Taxlink by Andy Biebl

How is Land Inside an LLC Taxed at Death?

Andy Biebl
By  Andy Biebl , DTN Tax Columnist
An LLC taxed as a partnership qualifies for a step up in basis on shares when a partner dies, but the same is not true when an LLC is taxed as an S corporation. (DTN file photo)

QUESTION

We have been following your column for years. We have a Limited Liability Company (LLC) that contains all of our farms and one of my stock accounts. We formed it many years ago to protect the land from potential bad decisions our two children might make during their formative years. Our LLC bylaws allow for only lineal descendants to own shares in the future and it requires 100% agreement to sell the land. My wife and I are the only current stockholders and the LLC will pass to our two children and four grandchildren.

It was my understanding when we formed the LLC years ago that the value of the farm land in the LLC would get a step up to market value at the time of our death and this value would be used in probate and hopefully fall under the current limit. However, if the "new group" of LLC stockholders decided to sell some of the land in the future, is the cost basis the step up value? This is important to us since most of the land has been in my wife's family for decades and has a very low cost basis now.

Am I anywhere near being correct, or are we in danger of creating a real problem for our children in the future?

ANSWER

You are correct in your assumptions about a step-up in basis, assuming your entity is reporting as a partnership. In general, an LLC reports under partnership tax status. It files annual IRS Form 1065. When the death of a partner occurs and the partner's interest in the LLC passes to heirs, the interest is valued at the fair market value at date of death. The partnership then makes a Sec. 754 election, which has the effect of increasing the inside basis of the land for the deceased partner's share. As a result, the tax basis in the land held by the partnership will correlate to the stepped-up outside basis in the partnership interest. So, assuming the LLC ownership units pass through one or both of your estates to the children and grandchildren and further that the Sec. 754 tax election is properly made, your heirs will have a fresh tax cost in the land based upon values at each person's death.

In some cases, the owners of an LLC might elect to have the entity taxed as an S corporation (this is done by filing IRS Form 2553, and the entity then reports annually on Form 1120-S). The annual operations are reported essentially the same as a partnership: The entity does not pay tax, but rather reports its net income annually to the owners who pay the tax in their Forms 1040. But there is a big difference at the death of a stockholder. The stock is revalued and gets the step-up in basis, but there is no Sec. 754 election equivalent. As a result, the land inside the S corporation retains its low historical basis, and a large capital gain will occur at some point down the road if land is sold.

I have explained this distinction between a partnership and an S corporation because your question refers to an LLC, but uses "stockholder" terms. To a tax professional, ownership of an LLC is normally referred to as member units, partnership units or a partnership interest, whereas an S corporation is technically owned by stockholders and has units of stock outstanding. Hopefully, you have an LLC taxed as a partnership, and your heirs will receive a basis step up in the land via the Sec. 754 election.

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QUESTION

I own an 80-cow dairy with one full-time employee. This spring I purchased a trailer home at the nearby trailer park for him to live in. I pay the $400/month lot rent, insurance, property taxes, and cover any repairs. He is responsible for his utilities. We agreed to lower his hourly wage to offset the housing arrangement. Everything is going well and both of us like the arrangement. My questions are: (1) Can I use the purchase of the trailer as a Sec. 179 deduction? (2) Can I deduct the lot rent, insurance, taxes and repairs as a labor expense? (3) Do I have to add anything to his W-2 for the housing?

ANSWER

The purchase of the trailer is a depreciable asset to your farm business, as it is used for employee housing. Unfortunately, the tax law prevents use of the Sec. 179 deduction for property used to furnish lodging, including employee lodging [Sec. 179(d)(1), via ref to Sec. 50(b)]. You are entitled to depreciate the trailer. If it was a new (not used) asset at purchase, it qualifies for the 50% first-year bonus deduction.

The balance of the story is also not good news. An employer can provide tax-free housing for an employee if necessary for business reasons, but only if the lodging is located on the employer business premises [Sec. 119(a)(2)]. Because the lodging benefits you are paying are not on your farm site, they cannot be a tax-free fringe to your employee. They must be reported as taxable compensation. Accordingly, you need to add the lot rent, insurance, property taxes and any repairs you paid during 2016 to the Form W-2 wages of the employee. These non-cash wages are reported only in Box 1 of the W-2; they are exempt from FICA/Medicare taxes (because it is for agricultural labor). But the result is that the employee has more taxable income than perhaps anticipated.

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QUESTION

I have a tax question that might make a good column for Andy Biebl. Our parents left their land to my brother, sister and me. We have a share crop arrangement with a young farmer and are working to divide the properties. Since we continued operating the farms together, how long do we have to wait to make a like-kind exchange of properties to divide the land?

ANSWER

Great question, but unfortunately the answer will be a bit lame. The Sec. 1031 like-kind exchange rules require that property must be "held for productive use in a trade or business or held for investment." When a taxpayer receives property and immediately disposes of it in a like-kind exchange, the IRS can easily assert that it was not held for a sufficient period that established its use in a business or holding for investment. We particularly have this concern when a land-holding partnership is terminated tax-free, but then the partners (with newly acquired direct ownership in land) enter into a 1031 swap. Unfortunately, there is no bright line test defining the requisite period of ownership to meet the "held for" test.

You state that after inheriting the land from parents, you and your siblings "continued operating the farms together." That suggests to me that you have held the land for perhaps several years as landlords, and are now looking to exchange into specific parcels for each heir rather than continuing as co-owners with undivided interests in each parcel. Most tax advisers like to see two years of ownership before recommending a like-kind exchange (there are other areas in the tax law that use two years as indicative of the status of property). My advice would be to get through two years of your rental ownership before separating your interests via a Sec. 1031 exchange.

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Editor's Note: Andy Biebl is a CPA and tax principal with the firm of CliftonLarsonAllen LLP in Minneapolis with more than 40 years' experience in ag taxation, including as a trainer for the American Institute of CPAs and other technical seminars. To pose questions for future tax columns, e-mail AskAndy@dtn.com .

(MZT/SK/AG)