://star.comptroller.texas.gov/search?doc_type_code=L&tax_type_code=FIT
• Opinion: https://star.comptroller.texas.gov/view/9709756L

Original ruling text

September 25, 1997

Dear **:

In your FAX of August 21, 1997, you requested a determination regarding the
franchise tax consequences of a transfer of assets and liabilities to a limited
liability company and the subsequent sale of interests in the limited liability
company.

You indicate that Company A and its subsidiaries (Seller) will transfer certain
assets and related liabilities to a LLC or limited partnership (the LLC). The
LLC will be treated as a partnership for federal income tax purposes.
Subsequently, Buyer or its subsidiary would purchase approximately 90% of the
LLC interests from Seller. The LLC will make an election under Internal
Revenue Code (IRC) Sec. 754 to adjust the basis of its assets to reflect the
gain recognized by Seller on the sale of the LLC interests to buyer.

For federal income tax purposes, the sale of the interest in the LLC is treated
as the sale of a partnership interest; not as the sale of the underlying
assets. Because the LLC makes the IRC Sec. 754 election, the basis of the LLC
property is adjusted under IRC Sec. 743. Accordingly, the LLC increases or
decreases the basis of the property as a result of the sale (even though the
LLC recognizes no gain or loss on the sale of the interests). However, the
adjustment to the basis of LLC property is taken into account only in
connection with determining the income and loss of the purchaser of the LLC
interest. Accordingly, the LLC will compute the taxable income items reported
to the LLC members (on Form 1065 and attached schedules) using the adjustment
to the basis. However, the adjustment will affect only the buyer's taxable
income or loss on Form 1065, Schedule K-1.

I have restated each of the rulings you requested followed by a response.

1. The gain from the sale of the LLC interests by Seller are treated as gain
   from the sale of an intangible asset that is apportioned based on the location
   of payor test for the taxable capital and earned surplus components.

Response

Correct, if the gain is unitary income.

2. For purposes of determining the LLC's earned surplus component, the LLC
   will not recognize any gain as a result of the sale of Seller's LLC interests
   and the adjusted basis in the LLC's assets resulting from the IRC Sec. 754
   election will be utilized for purposes of determining depreciation and gain or
   loss.

Response

Correct.

This response is based on the facts presented and current law. If there are
different or additional facts, the response may change.

If you have any questions, contact Tax Policy Division. You may call toll free
1-800-531-5441, or our regular number is 512/463-4600. My extension is 3-4662.
You may write me at Tax Policy Division, Comptroller of Public Accounts.

Sincerely,

Bob Jeffcoat
Tax Policy Division