When you form an LLC, you will need to transfer assets into the company in order to properly capitalize the business. If you have business partners, they too will contribute assets in exchange for an ownership percentage.
Capitalization is critical to your LLC. Bank loans are nearly impossible to receive for business owners with no equity in their company. In addition, members of an under-capitalized LLC may be found ineligible for the liability protection generally provided by an LLC.
Let's look at how transferring assets works.
A capital contribution is an asset given to your LLC in exchange for equity (the value of your ownership percentage). An asset can be cash, property, or professional services.
Most capital contributions are tax-free. If you initially invest $10,000 in your LLC as a capital contribution, you would receive $10,000 of equity. You would not be required to pay a capital gains tax on your new equity. This same rule applies to your LLC, which would not pay a tax on the $10,000 of new working capital.
Cash is simple. More complicated is the transfer of property, such as computers, vehicles, or real estate. When transferring property, you must properly record the Fair Market Value (FMV) of the property, what you paid for it originally, as well as any depreciation. FMV and depreciation affect both the equity you receive as well as the company's tax basis.
Capital contributions must be carefully recorded in your Operating Agreement. Undocumented contributions often lead to significant tax concerns later on.
The following information should be recorded in your Operating Agreement:
- Name, address, and SSN/EIN of the member and LLC
- Description of asset
- Value of asset
- Date of contribution
- Ownership percentage received
- All liabilities assumed with the asset
- Written transfer document (if applicable)
- Adjusted basis of asset (if applicable)
Sale & Purchase
Instead of transferring assets as a capital contribution, you can also sell assets directly to your LLC. The most significant difference between a contribution and a sale is that the sale creates no equity in the company.
For example, if you sold a chunk of land to McDonald's and a drive-in was later built on the property, you would not receive shares of McDonald's stock in return for the land.
Sales are also not without certain tax implications, both for you, the seller, and your LLC, the purchaser.
Let's say you sell a car for $10,000 to your LLC. The cash you receive is now a taxable gain which must be reported on your income tax return. As well, your LLC has received an asset with a depreciable basis ($10,000 which will depreciate over time).
Asset purchases should be as carefully recorded as capital contributions, although there is no reason to record purchases in your Operating Agreement. Instead, you should keep careful records of each purchase and ensure that all titles and deeds are properly transferred into the name of the LLC.
Filing an Asset Transfer Document
Certain assets come with deeds or titles proving ownership. With these assets, correct transfer requires that a Transfer Document be filed and a new deed or title issued.
You can obtain a Transfer Document from the agency where the original deed/title is filed. For example, a vehicle title is generally filed with your local Department of Licensing. You can fill out the Transfer Document and then bring it to a notary. Once the document is notarized, you can file the original deed/title and the Transfer Document with the filing agency. A new deed/title will be issued showing that your LLC is now the owner.
If you are transferring an asset with a lien or mortgage, you will need written permission from the bank or lender in order to complete the transfer. The lender will want to assess the creditworthiness of your LLC before allowing the transfer.
Fraudulent Transfer of Assets
Not all asset transfers are legal. A fraudulent transfer or fraudulent conveyance is a transfer that is undertaken to hide assets from or put assets out of the reach of creditors. It can also, however, be done by mistake by new entrepreneurs not fully aware of how asset transfers work.
When examining asset transfers, a court will look for three primary elements:
- Was the transfer made with the intent to defeat creditors?
- Was the debtor insolvent at the time of the transfer or made insolvent by the transfer?
- Was the transfer without reasonably equivalent value?
Reasonably equivalent value refers to the value you receive in return for transferring an asset to your LLC. Let's say you transfer a piece of property valued at $100,000 to your LLC, and in return, you received $50,000 cash. While you received value through the transfer, you did not receive reasonably equivalent value, because the LLC paid you far less than the asset was worth. In this instance, the court may rule that the transfer was fraudulent and thus voidable.
To evaluate the reasonable equivalent value, a court will examine Fair Market Value; whether or not a transfer was made in good faith in the ordinary course of business; value of competitive bids; and the net effect on the debtor's estate with respect to funds available to unsecured creditors.