Should Machinery Be in an LLC? Part 2.

In our last blog post, we explored how an LLC affects liability when owning machinery. However, liability isn’t the only consideration when evaluating the benefits of an LLC for your machinery. In this article, we'll focus on the tax implications of establishing a machinery LLC. As with most legal and tax strategies, there are both advantages and disadvantages to weigh before making a decision.

Section 179 Deductions

Farmers often use Section 179 to immediately expense the purchase of machinery rather than taking depreciation over a number of years.  If the machinery is used in the farming operation, Section 179 can be taken regardless of whether the machinery is owned individually or in a business entity.  However, Section 179 may not be available to retired farmers who still own machinery.

A common farm transition plan is for the retiring farmer to continue to own the machinery and lease it to the next generation farmer.  This leasing strategy avoids a sale of the machinery that would result in significant income taxes.  Leasing also helps the next generation’s cash flow.  However, a challenge with this strategy is that Section 179 expensing is not available for individuals who lease their machinery.  Consider the following example:

Mom and Dad decide to retire from farming and transition their operation to Daughter.  To avoid significant taxes on a sale and to help Daughter cash flow her farming operation, Mom and Dad continue to own the machinery and lease to Daughter.  If Mom and Dad purchase new machinery to add to their inventory, they will likely not be eligible for Section 179 expensing.

Using an LLC can allow for Section 179 eligibility because business entities who lease machinery are eligible for Section 179.  Let’s continue the example:

Mom and Dad set up an LLC and transfer their machinery to the LLC.  This new entity leases the machinery to Daughter.  If the LLC buys new machinery, the newly purchased machinery will likely be eligible for Section 179.

As the examples illustrate, using an LLC can be an effective strategy to maintain Section 179 eligibility for farmers who may have retired but maintained ownership of the farm machinery.

Reducing Self-Employment Tax

Leasing personal property, including farm machinery, generally results in self-employment tax, unless the machinery is leased along with real estate. One potential strategy to mitigate self-employment tax is to establish an LLC taxed as an S-Corporation and contribute the machinery to the LLC. In theory, some of the rental income is distributed to the owners without being subject to self-employment tax.  However, this strategy carries several risks.

The first major risk is the loss of a stepped-up tax basis upon the owner's death. When machinery is owned by an individual or by an entity taxed as a partnership, heirs may receive a stepped-up tax basis on the machinery, allowing them to re-depreciate or sell the equipment with little to no taxable gain. When machinery is held by a corporation, the stepped-up basis only applies to the ownership interest, not the machinery.  Let’s explain this concept by continuing the previous example:

Mom and Dad’s LLC holds $1,000,000 of machinery and is owned in equal shares.  They decide to tax their LLC as a partnership.   If Dad dies, his estate can either receive a $500,000 stepped-up basis on his ownership interest or the machinery in the LLC will receive a stepped-up basis of $500,000.  Mom, as the executor, elects to take the stepped-up basis on the machinery.  Mom now has $500,000 of additional tax basis in the LLC that can be depreciated offsetting $500,000 of income.

Conversely, Mom and Dad decided to tax their LLC as an S-Corporation.  Dad’s estate will only receive a stepped-up basis on his shares of stock.  Mom cannot depreciate the stock.  The stepped-up basis will only help Mom if she sells the stock, which is unlikely.

The stepped-up basis upon the death of an owner can be a huge financial windfall to the surviving spouse or heirs.  A loss of stepped-up basis on the inside assets of an entity taxed as a corporation should be taken into consideration when deciding upon the tax structure of a business entity that will hold machinery.

Another downside of holding leased machinery in an S-Corporation is the potential passive income tax. If more than 25% of the S-Corporation’s total income comes from passive activities, including machinery leasing, the corporation may face a tax on its net passive income. If this passive income exceeds 25% for three consecutive years, the S-Corporation risks losing its status and may be forced to convert to a C-Corporation, which could have more complex tax consequences.

Beware of Debt on the Machinery

Normally, contributing machinery to an LLC does not trigger any tax.  However, there is an exception when the debt on the machinery exceeds the tax basis.  In this circumstance, the IRS may treat the excess amount as a gain for the individual transferring the asset.  This gain is subject to income tax and can create an unexpected tax liability for the owner of the machinery.  Consider the following example:

Mom and Dad own a tractor that has a $20,000 tax basis.  They have $50,000 of debt on the tractor.  They contribute the tractor to their LLC.  When their accountant prepares their tax return the following year, the accountant informs Mom and Dad that they owe income tax on the $30,000 difference between the debt and tax basis.

Before contributing machinery to an LLC, be sure to consult with your tax advisor to be sure that there will be no unexpected tax liabilities.

Importance of a Written Lease

No matter which entity or tax structure you choose, it’s important to have a written lease for your machinery. A formal written agreement clearly outlines the responsibilities of both the lessor and lessee, helping to prevent misunderstandings or disputes down the road.  A written lease also reinforces the legitimacy of the arrangement as a formal business transaction. Without a proper lease, the IRS might scrutinize the leasing arrangement, potentially treating it as a disguised sale or disallowing certain tax benefits, such as Section 179 deductions. To avoid these issues, always use a comprehensive, well-drafted lease for machinery leasing arrangements.

Seek Legal and Tax Advice

Using an LLC to hold farm machinery can provide tax benefits but is also fraught with potential pitfalls.  Be sure to consult with your legal and tax advisor before establishing an LLC and transferring your machinery to the LLC.  A careful analysis of the advantages and disadvantages of an LLC and its tax structure must be done to determine the best strategy to pursue.