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Tax
Return Preparers Urged to be More Circumspect? |
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The Business Entity Selected is a Big Decision!LIMITED LIABILITY COMPANIES AND TAXATION
What Business Owners Should Know About The LLC And Taxes?The Texas Franchise Tax (When does it apply to Out of State Entities?)
TEXAS LIEN CLAIMS: NOTICE & FILING DEADLINES (PRIVATE PROPERTY, NON-RESIDENTIAL)
Employee Versus Independent Contractor?
What is Innocent Spouse Defense?
Employee Versus Independent Contractor
(How Does the Internal Revenue Service Make A Determination?
Typically when Internal Revenue Service auditors examine a business for the purpose of determining worker classification, the Service will generally follow the United States Supreme Court’s 1947 decision in a case called, United States vs. Silk. In the Silk case, the Court said that whether a worker is properly classified as an employee or independent contractor turns on all the facts and circumstances. The Court delineated 20 factors, which if a majority of the factors can be answered yes, then the Internal Revenue Service is more likely than not, will classify the worker as an employee. These 20 factors are as follows:1. Is the worker required to comply with instructions about when, where, and how the work is to be done?
2. Is the worker provided training that would enable them to perform the job in a particular way?
3. Must the worker perform the services personally?
4. Is there a continuing relationship between the worker and the entity that hired the worker?
5. Are the services provided by the worker an integral part of the business’ operations?
6. Does the entity hire, supervise or pay assistants to help the worker on the job?
7. Does the recipient of the worker’s services set the work schedules?
8. Is the worker required to devote his or her full time to the person for whom he or she performs services?
9. Is the services performed at the place of business of the entity or at specific places designated by the business?
10. Does the recipient of the services direct the sequence in which the work must be done?
11. Is the method of payment hourly, weekly or monthly as opposed to commission or by the job?
12. Are business and/or traveling expenses reimbursed by the business to the worker?
13. Are regular oral or written reports required to be submitted by the worker?
14. Does the company furnish computers, work tools and supplies used by the worker?
15. Has the worker failed to invest in equipment or facilities used to provide services?
16. Does the arrangement put the worker in the position of realizing either a loss or profit on the work?
17. Does the worker perform services exclusively for the entity rather than working for various other entities at the same time?
18. Does the worker make the worker’s services available to the general public?
19. Is the worker subject to dismissal for reasons other than nonperformance of contract specifications?
20. Can the worker terminate the relationship without incurring a liability for failure to complete the assigned job?The cost for misclassification of workers can be tremendous. First and foremost your employees could be erroneously carrying the burden of self-employment taxes. Most importantly, misclassification of your workers means that you (the employer) are not paying your fair share of taxes and that may subject you to back taxes, interest and penalties. The Service wants the taxes to be paid by the proper party, and non-compliant entities could be eligible for certain safe-harbor provisions of the Internal Revenue Code.
If you are a worker paying self-employment taxes, or if you are an entity employing workers and cannot figure out how you should classify your workers, contact Coleman Jackson, Attorney & Counselor At Law.
© 2005 Coleman Jackson, A Legal Services Company
(972) 680-5118
www.cjacksonlaw.com
The Informer Act or the Federal False Claims Act is one attempt by the United States Government to be wise stewards of the monies that you and I send to Washington, D.C. in the form of federal taxes. By the use of this law the United States government rewards informers who report certain kinds of fraud perpetrated against the U.S. Government. Informers are also known as whistleblowers, qui tam claimants or relators under the Act.
The False Claims Act allows private individuals (whistleblowers) with knowledge of past or present fraud on the Federal Government to sue on the government’s behalf to recover compensatory damages, civil penalties, and triple damages. The law provides a reward to the informer of 10 to 30 percent of the monies recovered.
Common types of false claims lawsuits are as follows:
• Defense Contractor fraud- false negotiation or defective pricing cases involve submission of false cost and pricing data to the government during negotiation of a contract, change order or equitable adjustment in order to obtain an inflated price.
• Government Contract fraud- misrepresentation involving cost of services or supplies during performance of the contract, such as charging overhead, labor or materials in billings to the government although the facilities, employees or materials were not employed in supplying the service or supplies to the government.
• Medical Service Providers fraud- Medicare, Medicaid and other healthcare provider fraud, such as presenting to the government invoices for contrived orders, deceptive medical necessity certifications, reflex testing, defective testing and all such deceptive contrivances.Texas also has a false claims act that covers certain forms of misrepresentations in dealings with the state of Texas. False claims may involve the state government purchase of goods and services. In such scenarios, depending upon the facts and circumstances, the informer might be able to file suit on behalf of the state of Texas, or behalf of the U.S. Government or both.
Would Be Informer Beware: False Claims Cases are very complex. They are extremely factually driven and document intensive. Typically they involve accounting theories and principals, coupled with arcane legal rules and analysis. Moreover, the informer could be subjected to unfair treatment and harassment on their job and in their community. The defendant could counter sue the informer. Informer’s, who bring false claims allegations and are unsuccessful in the courts, may have to pay the attorney fees of the defendant.
If you have knowledge of past or present fraudulent acts against the government, contact Coleman Jackson, Attorney & Counselor At Law. We would like to guide you through the complex qui tam rules, practices, court decisions and limitations periods designed to prosecute a qui tam action.
© 2005 Coleman Jackson, A Legal Services Company
(972) 680-5118
www.cjacksonlaw.com
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What is Innocent Spouse Defense?
The general rule is that married couples that file joint federal income tax returns are jointly and individually liable for the full amount of tax due on the tax return. That means that when married taxpayers file a joint tax return, each spouse is jointly and individually responsible for the tax and any interest or penalty due on the joint return, even if they later divorce. This is true even if the divorce decree state that a former spouse will be responsible for any amounts due on previously filed joint tax returns. One spouse may be held responsible for all the tax due.
In fact, typically, an innocent spouse case involves divorcees where the divorce decree stipulated that a former spouse was responsible for all tax amounts owed on post divorce joint tax returns. However the Internal Revenue Service may hold each spouse fully liable for the tax, interest and penalties due.
What is the innocent spouse defense? Generally speaking, the innocent spouse defense is where one spouse argues that they should be relieved of liability and responsibility for tax, interest and penalties resulting from the fraudulent actions or misrepresentations of the other spouse on the joint federal tax return.
If you have reason to believe that you are an innocent spouse, contact Coleman Jackson, Attorney & Counselor At Law. We would like to guide you through the legal rules, regulations and court decisions that define Innocent Spouse Defense and the applicable limitations period.
© 2005 Coleman Jackson, A Legal Services Company
(972) 680-5118
www.cjacksonlaw.com
TEXAS APPRAISAL REVIEW BOARDS
Who Are They? How Do They Work? What Are Your Rights?
By: Coleman Jackson, A Legal Services CompanyWho Are They? They are citizens of the County where your property is situs who are authorized by the Texas Legislature in the Tax Code to hear properly filed property tax protest. After tax determinations of the County Appraisal District, these regular citizens are appointed to impartially resolve your complaints concerning valuation and taxability of property within the Appraisal District. These regular citizens (by this I mean that they are not governmental officials, they could be lawyers, doctors, engineers, home-makers, news reporters, scientist, fishermen, oilmen, (think of them as you would someone who is eligible to serve on a jury); they are the eligible citizens of the community.
The Tax Code empowers these citizens, who are called the Appraisal Review Board, (ARB) to hear and resolve tax protests regarding certain issues, such as, property valuation disputes, eligibility for exemptions (freehold, religious, homestead, etc.), inclusion of property on the appraisal roll of the District, property ownership issues, whether the alleged property is even property as in the case of certain intellectual property, e.g. computer software, whether due process notices and procedures were followed, property use determinations, such as in the case of rural property and forest land, or various other actions by the County Appraisal District that may effect your right to own, use and enjoy your property. The Tax Code does not empower these ARB’s to hear matters pertaining to whether you are able to pay the assessed tax or not.
How Do They Work? First of all, the tax protester must strictly comply with the requirements of the Tax Code to perfect a property tax protest. The property owner must file a written protest; the written protest can be in essentially any form, so long as, the property in question is identified, the tax period is identified, the type of tax is identified and you are identified. You should state the basis of your protest. And of course the protest must be sent to the proper County Appraisal District.
Upon receipt of a properly filed protest, the ARB will schedule an evidence hearing. The evidence hearing will probably proceed something like this. The term ‘something like this’ is used here, because the ARB conducts its deliberations in a very informal and sometime very ad hoc manner. Witnesses are sworn. That means that your testimony is under oath as in a Court of Law. But do not misunderstand me, ARB hearings does not come close to the formal procedures and rules of evidence that are applicable to court proceedings in Texas. ARB hearings are informal evidence gathering meetings, which are conducted by non-lawyers and non-judges armed with the Tax Code. The Board typically is made up of three to four citizens of the County. One member of the Board serves as the chair, which kind of supervises the process. The property owner typically offers evidence and argument as to why the decision of the Appraisal District violates the Tax Code and should be set aside. After the owner closes its evidence and argument the Appraisal District Representatives give evidence and argument in support of their decision. Some rebuttal time is given both sides, and typically the Board Chair polls the other Board Members and they render a decision. With that the hearing ends. Typically the ARB’s Order is sent to the protesting property owner within 10 days by Certified Mail.
What Are the Rights of the Property Owner? The property owner must exhaust its rights under the Tax Code. By filing a timely written protest as we have discussed above, and appearing in person or by attorney before the ARB, exhausts the property owner’s administrative remedies. Depending upon whether taxes have been assessed, the property owner typically must pay the tax amount that is not in dispute before they can file a lawsuit. If the property owner is unable to pay the disputed taxes before suit, the property owner may file an oath of “inability to pay” with the court. Once all this happens, within 45 days from receipt of the ARB Order of Decision, the property owner may file a lawsuit in the appropriate Texas District Court against the County Appraisal District and the ARB. In this lawsuit, the property owner will have the opportunity to present all its evidence and arguments afresh in a court of law. That means, the court will decide the case based on evidence presented in the courtroom and not on evidence and arguments made (or, not made) before the ARB.
© 2005 Coleman Jackson, A Legal Services Company
(972) 680-5118
www.cjacksonlaw.com
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Weapons Used by the IRS in Enforcing Collection of Delinquent Tax Debts
By: Coleman Jackson, A Legal Services Company
The United States Congress has given the Internal Revenue Service two strong weapons in enforcing collection of delinquent tax debts. The Service has been authorized by Congress to use the weapons of “federal tax lien” and “federal tax levy” to enforce the federal tax laws. We discuss only enforcement by the Service’s use of the federal tax lien in this paper.
Collection by Federal Tax Lien:
Internal Revenue Code Section 6321 states, in part, that, “[i]f any person liable to pay any tax neglects or refuses to pay the same after demand, the amount (including any interest, additional amount, addition to tax, or assessable penalty, together with any costs that may accrue in addition thereto) shall be a lien in favor of the United States upon all property and right to property, whether real or personal, belonging to such person.”
When does this lien arise? Internal Revenue Code Section 6322 states, in part, that, “[u] nless another date is specifically fixed by law, the lien imposed by section 6321 shall arise at the time the assessment is made and shall continue until the liability for the amount so assessed (or a judgment against the taxpayer arising out of such liability) is satisfied or becomes unenforceable by reason of lapse of time.” What does assessed mean? Simply put; Internal Revenue Code Section 6203 states, in part, that, “[t] he assessment shall be made by recording the liability of the taxpayer in the office of the Secretary in accordance with rules and regulations prescribed by the Secretary. Upon request of the taxpayer, the Secretary shall furnish the taxpayer with a copy of the record of the assessment.”Simply put, an assessment is a “bookkeeping entry” that is made when the Secretary of Internal Revenue or its designee make and entry on the IRS ledger that the taxpayer owes the IRS. Generally speaking, tax debts must be assessed within three years after the related tax return was filed, unless the taxpayer and the Service have agreed on an extension of the time. This three-year statute bars the enforcement action in Court on the lapse of the three-year statute of limitation. There are, of course, exceptions to the rule, for example, if fraud is alleged, the statute remains open; the IRS can assess the tax and file a lawsuit for collection at any time until the tax is paid.
What Effect Does Federal Tax Liens Have on Tax Debtors? The federal tax lien attaches to all real and personal property of the taxpayer, which the taxpayer owns and/or has the legal right to own. Except for certain property interest specifically depicted in Internal Revenue Code Section 6323, a perfected federal tax lien is superior to all other interest in the taxpayer’s property. The duly perfected tax lien claims superior interest to all of the taxpayer’s property and legal interest in property except for those super-persons who claim superior interest under the category of creditors of I.R.C. Section 6323. Moreover, the I.R.C. Section 6323 Creditor must have perfected its interest in the taxpayer’s property prior to notice of the IRS tax lien, or the tax lien defeats the I.R.C. Section 6323 priority. The common law lien priority doctrine of first-in-time- first-in-line determines the pecking order as to the creditor rights as against the other creditors listed in I.R.C. Section 6323.
Except as previously discussed in this paragraph regarding I.R.C. Section 6323 interest holders, the United States Government stands in the shoes of the taxpayer as for all properties owned by the taxpayer or due to the taxpayer. Here are some examples: the IRS could take the taxpayers, home, business and certain other assets, the employer could be ordered to pay the IRS all wages and monies due to the taxpayer, the business debtor could be ordered to pay the IRS all amounts due the taxpayer for services or products, future tax refunds could be taken by the IRS, and Trust and other asset protection devices used by financial planners and others could be declared (noid and void) as devices designed to avoid tax liens.
The federal tax lien’s consequences could be far more instructive in the delinquent taxpayers life, than merely encumbrance and loss of its property, for instance, tax liens are open to the public, therefore, credit worthiness could be negatively effected, employment relationships could be adversely effected (hiring, promotions, assignments of trust etc.— (tax liens are considered a ‘ red flag” of an indicator of possibly increased risk of employment dishonesty, employee fraud and internal control failures in businesses). Further, other relations could also be strained, challenged or damaged, such as, business relations, and personal relationships at home and in places of worship.
What Can The Taxpayer Do to Seek Relief? The taxpayer can pay the tax. Or, if the taxpayer has reason to believe that its Constitutional Due Process Rights have been violated, the taxpayer can seek relief from the Internal Revenue Service’s collection activities by federal court action. In general terms, since the federal tax lien is a creature of statute, the Service must comply with the statutory prescriptions in order to properly perfect and enforce the statutory lien provisions. The grounds for such due process challenges could be, such as, defective assessment, improper notice, or defective demand for payment, or something of the sort.
Disclaimer: This article is for general information and does not constitute legal advice. Law is fact, circumstance and jurisdictionally (for, instance, property interest are defined by State law, which can vary from State to State) driven; therefore, you should consult with legal representation regarding your own tax situation.
© 2005 Coleman Jackson, A Legal Services Company
(972) 680-5118
www.cjacksonlaw.com
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Tax Return Preparers Urged to be More Circumspect?
By: Coleman Jackson, A Legal Services Company
According to the United States Tax Court, in a recent summary opinion, misbehavior by Tax Preparers is on the rise. The Court noted that the Court has seen an increasing number of cases where “there has been no discernible substance to the case other than an inept attempt to take advantage of tax deductions and credits”. The Court urged those taxpayers and their advisors to be more circumspect. The aggressive position advised by the Tax Return Preparer could subject the taxpayer to a gruesome tax audit; the taxpayer may also incur interest and penalties on the understatement due to the unrealistic positions advised by their tax preparer. Further the taxpayer could suffer denial of otherwise allowable credits in the future. See Internal Revenue Code Section 32(k).
Who Qualifies as a Tax Return Preparer Under the Internal Revenue Code? Internal Revenue Code Section 7701(36)(A) defines the term “income tax return preparer” as “any person who prepares for compensation, or who employs one or more persons to prepare for compensation, any return of tax imposed by subtitle A or any claim for refund of tax imposed by subtitle A. For purposes of the preceding sentence, the preparation of a substantial portion of a return or claim for refund shall be treated as if it were the preparation of such return or claim for refund.” Provided that a preparer is associated with a firm, only the preparer who signed the return is considered a tax preparer. This is known as the “one-preparer-per-firm rule”.A person could be considered a tax preparer even though, they do not actually record information in the taxpayer’s tax return. Thus, tax planners, financial planners and software companies or other persons that prepare computer programs and sell them to taxpayers for use in preparing their returns could all fall within the contours of Code Section 7701(36)(A).
The Code of Federal Regulations define tax preparers as ‘signing preparer” or “non-signing preparer”. The ‘signing preparer’ is the person who actually signs the preparer box on the taxpayer’s tax return. The ‘non-signing preparer” could be anyone who prepares a schedule or entry that constitutes a substantial portion of the return. Revenue auditors will generally look at the relationship between the alleged tax deficiency and the work of the non-signing preparer.
What Can Happen to Tax Return Preparers Who Are Not Circumspect? Besides the real risk of being sued by their clients, the Internal Revenue Service could assess penalties against the tax return preparer under the Internal Revenue Code. Congress has given the Internal Revenue Service some tools to make tax return preparers comply with the federal tax laws. Internal Revenue Code Sections 6694 and 6695 authorizes penalties against income tax preparers who behave in an unacceptable manner. Circular 230 set out standards of conduct expected of tax return preparers.What Can the Internal Revenue Service Do to the Tax Return Preparer?
Access Penalties Under Code Section 6694
This Code Section exacts a penalty on tax return preparers for an understatement of a taxpayer’s income tax liability based on an unrealistic position. It in pertinent part says that, the penalty applies to understatements due to unrealistic positions, which are defined, as positions for which there were not a realistic possibility of being sustained on its merits. And if the tax return preparer knew of that position or should have reasonably known of the position and or was frivolous or did not disclose the position, the tax preparer is subject to a $250 per return penalty assessment. This is a negligence penalty.Code Section 6694(b) is a penalty provision that applies for willfully violating the Internal Revenue laws. A preparer’s intentional disregard for the Internal Revenue Code and the related regulations in preparing a taxpayer’s income tax return constitutes “willful conduct”. This penalty also applies if the tax return preparer conduct was reckless. The penalty may not apply if the preparer properly disclosed the position. The Fifth Circuit Court of Appeals (Texas is in the Fifth Circuit) has held that the IRS must prove that the tax preparer committed, at least, one affirmative act to prove fraud. The Penalty for willfully or recklessly violating the rules and regulations is $1,000 per return. Further, the fraud penalty is $500 if the tax return preparer negotiated and cashed the federal income tax checks made payable to the taxpayer.
Access Penalties Under Code Section 6695:
This Code Section exacts a penalty on tax return preparers who fail to comply with:
1. I.R.C. Section 6107(a) that requires that an income tax return preparer furnish a completed copy of the return or claim prepared to the taxpayer no later than “the time such return or claim is presented for such taxpayer’s signature.” or
2. I.R.C. Section 6109(a)(4) that requires that any return or claim for refund prepared by an income tax return preparer must bear the identification number for the preparer, the preparer’s employer or both, or
3. I.R.C. Section 6107(b) that requires an income tax return preparer to “(1) retain a completed copy of such return or claim, or retrain, on a list, the name and taxpayer identification number of the taxpayer for whom such return or claim was prepared, and (2) make such copy of list available for inspection upon request by the Secretary for a time period of three years from the date the return year closed.”
I.R.C. Section 6695 provides that any person who is an income tax return preparer with respect to any return or claim for refund who fails to comply with these requirements with respect to such return or claim shall pay a penalty of $50 for such failure, unless it is shown that such failure is due to reasonable cause and not due to willful neglect. The maximum penalty imposed under this subsection on any person with respect to documents filed during any calendar year shall not exceed $25,000.
Proceed to Federal District Court to Seek Injunction to Shut the Preparer’s Business Down:
Special rules apply to the assessment of the tax preparer penalties discussed in this article; there are only limited pre-assessment appeal rights open to the preparer. The IRS may assess the penalty or proceed directly to Federal District Court without assessment at any time. The service may in certain egregious tax preparer cases seek injunctive relief to shut down the tax preparer’s business under I.R.C Section 7407. Although the statute of limitations for the Service to bring a tax preparer penalty assessment varies depending on the Code Section of penalty, the general preparer penalty statute of limitation lapses three years from the latest of, the due date of the related return or the date the related return was actually filed. But under some Code Sections, such as I.R.C. Section 7407, the Statute of Limitations is perpetual, meaning; the IRS can seek injunctive relief indefinitely.Except for fraudulent preparer penalties, the taxpayer bears the burden of proof in preparer cases, and has a right to trial by a jury.
© 2005 Coleman Jackson, A Legal Services Company
(972) 680-5118
www.cjacksonlaw.com
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TEXAS LIEN CLAIMS: NOTICE & FILING DEADLINES
(PRIVATE PROPERTY, NON-RESIDENTIAL)
Month When Labor and/or Materials Provided SUB-SUBCONTRACTOR’S NOTICE TO GENERAL CONTRACTOR SUB-SUBCONTRACTOR’S NOTICE TO OWNER & GENERAL CONTRACTOR / SUBCONTRACTOR’S NOTICE TO OWNER & GENERAL CONTRACTOR M & M LIEN AFFIDAVIT & NOTICE OF FILED AFFIDAVIT (Send Sec. 53.055(a) Notice no later than fifth day after date affidavit is filed.)
FEB
MAR
APR 15
MAY 15
MAY 15
JUN 15
JUN 15
JUL 15
MAY
JUN
JUL 15
AUG 15
AUG 15
SEPT 15
SEPT 15
OCT 15
AUG
SEPT
OCT 15
NOV 15
NOV 15
DEC 15
DEC 15
JAN 15
NOV
DEC
JAN 15
FEB 15
FEB 15
MAR 15
MAR 15
APR 15
Texas law requires that you send one copy of the lien affidavit by registered or certified mail, to the Owner and the General Contractor no later than five (5) calendar days after the date the affidavit is filed with the County Clerk.
If the project is bonded, also send the 3rd month notice to the Surety.
Suit To Foreclose Lien: No later than two (2) years after the last day a Claimant may file the lien affidavit under Sec 53.052 of the Texas Property Code, or file suit within one (1) year after completion, termination or abandonment of the work under the Original Contract under which the lien is claimed, whichever is later.
© 2005 Coleman Jackson, A Legal Services Company
(972) 680-5118
www.cjacksonlaw.com
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LIMITED LIABILITY COMPANIES AND TAXATION
What Business Owners Should Know About The LLC And Taxes?
By Coleman Jackson, A Legal Services CompanyWhat Is a Limited Liability Company?
The Limited Liability Company (LLC) is a popular new form of business in Texas because owners’ personal assets are protected from the liabilities incurred by the LLC. This article will address the federal taxation of LLC’s. But there are certainly other legal issues that should be addressed when selecting a business entity in Texas. We deal only with taxation in this article!
The Texas Limited Liability Company Act (the “Act”) defines a “Limited Liability Company” as a limited liability company organized and existing under the Act. The Act defines a “Foreign Limited Liability company” as an entity formed under the laws of a jurisdiction other than Texas (a) that is characterized as a limited liability company by such laws or (b) although not so characterized by such laws, that elects to procure a certificate of authority pursuant to Article 7.01 of this Act, that is formed under laws which provide that some or all of the persons entitled to receive a distribution of the assets thereof upon the entity’s dissolution or otherwise or to exercise voting rights with respect to an interest in the entity shall not be liable for the debts, obligations or liabilities of the entity and which is not eligible to become authorized to do business in Texas under any other statute.
Federal Taxation of Limited Liability Companies:
From a federal taxation perspective, the Limited Liability Company is a pass-through entity. The LLC passes-through profit and losses to its individual members; who in turn, offset profits and losses from other sources. This pass-through feature is, in a nutshell, the primary federal tax advantage of an LLC. The bulk of the issues from the taxation perspective do not deal with the pass-through of profits, but with the pass through of losses to LLC members.
BUT BEFORE WE MOVE ON, INVESTORS BEWARE! Limited liability investors (who are called members under the Act) could be subject to self-employment taxes on the profits of the LLC, if they are like sole proprietors or like general partners in a partnership. If they are like limited partners and they perform services for the LLC, they are subject to self-employment taxes on wages paid. Self-Employment taxes could be a major disadvantage, a major burden and a major surprise if business organizers do not thoroughly research the issues during the entity formation planning process. Federal reallocation rules also apply to LLC distributions.
We will note here, without discussing further in this article, that the Texas Franchise tax applies to Limited Liability Companies organized under the Act or doing business in Texas.
Federal Taxation Of Limited Liability Companies:But for now, let us consider the issue of federal taxation and pass-through of LLC losses to members. Pass-through of Limited Liability Company losses is subject to some very complex federal tax rules; perhaps the rules are not complex in theory, but in application they can be traps to the unwary.
Basis Requirements:
First of all, basis for tax purposes and for book accounting purposes can be different. We will not discuss why inside (book) and outside (tax) basis could be different in this article. Simply stated, tax basis is the adjusted ownership interest of the member in the limited liability company. The members adjusted ownership interest in the LLC consists of its contributions, withdrawals, distributions and other increases or diminutions in the owner’s capital account over time. A member’s deduction of LLC losses is limited to the member’s tax basis in the limited liability company. A member may deduct on the member’s individual, or corporate, or partnership, or trust, or other appropriate entity tax return its distributive share of limited liability company losses, including capital losses, to the extent of the member’s tax basis in the LLC at the end of the LLC’s tax year of the loss. Any allocated LLC loss in excess of the member’s tax basis cannot be deducted in the current tax year. Disallowed allocated LLC losses can be carried forward indefinitely and deducted in subsequent years to the extent the member has sufficient subsequent tax basis. The LLC’s current losses and profits are taken into consideration in determining whether the member has sufficient tax basis in order to deduct disallowed LLC losses during any particular year. Disallowed limited liability company losses could remain suspended indefinitely, until such time, as the member has sufficient tax basis to absorb the disallowed allocated losses. The emphasis throughout is on the member’s tax basis in the LLC; that is because the disallowed LLC loss belongs to the member. If the member for any reason is disgorged of the LLC interest, the disallowed LLC loss is most likely forever lost. Subsequent purchases, inheritors, creditors; I mean no one may use the suspended loss to offset income on their tax return. Certain tax planning or LLC exit strategy planning techniques could possibly help soften the blow. We walk through a few examples below to demonstrate how basis rules and tax reallocation rules might affect LLC distributive shares in practice:
Example 1At the end of the limited liability company taxable year 2004, Apple & Banana Ventures, LLC has a loss of $20,000. Member A’s distributive share of this loss is $10,000. At the end of such year, A’s adjusted basis for his interest in the LLC (not taking into account his distributive share of the loss) is $6,000. Under I.R.C. Section 704(d), A’s distributive share of LLC loss is allowed to him (in his taxable year within or with which the LLC taxable year ends) only to the extent of his adjusted basis of $6,000. The $6,000 loss allowed for 2004 decreases the adjusted basis of A’s interest to zero. Assume that, at the end of LLC taxable year 2005, A’s share of partnership income has increased the adjusted basis of A’s interest in the LLC to $3,000 (not taking into account the $4,000 loss disallowed in 2004). Of the $4,000 loss disallowed for the partnership taxable year 2004, $3,000 is allowed A for the LLC taxable year 2005, thus again decreasing the adjusted basis of his interest to zero. If, at the end of LLC taxable year 2006, A has an adjusted basis of his interest of at least $1,000 (not taking into account the disallowed loss of $1,000), he will be allowed the $1,000 loss previously disallowed.
Example 2At the end of limited liability company taxable year 2005, member, ‘Do It All’ has the following distributive share of LLC items described in Internal Revenue Code Section 702 (a): Long-term capital loss, $4,000; short-term capital loss, $2,000; income as described in I.R.C. Section 702 (a) (9), $4,000. ‘Do It All’s’ adjusted basis for his LLC interest at the end of 2005, before adjustment for any of the above items, is $1,000. As adjusted under I.R.C. Section 705 (a) (1) (A), ‘Do It All’s’ basis is increased from $1,000 to $5,000 at the end of the year. ‘Do It All’s’ total distributive share of LLC loss is $6,000. Since without regard to losses, ‘Do It All’ has a basis of only $5,000, ‘Do It All’ is allowed only $5,000/$6,000 of each loss, that is, $3,333 of his long-term capital loss, and $1,667 of his short-term capital loss. ‘Do It All’ must carry forward to succeeding taxable years $667 as a long-term capital loss and $333 as a short-term capital loss.
Example 3
Quit and Run form a Texas limited liability company with contributions of $20,000 and $180,000, respectively. Q, a member of the LLC, is a Nevada corporation that has $2,000,000 of net operating loss carryforwards that will not expire for 8 years. Q does not expect to have sufficient income (apart from the income of the LLC) to absorb any of the net operating loss carryforwards. R, the other LLC member, is a Georgia corporation that expects to be in the 46 percent marginal tax bracket for several years. The LLC operating agreement provides that the members’ capital accounts will be determined and maintained in accordance with paragraph (b) (2) (iv) of Treasury Regulation Section 1.704, distributions in liquidation of the LLC (or any member’s interest) will be made in accordance with the members’ positive capital account balances, and any member with a deficit balance in his capital account following the liquidation of his interest must restore that deficit to the LLC (as set forth in paragraphs (b) (2) (ii) (b) (2) and (3) of Treasury Regulation Section 1.704). The Limited Liability Company’s cash, together with the proceeds of an $800,000 loan, are invested in assets that are expected to produce taxable income and cash flow (before debt service) of approximately $150,000 a year for the first 8 years of the limited liability company’s operations. In addition, it is expected that the LLC’s total taxable income in its first 8 taxable years will not exceed $2,000,000. The limited liability company’s $150,000 of cash flow in each of its first 8 years will be used to retire the $800,000 loan. The LLC operating agreement provides that limited liability company net taxable income will be allocated 90 percent to Q and 10 percent to R in the first through eighth limited liability company taxable years, and 90 percent to R and 10 percent to Q in all subsequent LLC taxable years. Net taxable loss will be allocated 90 percent to R and 10 percent to Q in all LLC taxable years. All distributions of cash from the LLC to members (other than the priority distributions to Q described below) will be made 90 percent to R and 10 percent to Q. At the end of the LLC’s eighth taxable year, the amount of Q’s capital account in excess of one-ninth of R’s capital account on such date will be designated as Q’s ‘excess capital account”. Beginning in the ninth taxable year of the LLC, the undistributed portion of Q’s excess capital account will begin to bear interest (which will be paid and deducted under I.R.C. Section 707(c ) at a rate of interest below the rate that the LLC can borrow from commercial lenders, and over the next several years (following the eighth year) the LLC will make priority cash distributions to Q in prearranged percentages of Q’s excess capital account designed to amortize Q’s excess capital account and the interest thereon over a prearranged period. In addition, the LLC’s operating agreement prevents Q from causing his interest in the LLC from being liquidated (and thereby receiving the balance in his capital account) without R’s consent until Q’s excess capital account has been eliminated. The below market rate of interest and the period over which the amortization will take place are prescribed such that, as of the end of the limited liability company’s eighth taxable year, the present value of Q’s right to receive such priority distributions is approximately 46 percent of the amount of Q’s excess capital account as of such date. However, because the LLC’s income for its first 8 taxable years will be realized approximately ratably over that period, the present value of Q’s right to receive the priority distributions with respect to its excess capital account is, as of the date the limited liability company’s operating agreement is entered into, less than the present value of the additional federal income taxes for which R would be liable if, during the LLC’s first 8 taxable years, all LLC income were to be allocated 90 percent to R and 10 to Q. The allocation of the LLC taxable income to Q and R in the first through eighth LLC taxable years has economic effect. However, such economic effect is not substantial under the general rules set for in Treasury Regulation 704 paragraph (b) (2) (iii). This is true because R may enhance his after-tax economic consequences, on a present value basis, as a result of the allocations to Q of 90 percent of the LLC’s income during taxable years 1 through 8, and there is a strong likelihood that neither R nor Q will substantially diminish its after-tax consequences, on a present value basis, as a result of such allocation. Accordingly, limited liability company taxable income for LLC taxable years 1 through 8 will be reallocated in accordance with the members’ interests in the Limited Liability Company under paragraph (b) (3) of Treasury Regulation 1.704.
At-Risk Rules:
As other business owners, members of limited liability companies are generally subject to Internal Revenue Code Section 465- “At Risk Rules”. I.R.C. Section 465 states, in part that a taxpayer (this could be an individual, shareholder, partner, or limited liability company member) engaged in an activity to which Section 465 applies, any loss from such activity for the taxable year shall be allowed only to the extent of the aggregate amount with respect to which the taxpayer is at risk (within the meaning of subsection (b) for such activity at the close of the taxable year. Any loss from an activity to which this 465 applies and not allowed for the taxable year shall be treated as a deduction allocable to such activity in the first succeeding taxable year. Subsection (b) defines the amount considered at risk as follows:
(1) In general
For purposes of this section, a taxpayer shall be considered at risk for an activity with respect to amounts including—(A) the amount of money and the adjusted basis of other property contributed by the taxpayer to the activity, and
(B) amounts borrowed with respect to such activity (as determined under paragraph (2).(2) Borrowed amounts
For purposes of this section, a taxpayer shall be considered at risk with respect to amounts borrowed for use in an activity to the extent that he—(A) is personally liable for the repayment of such amounts, or
(B) has pledged property, other than property used in such activity, as security for such borrowed amount (to the extent of the net fair market value of the taxpayer’s interest in such property).No property shall be taken into account as security if such property is directly or indirectly financed by indebtedness which is secured by property described in paragraph (1).
(3) Certain borrowed amounts excluded
(A) In general
Except to the extent provided in regulations, for purposes of paragraph (1)(B), amounts borrowed shall not be considered to be at risk with respect to an activity if such amounts are borrowed from any person who has an interest in such activity or from a related person to a person (other than the taxpayer) having such an interest.(B) Exceptions
(i) Interest as creditor Subparagraph (A) shall not apply to an interest as a creditor in the activity.
(ii) Interest as shareholder with respect to amounts borrowed by corporation in the case of amounts borrowed by a corporation from a shareholder, subparagraph (A) shall not apply to an interest as a shareholder.
(C) Related person
For purposes of this subsection, a person (hereinafter in this paragraph referred to as the “related person”) is related to any person if—
(i) the related person bears a relationship to such person specified in section 267 (b) or section 707 (b) (1), or
(ii) the related person and such person are engaged in trades or business under common control (within the meaning of subsections (a) and (b) of section 52).For purposes of clause (i), in applying section 267 (b) or 707 (b) (1), “10 percent” shall be substituted for “50 percent”.
(4) Exception
Not withstanding any other provision of this section, a taxpayer shall not be considered at risk with respect to amounts protected against loss through nonrecource financing, guarantees, stop loss agreements, or other similar arrangements.(5) Amounts at risk in subsequent years
If in any taxable year the taxpayer has a loss from an activity to which subsection (a) applies, the amount with respect to which a taxpayer is considered to be at risk (within the meaning of subsection (b) in subsequent taxable years with respect to that activity shall be reduced by that portion of the loss which (after the application of subsection (a) is allowable as a deduction.(6) Qualified nonrecourse financing treated as amount at risk
For purposes of this section—(A) In general
Nothwithstanding any other provision of this subsection, in the case of an activity of holding real property, a taxpayer shall be considered at risk with respect to the taxpayer’s share of any qualified nonrecourse financing which is secured by real property used in such activity.(B) Qualified nonrecourse financing
For purposes of this paragraph, the term “qualified nonrecourse financing’ means any financing—(i) which is borrowed by the taxpayer with respect to the activity of holding real property,
(ii) which is borrowed by the taxpayer from a qualified person or represents a loan form any Federal, State, or local government or instrumentality thereof, or is guaranteed by any Federal, State, or local government,
(iii) except to the extent provided in regulations, with respect to which no person is personally liable for repayment, or
(iv) which is not convertible debt.(C) Special rule for partnerships
In the case of a partnership, a partner’s share of any qualified nonrecourse financing of such partnership shall be determined on the basis of the partner’s share of liabilities of such partnership incurred in connection with such financing (within the meaning of section 752).(D) Qualified person defined
For purposes of this paragraph—(i) In general the term “qualified person” has the meaning given such term by section 49 (a) (1) (D) (iv).
(ii) Certain commercially reasonable financing from related persons for purposes of clause (i), section 49 (a) thereof (relating to financing from related persons) if the financing from the related person is commercially reasonable and on substantially the same terms as loans involving unrelated persons.(E) Activity of holding real property
For purposes of this paragraph(i) Incidental personal property and services, the activity of holding real property includes the holding of personal property and providing of services, which are incidental to making real property available as living accommodations.
(ii) Mineral property, the activity of holding real property shall not include the holding of mineral property.
Except those activities specifically exempt from I.R.C. Section 465, since December 31, 1978, the at risk rules applies to each activity engaged in by the taxpayer in carrying on a trade or business or for the production of income.In examples below, we examine how the at risk rules outlined in Internal Revenue Code Section 465 might impact members of limited liability companies:
Example 1 Personal liability of a partnership; incidental propertyRoses & Daffodils is a Texas limited liability company that is classified as a partnership for federal tax purposes. Roses & Daffodils engages only in the activity of holding real property. In addition to real property used in the activity of holding real property, Roses & Daffodils owns office equipment, several pickup trucks, and maintenance equipment that it uses to support the activity of holding real property. Roses & Daffodils borrows $350,000 to use in the activity. Roses & Daffodils is personally liable on the financing, but no member of Roses & Daffodils and no other person are liable for repayment of the financing under Texas law. The lender may proceed against all of Roses & Daffodils assets upon default on the $350,000 loan.
Analysis
Under I.R.C. 465 paragraph (b) (2) (i), the personal property is disregarded as incidental property used in the activity of holding real property. Under paragraph (b) (4) of I.R.C. Section 465, the personal liability of Roses & Daffodils for repayment of the financing is disregarded and, provided the requirements contained in paragraphs (b) (1) (i), (ii), and (iv) of I.R.C. Section 465 are satisfied, the financing will be treated as qualified nonrecourse financing secured by real property.
Example 2 Bifurcation of financingAssume the same facts as Example 1, except that Apple, a member of Roses & Daffodils, is personally liable for repayment of $150,000 of the financing.
Analysis
If the requirements contained in paragraphs (b) (1) (i), (ii), and (iv) of I.R.C. Section 465 are satisfied, then under paragraph (b) (3) of I.R.C. Section 465, the portion of the financing for which Apple is not personally liable for repayment ($200,000) will be treated as qualified nonrecourse financing secured by real property.
Example 3 Personal guarantee by LLC Member
Salt & Pepper, LLC owes the equipment leasing company $500,000 on an equipment loan. The loan is in default and the leasing company is threatening to call the loan, seize the equipment and force Salt & Pepper, LLC into bankruptcy. Salt, a wealthy lawyer and member of Salt & Pepper, LLC negotiates a settlement arrangement with the leasing company whereby Salt agrees to personally guarantee repayment of the $500,000 debt. Pepper, also a member of the LLC decided not to sign the settlement agreement.
Analysis
Salt is at risk because he personally guaranteed repayment of the equipment loan; thus he is at risk for $500,000. However, Pepper is not at risk because as a limited liability company member, he is not personally liable for the debts of the LLC under the Texas Limited Liability Company Act.
Example 4 Personal Liability, Related partyAssume the same facts as Example 3- (Salt & Pepper, LLC Example), except in this example; Pepper owns 52 percent of the outstanding shares of the equipment leasing company.
Analysis
Even though Salt personally guaranteed the loan repayment to the leasing company, Salt is not at risk because under I.R.C. Section 465 (C) (i) the transaction would be classified as a related party transaction under I.R.C. Section 267. Neither Salt nor Pepper is at risk.
Example 5 Personal liability; Disregarded entityBereket is a single member limited liability company that is disregarded as an entity separate from its owner for federal tax purposes under Internal Revenue Code Section 301.7701-3. Bereket owns certain real property and property that is incidental to the activity of holding real property. Bereket does not own any other property. For federal tax purposes, M, the sole member of Bereket, is considered to own all of the property held by Bereket and is engaged in the activity of holding real property through Bereket. Bareket borrows $80,000 and uses the proceeds to purchase additional real property that is used in the activity of holding real property. Bereket is personally liable to repay the financing, but M is not personally liable for repayment of the financing under Texas law. The lender may proceed against all of Bereket’s assets if Bereket defaults on the financing.
Analysis
Bereket is disregarded so that the assets and liabilities of Bereket are treated as the assets and liabilities of M. However, M is not personally liable for the $80,000 liability. Provided that the requirements contained in paragraphs (b) (1) (i), (ii) and (iv) of I.R.C Section 465 are satisfied, the financing will be treated as qualified nonrecourse financing secured by real property with respect to M.
Passive Loss Rules:What is a passive activity loss? Passive activity losses are created whenever total deductions for a taxable year exceed the passive entity’s total gross income for a taxable year.
What is the passive loss rule? I.R.C. Section 469 limits passive activity losses and credits. Section 469 (a) reads as follows:(a) Disallowance
(1) In general
If for any taxable year the taxpayer is described in paragraph (2), neither—(A) the passive activity loss, nor
(B) the passive activity credit,
for the taxable year shall be allowed.(2) Persons described
The following are described in this paragraph(A) any individual, estate, or trust,
(B) any closely held C corporation, and
(C) any personal service corporation.(b) Disallowed loss or credit carried to next year
Except as otherwise provided in this section, any loss or credit from an activity which is disallowed under subsection (a) shall be treated as a deduction or credit allocable to such activity in the next taxable year.
What is a passive activity? A passive activity is defined in I.R.C. Section 469 (c) as follows:(1) In general
The term “passive activity” means any activity—
(A) which involves the conduct of any trade or business, and
(B) in which the taxpayer does not materially participate.(2) Passive activity includes any rental activity
Except as provided in paragraph (7), the term “passive activity” includes any rental activity.I.R.C. Section 469 (c) (7) reads as follows:
(7) Special rules for taxpayers in real property business
(A) In generalIf this paragraph applies to any taxpayer for a taxable year—
(i) paragraph (2) shall not apply to any rental real estate activity of such taxpayer for such taxable year, and
(ii) this section shall be applied as if each interest of the taxpayer in rental real estate were a separate activity.Nothwithstanding clause (ii), a taxpayer may elect to treat all interests in rental real estate as one activity. Nothing in the preceding provisions of this subparagraph shall be construed as affecting the determination of whether the taxpayer materially participates with respect to any interest in a limited partnership as a limited partner.
(B) Taxpayers to whom paragraph applies
This paragraph shall apply to a taxpayer for a taxable year if—(i) more than one-half of the personal services performed in trades or businesses by the taxpayer during such taxable year are performed in real property trades or businesses in which the taxpayer materially participates, and
(ii) such taxpayer performs more than 750 hours of services during the taxable year in real property trades or businesses in which the taxpayer materially participates.In the case of a joint return, the requirements of the preceding sentence are satisfied if any and only if either spouse separately satisfies such requirements. For purposes of the preceding sentence, activities in which a spouse materially participates shall be determined under subsection (h).
(C) Real property trade or business
For purposes of this paragraph, the term “real property” trade or business” means any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.(D) Special rules for subparagraph (B)
(i) Closely held C corporations: In the case of a closely held C corporation, the requirements of subparagraph (B) shall be treated as met for any taxable year if more than 50 percent of the gross receipts of such corporation for such taxable year are derived form real property trades or businesses in which the corporation materially participates.
(ii) Personal services as an employee: For purposes of subparagraph (b), personal services performed as an employee shall not be treated as performed in real property trades or businesses. The preceding sentence shall not apply if such employee is a 5-percent owner (as defined in section 416 (I) (1) (B) in the employer.The IRS has promulgated Final Income Tax Regulation 1.469-4, which sets forth the rules for grouping a taxpayer’s trade and business activities and rental activities for purposes of applying the passive activity loss and credit limitation rules of I.R.C. Section 469. A taxpayer’s activities include those conducted through C corporations that are subject to Section 469, S corporations and partnerships and limited liability companies. The 5th Circuit Court of Appeals (this is the federal circuit court that hears tax appeals from federal district courts in Texas, Louisiana and Mississippi). The 5th Circuit Court of Appeals has held on a number of occasions that the IRS has broad discretion promulgating treasury regulations interpreting the Internal Revenue Code. Recently the Court repeated this position in ruling on the “self-rental rule” of Treasury Regulation Section 1.469-2 (f) (6), which provides that an amount of the taxpayer’s gross rental activity income for the taxable year from an item of property equal to the net rental activity income for the year from that item of property is treated as not from a passive activity if the property—(i) is rented for use in a trade or business activity (within the meaning of paragraph (e) (2) of Section 469) in which the taxpayer materially participates (within the meaning of Temporary Treasury Regulation 1.4695T) for the taxable year; and (ii) is not described in Temp. Treas. Reg. Sec. 1.469-2T (f) (5). The 5th Circuit Court of Appeals was taking a page from the United States Tax Court’s ruling in Schwalbach v. Commissioner, 111 T.C. 215, 220 (1998), where the Tax Court upheld the IRS’s position that rental activity was non-passive, when typically rental activity is passive. A review of the court cases shows that the passive activity rules turns on all the facts and circumstances.
What does material participation mean? I.R.C. Section 469 (h) defines material participation as follows:(h) Material participation defined
For purposes of this section—(1) In general
A taxpayer shall be treated as materially participating in an activity only if the taxpayer is involved in the operations of the activity on a basis which is-(A) regular,
(B) continuous, and
(C) substantial(2) Interest in limited partnerships
Except as provided in regulations, no interest in a limited partnership as a limited partner shall be treated as an interest with respect to which a taxpayer materially participates.
How is material participation defined in regulations? Temporary Treasury Regulation Section 1.465-5T defines material participation that applies in general, in part, as follows:(a) In general. Except as provided in paragraphs (e) and (h) (2) of this section, an individual shall be treated, for purposes of section 469 and the regulations there under, as materially participating in an activity for the taxable year if and only if—
(1) The individual participates in the activity for more than 500 hours during such year;
(2) The individual’s participation in the activity for the taxable year constitutes substantially all of the participation in such activity of all individuals (including individuals who are not owners of interests in the activity) for such year;
(3) The individual participates in the activity for more than 100 hours during the taxable year, such individual’s participation in the activity for the taxable year is not less than the participation in the activity of any other individual (including individuals who are not owners of interests in the activity) for such year;
(4) The activity is a significant participation activity (within the meaning of paragraph (c) of this section) for the taxable year, and the individual’s aggregate participation in all significant participation activities during such year exceeds 500 hours;
(5) The individual materially participated in the activity (determined without regard to this paragraph (a) (5) for any five taxable years (whether or not consecutive) during the ten taxable years that immediately precede the taxable year;
(6) The activity is a personal service activity (within the meaning of paragraph (d) of this section), and the individual participates in the activity on a regular, continuous, and substantial basis during such year; or
(7) Based on all of the facts and circumstances (taking into account the rules in paragraph (b) of this section), the individual participates in the activity on a regular, continuous, and substantial basis during such year.Temporary Regulation 1.469-5T(e) defines the material participation standard that applies, in part, to limited partners as follows:
(e) Treatment of limited partners—(1) General rule. Except as otherwise provided in this paragraph (e), an individual shall not be treated as materially participating in any activity of a limited partnership for purposes of applying section 469 and the regulations there under to—
(i) The individual’s share of income, gain, loss, deduction, or credit from such activity that is attributable to a limited partnership interest in the partnership; and
(ii) Any gain or loss from such activity recognized upon a sale or exchange of such an interest.(2) Exceptions. Paragraph (e) (1) of this section shall not apply to an individual’s share of income, gain, loss, deduction, and credit for a taxable year from any activity in which the individual would be treated as materially participating for the taxable year under paragraph (a) (1), (5), or (6) of this section if the individual were not a limited partner for such taxable year.
(3) Limited partnership interest—(i) In general. Except as provided in paragraph (e) (3) (ii) of this section, for purposes of section 469 (h) (2) and this paragraph (e), a partnership interest shall be treated as a limited partnership interest if--
(A) Such interest is designated a limited partnership interest in the limited partnership agreement or the certificate of limited partnership, without regard to whether the liability of the holder of such interest for obligations of the partnership is limited under the applicable State law; or
(B) The liability of the holder of such interest for obligations of
the partnership is limited, under the law of the State in which the
partnership is organized, to a determinable fixed amount (for
example, the sum of the holder’s capital contributions to the
partnership and contractual obligations to make additional capital
contributions to the partnership).What is the Internal Revenue Service’s Position on LLC members? The Internal Revenue Service’s official position is that members of limited liability companies are always like limited partners in a partnership. As stated above, Treasury Regulation Section 1.469T (e) (B) states that a partnership interest shall be treated as a limited partnership interest if the liability of the holder of such interest for obligations of the partnership is limited, under the law of the State in which the partnership is organized, to a determinable fixed amount (for example, the sum of the holder’s capital contributions to the partnership and contractual obligations to make additional capital contributions to the partnership. The IRS position on LLC members is also documented in the IRS Market Segment Specialization Program’s Audit Guidelines on Passive Activity Losses (April 25, 1994), which clearly states that members in an LLC are analogous to limited partners for passive activity purposes and that the test to determine whether they materially participate in the trade or business is determined pursuant to the material participation standards for limited partners rather than general partners. This is the audit manual that the internal revenue officers use when auditing taxpayers on passive activity issues.
What does this mean for members of Texas limited liability companies? Article 4.03 (A) of the Texas Limited Liability Company Act states that “except as and to the extent the regulations specifically provide otherwise, a member or manager is not liable for the debts, obligations or liabilities of a limited liability company including under a judgment decree, or order of a court.” Members of LLC’s formed in Texas would, more than likely, be treated like limited partners by the Internal Revenue Service. Whether an LLC member is treated like a limited partner or general partner is a fact issue for the courts. Some courts have ruled that if an LLC member actively participates in the day-to-day management of the LLC, that LLC member should be treated like a general partner.
Application of the Passive Loss Rule:Example 1
Farmer, an individual, owns an interest in a partnership that buys and sells turkeys. The general partner of the partnership periodically sends Farmer an email setting forth certain proposed actions and decisions with respect to the turkey purchases and sales. These emails include attachments, which shows, such information, as suppliers of the turkeys and prices paid for turkeys for the most recent twelve month rolling year period. The attachments also include information regarding sales data, which shows sales figures by quarter, by sales staff, quotas versus actual sales, and so forth. In addition to the periodic emails, Farmer also has access to the partnerships monthly financial statements that are on the partnerships intranet website. On occasion Farmer glances at the operating reports. The partnership agreement stipulates that significant management decisions are to be made by all the partners, including Farmer. The general partner receives a fee that constitutes earned income (within the meaning of I.R.C. Section 911 (d) (2) (A) for managing the turkey business.
Analysis:
Farmer only participation in the turkey business operation is to make certain managerial decisions. Under paragraph (b) (2) (ii) of I.R.C. Section 469, such management services are not taken into account in determining whether the taxpayer is treated as materially participating in the activity for a taxable year under paragraph (a) (7) of I.R.C. Section 469, if any other person performs services in connection with the management of the activity and receives compensation described in I.R.C. Section 911 (d) (2) (A) for such services. Therefore, Farmer is not treated as materially participating for the taxable year in the turkey operations.
Example 2Abraham, a calendar year taxpayer, owns a single member Texas Limited Liability Company. The limited liability company has a single activity, a computer software development shop. The operations of the LLC are a trade or business within the meaning of Treas. Reg. Sec. 1.469-1T (e) (2). During the taxable year, Abraham works for an average of 30 hours per week in connection with the LLC’s activities.
Analysis:
Under Treas. Reg. Sec. 1.469-5T (a) (1) and (e) (2), Abraham is treated as materially participating in the activity for the taxable year because he participated in the software development LLC for the taxable year for more than 500 hours.
Example 3Taxpayer Texas, an individual, owns and operates a cattle ranch. Texas is also a member of MPP, a limited liability company that operates a meat packing plant. Texas actively participates in management of MPP. Texas is the foreman on the ranch; therefore, she rarely has a chance to even visit MPP. However, during the last three months of the tax year, Texas did manage to spend approximately 100 hours at MPP where he hosed down the meat packing equipment, cleaned the freezer, and performed some repairs on the LLC’s four by four. MPP did not pay Texas for performing these chores. Other employees perform the day to day meat packing duties at MPP, a General Shop Foreman handles all of the responsibilities in the plant, the Vice President of Finance handles all of the financial chores and the Comptroller handles just about everything else. With the heavy administrative and shop overhead, MPP sustained $500,000 in losses in 2004. Texas deducted her share of these losses on her personal income tax return offsetting the substantial profits realized from her cattle ranch operations.
Analysis:
As was discussed above, the Internal Revenue Service’s official position could be that Texas cannot deduct the MPP losses because they are passive losses. The IRS position is that Texas should be treated as a limited partner because MPP is a limited liability company therefore; the more restrictive material participation standard that applies to limited partners should be applied to Texas. Under that standard, Texas did not satisfy the requirements because he did not work 500 hours for MPP, others performed substantially more services for which they were paid, and Texas services to MPP are not regular and consistent.
Example 4H & W, a married couple owned an undivided one-half interest in a building. The couple leased that building to a single tenant, Trials and Testimony, a legal document services firm organized under the Texas Business Corporation Act. W was the sole shareholder of the corporation. On their 2003 joint federal income tax return, the couple treated the rental income as passive activity income. The couple also had substantial, unrelated passive activity losses. Because I.R.C. Section 469 allows deductions for passive activity losses up to the amount of passive activity income, the couple’s characterization of the rental income allowed them to maximize the amount of passive activity losses that they could deduct in 2003.
Analysis
In a fact pattern substantially the same as this, the IRS rejected the taxpayers’ treatment of their rental income and denied their request for a refund. The taxpayers filed suit for refund in District Court; the District Court granted the government’s summary judgment motion. And on appeal to the 5th Circuit Court of Appeals, the appellate court upheld the lower court judgment against the Taxpayer. The Court noted that Congress intended to give the IRS broad discretion in certain situations in which the IRS may treat activities as defined as passive under I.R.C. Section 469 (c), including rental activity, as non-passive. Moreover the court ruled that the purpose of I.R.C. Section 469 was not to privilege rental income by generally classifying it as passive, but rather, the purpose animating the statute was to foreclose tax shelters. Therefore, depending upon all the facts and circumstances, the IRS may be permitted by I.R.C. Section 469 (I) to reclassify rental income as either passive or non-passive. The I.R.S. has promulgated Trea. Reg. Section 1.469-2 (f) (6) to combat tax shelters, where parties create tax effects with self-rent arrangements.
Example 5
Africa is the sole shareholder in a C corporation that markets books over the Internet. He hires a small group of clerical workers to download the orders from the corporation’s website and he personally handle all the other chores of the corporation, such as, ordering supplies, shipping the orders, and maintaining the financial records. Approximately June 15, 2004, on the advice of his financial advisor, he formed a limited liability company, and transferred all the assets of the corporation into the LLC and filed corporate dissolution documents with the Secretary of State’s office. He hired professionals to run the day-to-day operations of the LLC. After the transfer of the corporation’s assets into the LLC, he did not perform any services for the corporation, but he performed about 125 hours of services for the LLC. However the professional managers and other staff performed the bulk of the work at the LLC. After the dissolution of the corporation, Africa spent most of his days and nights golfing and fishing. The LLC had $1,000,000 in losses in 2004. Africa had passive income from unrelated sources in the amount of $500,000. At the end of the tax year 2004, Africa offset $500,000 of the LLC losses against passive income and he deducted the remaining $500,000 on Form 1040, Schedule C.
Analysis
The IRS position is that a member of an LLC should be treated like a limited partner for purposes of application of the passive activity rules. Therefore, the Service is likely to disallow the $500,000 deduction on Schedule C because Africa did not perform 500 hours of service for the LLC during the tax year. Nor did Africa meet the other requirements set forth above in the material participation standard applied to limited partners. The $500,000 loss that Africa offset against passive income will likely be allowed because it is consistent with I.R.C. Section 469. But courts may view this fact situation differently than the IRS under I.R.C. 469 because Africa was the sole shareholder of the C corporation, which was subject to the passive activity rules of I.R.C. Section 469 and he is the sole member of an LLC that is also subject to the passive activity rules. Moreover, he is conducting the same trade and business activity in the LLC that he was conducting in the dissolved C corporation. In the C corporation, he performed substantial services, and if these hours are added to his hours of services for the LLC, arguably Africa performed in excess of 500 hours of services in 2004; therefore, Africa may be able to deduct the losses as ordinary business losses on Form 1040, Schedule C.
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