Tax Matters Related to the Transfer of Property Through Divorce How is my Settlement Taxed?
Scroll to top
How does minimum gain chargeback work?
Many LLCs finance acquisitions of property with nonrecourse debt. When this occurs, the economic risk to individual members is limited to their cash investment and any portion of the loan for which they may be personally liable.
We use the term “economic risk” because if the LLC were to walk away from the debt, the nonrecourse nature would leave each member at a loss only to the extent of their cash investment in securing the loan. Therefore, allocating a depreciation deduction to each member lacks economic effect unless it accurately reflects a corresponding economic burden to the member.
This is where minimum gain comes into the picture. Because an allocation of a nonrecourse deduction lacks economic effect, the regulations will only allow such allocation provided the tax payback is accomplished through a “minimum gain chargeback” (Reg. Sec. 1-704(2(f)(1)). A minimum gain chargeback is a provision within the operating agreement requiring the LLC to allocate minimum gain to those members who previously were allocated nonrecourse deductions.
A good way to think of minimum gain is this: any excess of the nonrecourse liability over the adjusted basis of the property that secures the debt results in a minimum gain situation. In other words, an LLC is only in a minimum gain situation if they were to dispose of the property and the debt exceeds the adjusted basis.
For example, assume member A and member B form an LLC to acquire property they plan to fix up and sell. Both contribute $50,000 to the LLC, which they use to secure a $1,000,000 piece of property (down payment of $100,000 and $900,000 as a nonrecourse loan). Let’s also assume no principal payments are due on the loan for 5 years.
In year one the LLC is permitted to take a $50,000 depreciation deduction, which is allocated 50/50 to each member. Do we have a minimum gain situation? No. In year one the LLC would not realize minimum gain because if the property was disposed for full satisfaction of the nonrecourse debt ($900,000) its amount realized would not exceed its adjusted basis ($950,000).
Now in year two the same $50,000 depreciation deduction occurs. Do we have minimum gain? We still do not, as the debt ($900,000) does not exceed the adjusted basis ($900,000).
How about in year three if the LLC takes another $50,000 deduction allocating the deduction 50/50 to each member? Yes! Now the debt ($900,000) exceeds the adjusted basis ($850,000).
To summarize, minimum gain is a neutralizing provision that permits a member to receive a tax benefit in a year despite the benefit lacking economic effect (i.e. the member has no economic risk if the property goes under due to the loans nonrecourse nature). However, to offset the benefit the taxpayer receives, a minimum gain chargeback provision within the operating agreement requires the member to have a tax burden based on the amount of allocation they took below the adjusted basis if the property were to be disposed. In our example above, if the property were sold after year three the chargeback would be $50,000, which is the amount of nonrecourse debt that exceeded the adjusted basis.
As you can see, minimum gain can be tricky. However, for many LLCs the benefits can certainly outweigh the risks. It’s important to ensure you talk to a tax professional and an attorney when putting together an operating agreement as typical boilerplate language may not cover your unique situation.
For question or comments about this article, or to talk through your particular situation, please call us at 415 633 6841 or email us at [email protected]
Disclaimer: This article discusses general legal issues, but it does not constitute legal advice. No reader should act or refrain from acting on the basis of any information presented herein without seeking the advice of counsel in the relevant jurisdiction. Bend Law Group, PC expressly disclaims all liability in respect of any actions taken or not taken based on any contents of this article.
- Click to share on Twitter (Opens in new window)
- Click to share on Facebook (Opens in new window)
- Click to share on Google+ (Opens in new window)