federal income tax consequences

ISSUE
Please write a memo that discusses the potential federal income tax consequences when a single member domestic limited liability company (“LLC” hereinafter) that is disregarded for federal tax purposes as an entity separate from its owner under Treas. Reg. § 301.7701-3 becomes an entity with more than one owner that is classified as a partnership for federal tax purposes.
– Sale or Exchange
– Gain or loss
– Inside and outside basis
– Holding period

FACTS
In each of the following two situations, an LLC is formed and operates in a state which permits an LLC to have a single owner. Each LLC has a single owner, A, and is disregarded as an entity separate from its owner for federal tax purposes under Treas. Reg. § 301.7701-3. In both situations, the LLC would not be treated as an investment company (within the meaning of Internal Revenue Code (“IRC” hereinafter) § 351) if it were incorporated. All of the assets held by each LLC are capital assets or property described in IRC § 1231. For the sake of simplicity, it is assumed that neither LLC is liable for any indebtedness, nor are the assets of the LLCs subject to any indebtedness.
Case 1. B, who is not related to A, purchases 50% of A’s ownership interest in the LLC for $5,000. A does not contribute any portion of the $5,000 to the LLC. A and B continue to operate the business of the LLC as co-owners of the LLC.
Case 2. B, who is not related to A, contributes $10,000 to the LLC in exchange for a 50% ownership interest in the LLC. The LLC uses all of the contributed cash in its business. A and B continue to operate the business of the LLC as co-owners of the LLC. After the sale, in both situations, no entity classification election is made on Form 8832 under Treas. Reg. § 301.7701-3(c) to treat the LLC as an association for federal tax purposes.

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