Archive for LLC

IRS Proposes New Treatment of LLC Members, Limited Partners Under Passive Loss Rules

In November 2011 the IRS issued proposed regulations (REG-109369-10) that would redefine “interest in a limited partnership as a limited partner” for purposes of determining material participation under the Sec. 469 passive loss rules.

What that means in plain terms is that historically under Sec. 469(h)(2), losses from an interest in a limited partnership have been treated as passive losses because essentially no limited partner in a limited partnership is treated as materially participating in the management of the investment.

With these proposed regulations, the IRS is more narrowly defining when a partner’s interest will be treated as a limited partnership interest for purposes of the passive activity rules which I believe to be good. Under the proposed regulations, an interest in an entity will be treated as an interest in a limited partnership under Sec. 469(h)(2) if:

  1. The entity is classified as a partnership for federal tax purposes; and

  2. The holder of the interest does not have rights to manage the entity at all times during the entity’s tax year under the law of the jurisdiction in which the entity was organized and under the entity’s governing agreement. Rights to manage include the power to bind the entity.

The IRS emphasizes that these rules are provided solely for purposes of the passive activity rules and not for any other provision that makes a distinction between a general partner and a limited partner. The IRS requested the change evidently because under the Revised Uniform Limited Partnership Act of 1985, many states have adopted laws that allow limited partners to participate in the management and control of the partnership without losing their limited liability. In addition, under state LLC laws, LLC members do not lose their limited liability by management participation in the LLC’s business. Nevertheless, the IRS has historically treated members of LLCs as limited partners for purposes of this rule. Various courts have disagreed with the IRS and have allowed LLC members to be treated as general partners and therefore allowed them to prove material participation under the passive loss rules.

Comments on the proposed changes are due Feb. 27, 2012. The regulations would apply to tax years beginning on or after the date of their publication in the Federal Register.

Should A Husband/Wife Form a Limited Liability Corporation (LLC) to Invest In Real Estate?

A husband and wife formed a Limited Liability Corporation (LLC) that invests in rental real estate to protect themselves in event of a lawsuit. They want to know if they formed the most appropriate business structure and whether their rental activity is reported on IRS Form 1040 Schedule E. To answer this question I turned to my friend and all around great guy, Michael P. Merrion, who has supplied this blog its first guest post. Please contact me directly for information on how to reach out to him.

Pursuant to the rules of professional conduct set forth in US Treasury Department Circular 230 nothing contained in this blog was intended to be used by any taxpayer for the purpose of avoiding penalties that may be imposed by the Internal Revenue Service, and it cannot be used by any taxpayer for such purpose.

This question raises a number of collateral issues which are not readily apparent from the skeletal statement of facts, but which require some consideration when addressing the underlying issues.

Income from a rental property owned by one person is generally[1] reported on page 1 of Schedule E.  The same is true if the rental property is owned by a husband and wife who elect to be treated as a single taxpayer by filing a joint return.  However, if the property is owned by two or more persons who are not spouses, and who cannot therefore elect to file jointly, the reporting treatment depends upon the nature of the activity in the venture (addressed more fully below).

In the present case, however, the rental property is actually owned by the limited liability company which is, in turn, wholly owned by the spouses.  This tiered ownership structure adds a level of complexity to the analysis.  If only one spouse owned the entire LLC interest, then the LLC would be considered to be a “disregarded entity”[2] for tax purposes and the rental activity would still be reported on page 1 of the Schedule E.  However, if the LLC is owned by two persons, it is not considered to be “disregarded” and the LLC would have a separate tax filing requirement.  In that case, each “partner” would receive a form k-1, and the income from the venture (partnership) would be reported on page 2 of the taxpayers’ Schedule E.

But wait!  What if the only owners of the LLC holding the rental property are spouses who elect to be treated as one taxpayer (by filing jointly).  Are they entitled to any special consideration in determining whether the interests must be reported as a separate entity?  Sadly, they are not.  With one notable exception, an LLC owned by two persons, regardless of their relationship, is considered a separate entity for filing purposes.

With regard to the “notable exception” mentioned above, one should note that the above discussion assumes that the spouses are not living in a community property state.  The IRS has acknowledged[3] that spouses living in a community property state may elect to treat their co-ownership of a business entity formed under the laws of that state as a disregarded entity for federal tax purposes.  In this limited instance, the spouses could elect to disregard the entity in the same manner as a sole member of an LLC in any other state, and report the income on page 1 of Schedule E.

That said, there are several provisions in the Code and Regulations that raise interesting possibilities and to which one might be drawn when counseling the taxpayers in this case.  The tempting nature of these provisions warrant some additional discussion.

Anytime there is an association of persons engaged in an endeavor, and the participants have not taken the additional step of formalizing the terms of the venture, perhaps with formal organization (i.e., a corporation or LLC), or simply with a formal document (partnership agreement, etc.), a certain amount of confusion must necessarily follow.  It appears that the principal reason for the amount of confusion which typically accompanies an analysis of a client’s “joint venture” is the terminology itself.  For tax purposes, the term “joint venture” has been defined as a “special combination of two or more persons, where in some specific venture a profit jointly sought without any actual partnership or corporation designation.”[4]  Thus, the tax compliance requirements which more naturally accompany the formal organization of a corporation or LLC, or even the imposition of a simple partnership agreement, become more obscure when dealing with a joint venture, or even mere co-ownership of property.

Under the “check-the-box” regulations[5], the default classification of a joint venture is a partnership.  It is encouraging, however, that those regulations also acknowledge that mere co-ownership of property does not necessarily create a separate entity.  Something more is needed to raise the ownership to the level of a reporting partnership.  For example, mere cost sharing arrangements, or even co-ownership of property that is maintained, kept in good repair and rented does not constitute a separate entity for tax reporting purposes.  But if the venture is a trade or business, or is a co-ownership venture which also provides services in connection with a mere rental activity (whether directly or through an agent), the venture assumes the mantle of a reporting entity.  The problem in the case before us, is that there is no co-ownership of the rental property.  It is clearly wholly owned by the LLC.  The co-ownership is of the LLC, which is treated in much the same manner as that of co-ownership of a corporation.[6]

Another tempting provision is contained in IRC §761(a), which provides a definition of what constitutes a partnership for federal tax filing purposes (including a “joint venture”), and also provides that members of an unincorporated organization may elect out of Subchapter K (partnership reporting requirements) in three limited instances,[7] one of which arises where the venture is availed of for investment purposes only, and not for the active conduct of a business.  This election requires[8] that the co-owners (1) own the property as co-owners, (2) reserve the right separately to take or dispose of their shares of any property acquired or retained, and (3) do not actively conduct business (whether directly or through an agent).  Again, the co-ownership requirement limits the application of the provision in this instance.  The use of a state recognized entity such as a corporation or LLC[9] disqualifies the taxpayer from using this provision.[10]

There has also been some confusion regarding the application of the “Qualified Joint Venture” (“QJV”) rules of IRC §761(f) which became effective for tax years beginning after 12/31/2006 and which allow a husband and wife to report a jointly owned trade or business on separate schedule C’s[11] rather than having to a separate file partnership return.  This election is only available where (1) the only members of the joint venture are a husband and wife, (2) both spouses materially participate (within the meaning of IRC §469(h), i.e., the “passive activity rules”), and (3) both spouses elect the treatment.  It also requires that the spouses be conducting a trade or business: mere joint ownership of property does not qualify for the election.[12]  In addition, the election to be treated as a QJV is not available when the venture is held in the name of a state law entity such as a partnership or LLC.[13]

Thus, unless the owners elect some other entity classification under the “check-the-box” regulations, the spouses in our case will be required to file a partnership return for the LLC and each report their share of the financial activity of the LLC on page two of their joint Schedule E.


[1] Presumably, if the amount of rent related activity rises to the level of a trade or business, even rental income would be seen to be a trade or business, reportable on schedule C and subject to SE tax.

[2] See Treas. Reg. 301.7701-2(c)(2)(i).

[3] See Rev. Proc. 2002-69, 2002-2 CB 831 (10/9/2002).

[4] See Haley v. Commissioner, 203 F.2d 815, 818 (C.A. 5, 1953); Aiken Mills v. United States, 144 F.2d 23 (C.A. 4, 1944); Tompkins v. Commissioner, 97 F.2d 396 (C.A. 4,  1938).

[5] See Treas. Reg. 301.7701-1(a)(2).

[6] One sees this argument particularly in connection with like kind exchanges under IRC §1031, in cases where the “partners” wish to liquidate the property and some want to utilize the §1031 deferrals, while others just want to “cash-out.”  This is a problem as the like-kind exchange can only be accomplished by the owner (i.e., the LLC) and will impact all of the partners in the same manner.

[7] We will ignore the other two instances where taxpayers can elect out of Subchapter K, as they are not relevant to this discussion.

[8] See Treas. Reg. 1.761-2(a)(2).

[9] An LLC owned by more than one person is treated as an “other business entity” pursuant to Treas. Reg. 301.7701-2(c), i.e., not a corporation and not a disregarded entity for tax purposes.

[10] Treas. Reg. 1.761-2(a)(1) specifically excludes from this election out of Subchapter K “Any syndicate, group, pool, or joint venture which is classifiable as an association, or any group operating under an agreement which creases an organization classifiable as an association.”

[11] There is an additional collateral issue if QJV spouses elect to treat rental properties as QJV’s.  Since they are, in essence, taking the position that the activity constitutes a business reportable on schedule C, the question arises as to whether the net rental income is then taxable for self-employment purposes.  In a 2008 Chief Counsel Advice (CCA 200816030, 4/18/2008), the IRS, deferring to IRC §1402(a)(1), has clarified that if income is otherwise excludible from net earnings from self-employment under §1402(a), the election of QJV status does not convert such income to net earnings from self-employment.

[12] See CCS 200816030, Ibid.

[13] See page 2 of the 2010 instructions for form 1065.

Single member LLC

Over the years, there has been confusion regarding Single Member Limited Liability Companies (SMLLCs) in general and specifically, how they can report and pay employment taxes.

An LLC is a new entity created by state statute. The IRS did not create a new tax classification for the LLC when it was created by the states; instead IRS uses the tax entity classifications it has always had for business taxpayers: corporation, partnership, or sole proprietor. An LLC is always classified by federal law as one of these types of taxable entities.

A multi-member LLC can be either a partnership or a corporation, including an S corporation. To be treated as a corporation, an LLC has to file Form 8832, Entity Classification Election (PDF), and elect to be taxed as a corporation. A multi-member LLC that does not so elect will be classified by federal law as a partnership. A single member LLC (SMLLC) can be either a corporation or a single member “disregarded entity”. Again, to be treated by federal law as a corporation, the SMLLC has to file Form 8832 and elect to be classified as a corporation. An SMLLC that does not elect to be a corporation will be classified by the existing federal guidance as a Disregarded Entity which is taxed as a sole proprietor for income taxes.

The confusion in this area arises when determining employment tax requirements for an SMLLC that is a disregarded entity. Notice 99-6 gives the SMLLC classified as a “disregarded entity” two options for reporting and paying employment taxes:

Using the name and EIN assigned to the LLC, or
Using the name and EIN of the single member owner

Even if the employment tax obligations are reported using the SMLLC’s name and employer identification number (EIN), the single member owner retains ultimate responsibility for collecting, reporting and paying over the employment taxes.

An LLC applies for an EIN by filing Form SS-4, Application for Employer Identification Number, and completing lines 8 a, b, and c. An SMLLC that is a disregarded entity and does not have or will not have employees does not need an EIN. It should use the name and TIN of the single member owner for federal tax purposes. However, if a SMLLC, whose taxable income and loss will be reported by the single member owner, nevertheless needs an EIN to open a bank account or if state tax law requires the SMLLC to have a federal EIN, then the SMLLC can apply for and obtain an EIN. If the SMLLC has no employees, it will not use this EIN for any federal tax reporting purpose.

If an SMLLC has or intends to have employees, the EIN rules are different. If there is or will be employment tax reporting, both the single member owner and the SMLLC will need an EIN (two EIN’s). If the SMLLC has already received an EIN for reasons set out in the above paragraph, then only the owner will need to file the SS-4 and be assigned an EIN.

These numbers should not be used interchangeably. Doing so will result in complicated problems which could require the taxpayer’s, practitioner’s, and IRS’s resources to correct.

There are also instructions contained in Notice 99-6 which limit changing back and forth between reporting under the SMLLC or the single member owner’s EINs. Be sure to review this notice and its limitations before making a change.

What tax form must an LLC file – Limited Liability Corporation

For federal income tax purposes, there is no specific form for an LLC.

If an LLC has a single member and makes no election to be taxed otherwise, the LLC files as a disregarded entity. That means it files whatever form the activity performed in the LLC would have filed if there was no LLC. For instance, an individual taxpayer operating a non-farm trade or business in an LLC files Schedule C. If an individual taxpayer operates a rental property in an LLC, it would be reported on Schedule E. If an S corporation owns a single member LLC in which there is rental property, the corporation would file Form 8825 to claim the income and expense from that rental activity just as if the LLC did not exist.

If the LLC has more than one member, it usually defaults to a partnership.

The LLC can elect to be taxed in a different manner. The only limitations are that a single member cannot elect to be taxed as a partnership and a multi-member cannot elect to be taxed as a single member. See IRS Form 8832, Entity Classification Election, for more details.