I'm almost ready to file the papers for organizing my LLC. But I just
need some type of clear-cut explanation on the valuation of the LLC's
membership interest before I do so. It just seems like in the two LLC
formation books I have, and some random Googling I've done, give the
same vague explanation that just doesn't really make sense.

I guess the best way to ask this question is through an example. I am
putting in $750 for 75% membership interest, while a friend puts in
$250 for 25% interest. This would seem to "set a value" of $10 per 1%
membership interest. Now, say a new investor comes along, willing to
give us $500. But I don't want to give up half-ownership, obviously.
Am I thinking my friend and I can offer whatever percentage membership
we want, regardless of the previous "value" of $10/1%?

Let's assume I cough up 25% interest... Seemingly creating a new value
of $20/1% interest. Yet another person comes along, and wants to shell
out only $50. Again, does that mean I could theoretically negotiate to
give them, say, 10% interest?

At least with regular corporate stock, I *somewhat* understood par
(minimum) value, and kind of got it hammered through my head that the
stock markets work on an "auction" format, where the brokers
supposedly throw out bids for stock shares. Who knows, that could be
wrong too. :)

I'm just generally confused about the issue. It seems like an investor
can come along, say he wants to give up $x, and the existing
membership huddle together to say "okay, let's give him x% of
ownership", without respect to any type of set value of $x/x%
ownership.

To whomever picks this up... Thanks!!! :D

Hello and thank you for your question.

I think the best way to look at this is the way the IRS does.

Taking your example, let's say the LLC issued 100 ownership units, 75
to you at $10 per unit and 25 to your partner also at $10 per unit.

The new investor is budgeting $500, and you are offering the new
investor 25 of your units at a $20 per unit price.  The fact that the
new investor is willing to pay a higher price than you two founders
paid is not unusual or surprising - - it just means that the value of
your LLC has grown.

This is where the IRS comes in.  They will require you to apportion
your $750 basis among the 75 units (the same $10 per unit that we
derived above) which means that you have a cost basis of $250 in the
25 units that you sold.  And the IRS will require you to pay income
tax on the (500 - (25 * 10)) = $250 gain recognized by you on the
sale.  It will be a short term or long term capital gain depending on
whether more than a year passed between the date you funded the LLC
and the date you made the sale.

Now the ownership of the LLC is 25 - 50 - 25.  If a fourth person
comes along and accepts the $20 per unit value then $50 will only buy
2.5 units.  If you are the seller, you will have further gain of (50 -
(2.5 * 10)) = $25 taxable gain (as you note, since this sale would put
you under 50% you might demand a higher price if you were selling
because you are giving up the near-control that a 50% member enjoys).
But if the fourth person instead demands 10 units for that $50 and if
you are for some reason willing to sell, then your tax result is a
capital loss of
(50 - (10 * 10)) = -50
Either a short term or long term capital loss on those units depending
on whether you held them a year.

So it really matters not just how much a person pays, but also how
many units (that is, what percentage interest) the seller gives up for
that price.

And since LLC distributions will be paid out in proportion to the
units owned, there is what the tax law calls a substantial economic
effect to the transaction, which is why you will have a gain or loss
on these sales depending on what size intersts you sell.

Take a look at the (rather complicated) example on page 43 of Publication 550
http://www.irs.gov/pub/irs-pdf/p550.pdf

Search terms used:
publication allocate basis  gain site:irs.gov

Thanks for bringing us your question.  If you find the above unclear,
please request clarification.  I would appreciate it if you would hold
off on rating my answer until I have a chance to reply.

Sincerely,
Richard-ga

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Request for Answer Clarification by sbalmos-ga on 08 Jul 2004 07:37 PDT

Oh very nice Richard. Probably the first clear answer I've seen on
this, even in the books. :)

So the capital gain or loss is completely assigned to whomever is
effectively "selling" part of their ownership to the newbie. I guess
it may be prudent to periodically meet with the ownership and *set* an
arbitrary price per unit for a given period of time, rather than
randomly saying we'll give up x units for whatever the new person is
paying. Say for the next fiscal quarter, we're going to charge $5 per
voting unit, and $1 per nonvoting. The next quarter, we may up it to
$10/voting unit, and $5/nonvoting, etc.

Am I assuming right that no capital gain or loss is figured in if the
person is buying an outstanding unit of ownership? E.g. at formation,
say we issue 1,000 units. My friend buys 100 units, and I buy 400, at
$1/unit. So I have 80% ownership, and he has 20%. New person comes
along with $500. We don't want him to have half-ownership (making me
have 40%, friend 10%, and new guy 50%), so we give him 100 outstanding
units, at $5/unit. There's no capital gain on that, since the units
were outstanding and not owned by anyone, right?

I may have another question forming regarding how to handle
distributions of profit, and allocations of loss (more so loss
allocation), later on today. I'll put that in another question for
someone else. Unless you want to try to answer that in a
clarification, also, and I'll tip appropriately?

Thanks!

--Scott

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Clarification of Answer by richard-ga on 08 Jul 2004 16:59 PDT

Thank you for the kind words; I'm glad you found my answer useful.

Your notion that taxable gain can be avoided if the new investor makes
his or her payment to the partnership rather than to one of the
partners is correct:
"Usually, neither the partner nor the partnership recognizes a gain or
loss when property is contributed to the partnership in exchange for a
partnership interest. This applies whether a partnership is being
formed or is already operating."
http://www.irs.gov/publications/p541/ar02.html#d0e2680

If you a further question, I would prefer that you list it as a new
question at whatever price you consider appropriate.  If you wish, you
can mention my name in the question or you can simply leave it for any
interested Researcher to address.

Thanks again for letting us help.

Richard-ga

Clear, concise answer, explaining everything needed while cutting
through all the jargon.