A “99-5” refers to IRS Revenue Ruling 99-5, which discusses the federal income tax consequences of a transaction that takes place changing a single-member LLC (limited liability corporation) into a partnership for federal tax purposes.
Before we examine the transaction and the guidance provided by RR 99-5, let us briefly review the difference between the sole proprietorship, the LLC, and a C corporation. A sole proprietor does not need to file the legal documents to become an LLC; anyone can start a business independently if they intend to work alone. However, you can't share the ownership responsibilities, and you probably still need a business license in many cases. The disadvantage is that you remain liable for obligations incurred by the business, and this exposure may be significant.
A Limited Liability Corporation allows you to expand the number of owners in the present or future, so the structure provides you with greater flexibility as you grow. At the same time, you can protect yourself from risk since you are not personally exposed to liability for business debts. Because the LLC is a straightforward business structure, it is popular with small business owners, including real estate investors. Pass-through federal taxation is among the advantages for an LLC owner.
In contrast, if you have bigger plans for growth, a C Corporation might be a smart way to go. This route offers the potential to go public if that's a potential outcome, and C corps are recognized internationally. In addition, this structure, like the LLC, protects owners from liability. Still, both the corporation and the shareholders pay taxes on income, and you surrender some flexibility by having a board of directors.
When a Single-Member LLC Becomes a Multi-Member LLC
Assume that the business in question was formed as an LLC, and the sole owner plans to bring in a second member or multiple additional participants. Revenue Ruling 99-5 provides IRS guidance on the appropriate accounting procedures for that conversion, depending on whether the new member joins by contributing cash, property, or both.
The IRS guidance discusses scenarios in which the original LLC (owned by single-member A) becomes a co-ownership by member B purchasing an interest in the LLC from A, who retains the contributed funds for their own use; or by contributing to the LLC funds in exchange for a share of ownership but instead, the funds are used as part of the LLC operating capital. RR 99-5 states in both cases that no entity classification election is made to treat the LLC as an association.
The original owner's decision of whether to sell an interest for cash or allow a new participant to contribute property or money in exchange for an interest would likely be determined by whether the first owner wants personal cash flow or increased funds available for operating capital for the business.
Related Revenue Ruling 99-6
In the reverse scenario, a multi-member LLC can become a single-owner LLC when all owners sell their interests to one person. That person can either be one of the current owners or a current non-owner. The guidance issued by the IRS for that transaction is in Revenue Ruling 99-6.
