LLC lawyers should have at least a basic understanding of the IRC passive activity and at risk rules. Today’s Tax Notes has advised that IRS has just released Publication 925 (rev. 2015), Passive Activity and At-Risk Rules, for use in preparing 2015 returns, discussing the passive activity and at-risk rules that may limit the amount of a taxpayer’s deductible loss from a trade, business, rental, or other income-producing activity.
The default federal income tax regimen for multi-member LLCs is partnership taxation under Internal Revenue Code Subchapter K, and for many multi-member LLCs, partnership is better than the other main option—namely, taxation under Subchapter S—except for purposes of avoiding Social Security Taxes. Occasionally, prospective members of multi-member LLCs want to obtain at least a basic understanding of partnership taxation if they don’t already have one. I think the nine points below will help them to obtain this understanding.
However, I know there are at least a few members of this blog—and maybe a lot—who know much more about partnership taxation than I do. I know we’d all be grateful for any comment these members may have about the list below.
Chief characteristics of federal partnership taxation
Federal partnership taxation is complex, but its chief features are as set forth below. In the discussion below, “partnership” means an LLC taxable as a partnership and “partner” means a member of this partnership.
- Any person may be a member of a partnership. Any type of individual or entity, whether U.S. or foreign, may be a member of an entity taxable as a partnership.
- Contributions are generally tax-free. Contributions of cash, property and services to partnerships by the partners are generally tax-free both to the contributors and to the partnership.
- Partnership basis may be included in member basis. Each partner can increase his basis in the partnership (and thus the possibility that he will be able to lawfully reduce or avoid tax on his share of certain LLC income) to the extent of his share of any LLC debts, including mortgage debts.
- “Regulatory” special allocations. The LLC must make “special allocations” to the members—i.e., allocations of LLC income that are disproportionate to their shares of that income—to the extent required by U.S. Treasury Regulations. These are called “regulatory” special allocations. For example, the operating agreements of LLCs taxable as partnerships must generally provide that precontribution gain by the partnership from dispositions of property contributed to it must be allocated to the contributing partners.
- “Contractual” special allocations. However, an LLC taxable as a partnership may also make “contractual” special allocations as long as these special allocations are not merely to evade federal taxes. For example, an LLC may allocate a share of the LLC’s profits to a partner even if the partner make no contributions of cash, property or services to the LLC. Under this arrangement, that partner’s interest in the LLC will be called a “profits interest.”
- Only the partners, not the partnership, are subject to partnership federal income tax. The partnership is not subject to federal tax on its profits. However, on their respective shares of partnership income, partners are subject to federal tax. The rate of this tax for each partner is the partner’s individual federal income tax rate. The partners must each withhold and pay this tax on a roughly quarterly basis unless the partnership does the withholding.
- Distributions to partners are generally tax-free. Distributions of cash by the partnership to the partners are generally not subject to federal income tax in the hands of the partners unless they exceed the partners’ bases (i.e., the deemed amount of their investment in the partnership as determined under federal tax rules).
- Requirement to maintain capital accounts for the partners. A partnership must maintain a capital account for each partner in accordance with U.S. Treasury Department rules. These rules are intended to determine each partner’s share of the economic value of the partnership.
- “Zeroing out” of capital accounts. When a partner is bought out by the partnership and when the partnership is dissolved and liquidated, the LLC must pay the affected partners enough to zero out their capital accounts, and the partners must pay the LLC any deficit in these accounts.
Bob Keatinge is a leading national expert on LLC law and tax. In the e-mail below, he’s provided an excellent summary of the above statistics as applicable to LLCs taxable as partnerships. If you’re trying, for your own sake and that of your clients, to understand the LLC form in perspective and from a practical viewpoint, you’ll find Bob’s summary very useful.
On a snowy afternoon, nothing beats reading the statistics of income bulletin by the fire with cognac. The Fall 2015 Issue (https://www.irs.gov/uac/SOI-Tax-Stats-SOI-Bulletin-Fall-20150) , which includes the 2013 partnership return information has just come out.
The highlights of the report are as follows:
- Partnerships filed more than 3.4 million tax returns for 2013, a 2.1-percent increase over the number filed for 2012. These returns represented 27.5 million partners, up 8.5 percent from the previous year.
- Domestic limited liability companies (LLCs) made up the majority (66 percent) of all partnerships, surpassing all other entity types for the 12th consecutive year.
- Domestic limited partnerships represented only 12 percent of all partnerships but reported the most profits (32.4 percent), and the largest share of partners (45.2 percent).
- Real estate and rental and leasing accounted for about half (49.8 percent) of all partnerships and just over a quarter (27.7 percent) of all partners. The finance and insurance sector reported the largest shares of total net income (loss) (41.1 percent), total assets (56.7 percent), and total receipts (21.8 percent) in 2013.
- Total assets increased 9.8 percent between 2012 and 2013, from $22 trillion to $24.2 trillion. Some 18 (out of 20) industrial sectors reported an increase.
- Receipts totaled $7.1 trillion for 2013, up 7.1 percent from the amount reported for 2012. Business receipts made up the majority of total receipts (71.7 percent), rising 8.1 percent for the year.
- Total net income (loss), or profit, decreased 1.2 percent, from $777.9 billion for 2012 to $768.8 billion for 2013. Multiple components accounted for this decline, including ordinary income, interest income, and dividend income.
- Between 2012 and 2013, total income (loss) minus total deductions available for allocation increased from $1,400.8 billion to $1,478.5 billion. Partners classified as partnerships received the largest share of income (loss) allocated to partners, $491.6 billion.
One of the most interesting statements is “For the second consecutive year, partnerships surpassed both corporations and individuals as the top income (loss) recipients.”
The link below is to a recent blog post by Tom Rutledge, a leading U.S. LLC lawyer and scholar. I think I disagree with Tom on the issue whether LLCs should make S elections, but the issue is an important one for all accountants, and his post is well worth consideration.
Here’s the link:
The blog post under the link below summarizes a significant new IRS ruling permitting entities that are LLCs for law purposes but corporations for federal tax purposes to adopt ESOP programs. ESOPs can provide, among other things, an effective means for owners of closely held corporations to cash out.
John Cunningham teaches authoritative, affordable in-house seminars to legal and accounting firms nationwide on a wide variety of topics concerning LLC law, tax and practice and the use of LLCs for asset protection. For more information about these seminars, please call John at (603) 856-7172, e-mail him at firstname.lastname@example.org, or click here.
LLC lawyers are often asked by their clients to help them sell their LLC businesses. Under the following link is new and excellent blawg post from Lou Vlahos of the Farrell Fritz firm about the provisions in PATH about federal tax issues in these sales:
Under the following link is an excellent new post on PATH in the Farrell Fritz blog about closely held business tax: http://www.taxlawforchb.com/2015/12/protecting-americans-from-tax-hikes-of-2015-highlights-for-the-closely-held-business/?utm_source=Tax+Law+for+the+Closely-Held+Business&utm_campaign=98e4a6b6a0-RSS_EMAIL_CAMPAIGN&utm_medium=email&utm_term=0_4d5d267118-98e4a6b6a0-73367009
Even non-lawyer accountants should be aware of the developments described in the new blog post under the link below. The title of the post is:
New Partnership Audit Rules Impact Both Existing and New Partnership and LLC Operating Agreements
Under the link below is a useful new blog about partnership audits in the excellent Farrell Fritz blog called “Tax Law for the Closely Held Business.”
Here’s the link: http://www.taxlawforchb.com/2015/12/did-you-say-a-taxable-partnership/?utm_source=Tax+Law+for+the+Closely-Held+Business&utm_campaign=4f893424be-RSS_EMAIL_CAMPAIGN&utm_medium=email&utm_term=0_4d5d267118-4f893424be-73367009