1. Specific Tax Problems Related to Limited Liability Companies.
    1. In General.
      1. Limited liability companies (LLCs) are statutory creatures which combine the corporate characteristic of limited liability for all investors with the income flow-through attributes of a partnership. The basic characteristics of limited liability companies are as follows:
        1. Management authority may be vested in all, some or none of the members thereby providing absolute flexibility with regard to designing the allocation of authority and decision making.
        1. The owners are not liable for the debts of the entity.
        1. The entity may continue or dissolve upon the happening of specified events identified in the operating agreement giving the entity complete structuring flexibility as to dissolution, limited only by the goal of obtaining the desired outcome for federal income tax purposes.
        1. The transfer of an interest in the LLC and/or admission of new members to the LLC may be prohibited or allowed pursuant to any agreed upon criteria set forth in the operating agreement, thereby providing for absolute flexibility in structuring the business arrangement among the owners.
        1. The LLC may be organized for any lawful business whether profit or nonprofit.
        1. The LLC may have one or more members, depending on state statutes.
        1. The LLC was designed to be an entirely contractual-based entity allowing maximum flexibility while still making it possible to obtain partnership tax treatment and limited liability.
      1. Fifty states and the District of Columbia have enacted legislation recognizing limited liability companies (LLCs) as a form of business entity. The issuance of Rev. Rul. 88-76 sparked a substantial interest in LLCs among tax practitioners which, in a short time, led to the enactment of LLC statutes by a number of states. Given the potential for coupling limited liability with partnership tax treatment, LLCs gained instant popularity with real estate developers and investors. Moreover, as the number of states recognizing LLCs has grown over the past few years, the IRS began issuing private letter rulings confirming the partnership status of LLCs formed under a number of state statutes. Nevertheless, it was not until 1993 that the IRS finally issued additional revenue rulings to supplement Rev. Rul. 88-76. In the new rulings, Rev. Rul. 93-5, 1993-1 C.B. 227, Rev. Rul. 93-6, 1993-1 C.B. 229, Rev. Rul. 93-30, 1993-1 C.B. 231, and Rev. Rul. 93-38, 1993-1 C.B. 233, the Service concluded that LLCs organized under Virginia, Colorado, Nevada and Delaware statutes respectively would be treated as partnerships for federal tax purposes. (See also Rev. Rul. 93-49, 1993-2 C.B. 308, for Illinois LLCs; Rev. Rul. 93-50, 1993-2 C.B. 310, for West Virginia LLCs; Rev. Rul. 93-53, 1993-2 C.B. 312, for Florida LLCs; Rev. Rul. 93-81, 1993-2 C.B. 314, for Rhode Island; Rev. Rul. 93-91, 1993-2 C.B. 316, for Utah; Rev. Rul. 93-92, 1993-2 C.B. 318, for Oklahoma; Rev. Rul. 93-93, 1993-2 C.B. 321, for Arizona; Rev. Rul. 94-5, 1994-1 C.B. 312, for Louisiana; Rev. Rul. 94-6, 1994-1 C.B. 314, for Alabama; Rev. Rul. 94-30, 1994-1 C.B. 316, for Kansas; Rev. Rul. 94-51, 1994-32 I.R.B. 11, for New Jersey; Rev. Rul. 94-79, 1994-51 I.R.B. 7, for Connecticut; Rev. Rul. 95-9, 1995-3 I.R.B. 17, for South Dakota; and Rev. Rul. 95-55, 1995-35 I.R.B. 14, for New York.)
      1. LLCs are an attractive alternative to partnerships and corporations. General partners are subject to personal liability for entity-level obligations and limited partners are restricted from extensively participating in the partnership's management. S corporations subject participants to rigid statutory requirements and shareholder limitations (in type and number) and C corporations subject shareholders to double taxations. LLCs provide an option without such limitation. As a hybrid form, the LLC is a pass-through entity which combines the liability protection of an S corporation with the structuring and management ease of a partnership.
      1. The attributes of LLCs are similar, but not uniform, in the various state statutes. An LLC is a non-corporate entity based upon the concept of freedom of contract. Unlike corporations, LLCs have few statutory restrictions with respect to management, operations, and capital.
        1. Most LLC statutes require at least two members to have interests in an LLC. However, LLCs may be formed by organizers as corporations are formed by incorporators. In general, the LLC will be considered formed after the articles of organization are filed or a Certificate of Formation is issued by the state.
        1. Although not required by LLC statutes, an operating agreement, the equivalent of the by-laws of a corporation or a partnership agreement, governs the internal affairs of an LLC and the relationship of its members. Typical operating agreements address capital contributions, distributions, allocation of earnings, withdrawal or termination of members, management authority, transfer of LLC interests, and dissolution. Management of an LLC is vested in its members although the members may agree to limit this authority or delegate the authority to managers who may, but are not required to, be members of the LLC.
        1. The most significant non-tax attribute of LLCs is the limited liability of all of its members, regardless of the degree to which a member participates in the management of the LLC. A member's liability is generally limited to the amount of its capital contribution plus agreed but unpaid contributions. In jurisdictions without LLC acts, however, the possibility exists that an LLC with activities in the non-LLC jurisdiction would be treated as a general partnership thereby subjecting the LLC members to unlimited liability for the entity's debts and obligations.
      1. Prior to the IRS issuing Rev. Rul. 88-76, 1988-2 C.B. 360, it was uncertain how an LLC would be classified for federal income tax purposes. In Rev. Rul. 88-76, the IRS concluded that a Wyoming LLC would be treated as a partnership for federal income tax purposes. Rev. Rul. 88-76 holds that a Wyoming LLC will be characterized as a partnership for tax purposes because it lacks the corporate characteristic of continuity of life and free transferability of interests. The final classification regulations under Reg. § 301.7701-1 allow the LLC to elect to be taxed as a corporation for federal income tax purposes. In the absence of an election, a two member LLC is treated as a partnership for federal income tax purposes and a one member LLC is treated as the equivalent to a sole proprietorship.
    1. Operational Issues of a Limited Liability Company.
      1. Since a limited liability company organized and operated in accordance with the applicable state statutes pertaining to limited liability companies will be classified as a partnership for federal income tax purposes, the normal partnership provisions of Subchapter K apply to the limited liability company. Such operational provisions include:
        1. Formation.
          1. No gain or loss is recognized on the contribution of property to the partnership to either the contributing partner or to the partnership (See § 721 - § 724).
          1. With respect to property contributed to the partnership, the difference between the fair market value and the adjusted basis of the contributed property is required to be taken into account under the provisions of § 704(c).
        1. Operation - partnership operational provisions which apply to an LLC include:
          1. Any election affecting the taxable income of the partnership is to be made by the partnership under § 703(b).
          1. All items of income, gain, loss, and deduction flow through to the partners in accordance with their interests in partnership profits or losses.
          1. The character of the items which are required to be included within each partner's distributive share is determined by the character of the income to the partnership under § 702(b).
          1. The special allocation provisions of § 704(b) apply. In order for an allocation to be recognized for federal income tax purposes, the allocation must pass the substantial economic effect test of § 704(b).
          1. A partner's basis in his partnership interest is determined in accordance with the provisions of § 705(a) and § 705(b). Included in determining a partner's basis in his or her or its partnership interest is that partner's share of the partnership debt (both recourse and nonrecourse). Each partner's proportionate share of the debt is determined under the provisions of § 752.
          1. A partner is entitled to deduct his distributive share of the losses of the partnership as limited by his basis in his partnership interest under § 704(d). Any loss in excess of his basis may be carried forward and deducted in a year in which a partner has basis.
          1. The passive activity loss provisions of § 469 apply. In general, each limited partner's share of the partnership loss is considered to be a passive loss and may only be offset against other passive income. A member of a limited liability company is generally considered the same as a limited partner in a partnership.
        1. Sales and Exchanges - When a partner disposes of his interest in a partnership in a taxable sale or exchange, the provisions of § 741 - § 743 apply. Generally, the sale or exchange of a partner's entire interest in a partnership does not affect the partnership. It does, however, terminate the partner's taxable year with respect to the partnership. In addition, unless the partnership has a § 754 election in effect, the purchasing partner's basis inside the partnership is different than his basis outside the partnership.
        1. Current and Liquidating Distributions - With respect to current distributions or liquidating distributions, the rules of § 731 - § 736, including § 751(b), apply.
      1. Even though a two-member LLC is recognized and treated as a partnership for federal income tax purposes, and as such, the normal partnership provisions of Subchapter K apply to the LLC as explained above, there are a number of specific partnership problems to resolve when dealing with an LLC. These include:
        1. Conversion of a Partnership into an LLC.
          1. In Rev. Rul. 84-52, 1984-1 C.B. 157, a general partnership formed under the Uniform Partnership Act proposed to convert to a limited partnership under the Uniform Limited Partnership Act. Rev. Rul. 84-52 generally holds that:
            1. Under § 721, the conversion will not cause the partners to recognize gain or loss under § 741 or § 1001;
            1. Unless its business will not continue after the conversion, the partnership will not terminate under § 708 because the conversion is not treated as a sale or exchange for purposes of § 708;
            1. If the partners' shares of partnership liabilities do not change, there will be no change in the adjusted basis of any partner's interest in the partnership;
            1. If the partners' shares of partnership liabilities change and cause a deemed contribution of money to the partnership by a partner under § 752(a), then the adjusted basis of such a partner's interest will be increased under § 722 by the amount of the deemed contribution;
            1. If the partners' shares of partnership liabilities change and cause a deemed distribution of money by the partnership to a partner under § 752(b), then the basis of such a partner's interest will be reduced under § 733 (but not below zero) by the amount of the deemed distribution, and gain will be recognized by the partner under § 731 to the extent the deemed distribution exceeds the adjusted basis of the partner's interest in the partnership; and
            1. Under § 1223(1), there will be no change in the holding period of any partner's total interest in the partnership.
          1. In Rev. Rul. 95-37, 1995-1 C.B. 130 the Service ruled that the conversion of an interest in a domestic partnership into an interest in a domestic LLC that is classified as a partnership for federal tax purposes is treated as a partnership-to-partnership conversion that is subject to the principles of Rev. Rul. 84-52. As a result, Rev. Rul. 95-37 holds the following:
            1. The federal income tax consequences described in Rev. Rul. 84-52 apply to the conversion of an interest in a domestic partnership into an interest in a domestic LLC that is classified as a partnership for federal tax purposes. The federal tax consequences are the same whether the resulting LLC is formed in the same state or in a different state than the converting domestic partnership.
            1. The conversion of an interest in a domestic partnership into an interest in a domestic LLC that is classified as a partnership for federal tax purposes does not cause a termination under § 708.
            1. Moreover, because each partner in a converting domestic partnership continues to hold an interest in the resulting domestic LLC, the conversion is not a sale, exchange, or a liquidation of the converting partner's entire partnership interest for purposes of § 706(c)(2)(A). (See Rev. Rul. 86-101, 1986-2 C.B. 94, where the Service ruled that the taxable year of a partnership does not close with respect to a general partner when the partnership agreement provides that the general partner's interest converts to a limited partnership on the general partner's death because the decedent's successor continues to hold an interest in the partnership.) Consequently, the conversion does not cause the taxable year of the domestic partnership to close with respect to all the partners or with respect to any partner.
            1. Because the conversion of an interest in a domestic partnership into an interest in a domestic LLC that is classified as a partnership for federal tax purposes does not cause a termination under § 708, the resulting domestic LLC does not need to obtain a new taxpayer identification number.
        1. Taxable Year End - Under § 706(b), an LLC is restricted to the taxable year end as determined by the majority interest test, the principal partner test, or the least aggregate deferral method set forth in Reg. § 1.706-1T. The exceptions to the required taxable year end, such as the natural business year end test, the valid business purpose test, and the election under § 444 to have a taxable year end that results in a three-month or less deferral (provided the required payments of § 7519 are made) are also available. If a member of an LLC is someone other than an individual, particular attention should be paid to whether the LLC has adopted the correct taxable year end.
        1. Method of Accounting - If an LLC is not required to maintain a beginning or ending inventory, is it nevertheless restricted to the accrual method of accounting? If the LLC has a corporate member, § 448 might apply and restrict the LLC to the accrual method of accounting if the LLC's average annual gross receipts for the three preceding taxable years exceeds $5 million. In addition, there seems to be some controversy, and no resolution, of whether an LLC is a tax shelter or syndicate. If an LLC is considered as a tax shelter or syndicate, it is also restricted to the accrual method of accounting and there is no small business exception which applies.
          1. A tax shelter under § 461(i)(3) means any enterprise (other than a C corporation) if at any time interests in such enterprise have been offered for sale in any offering required to be registered with any federal or state agency having the authority to regulate the offering of securities for sale, any syndicate within the meaning of § 1256(e)(3)(B), and any tax shelter within the meaning of § 6661(b)(2)(C)(ii).
          1. The term "syndicate" means any partnership or other entity (other than a corporation which is not an S corporation) if more than 35% of the losses of such entity during the tax year are allocable to limited partners or limited entrepreneurs. Section 464(e)(2) provides that a limited entrepreneur means any person who has an interest in an enterprise other than as a limited partner and does not actively participate in the management of such enterprise.
          1. Section 6661(b)(2)(C)(ii) provides that the term "tax shelter" means a partnership or other entity, any investment plan or arrangement, or any other plan or arrangement, if the principal purpose of such partnership, entity, plan or arrangement is the avoidance or evasion of federal income tax.
          1. There are a number of private letter rulings which have been issued by the IRS which state that an LLC is not considered as a tax shelter unless such interests in the LLC have been offered for sale in any offering required to be registered with an federal or state agency having the authority to regulate the offering of securities for sale or until that point in time where more than 35% of the losses of such entity are allocable to limited partners or limited entrepreneurs (See PLR 9452024, September 29, 1994; PLR 9426030, March 31, 1994; PLR 9412025, February 24, 1994; PLR 9412030, December 22, 1993; PLR 9321047, February 25, 1993; PLR 8911011, December 14, 1988; PLR 8837068, June 22, 1988; and PLR 8753032, October 5, 1987).
        1. Tax Matters Partner.
          1. Prior to the enactment of the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA), adjustments attributable to the tax items of a partnership were made at the partner level. Section 402 of TEFRA added §§ 6221 through 6231 to allow for consolidated administrative and judicial proceedings to determine the tax treatment of partnership items at the partnership level. Under this consolidated proceeding, the tax matters partner of a partnership represents the partnership before the IRS in all tax matters for a specific taxable year.
          1. Section 6231(a)(7) provides that the tax matters partner of a partnership is the general partner designated as the tax matters partner as provided in regulations or, if no general partner is designated, the general partner having the largest profits interest in the partnership at the close of the taxable year involved (largest-profits-interest rule). Section 6231(a)(7) also provides that, if no general partner is designated and the Commissioner determines that it is impracticable to apply the largest-profits-interest rule, the partner selected by the Commissioner is treated as the tax matters partner.
          1. Reg. § 301.6231(a)(7)-2 provides that a "member-manager" of an LLC will be treated as a general partner for purposes of determining the tax matters partner of the LLC. Any member of an LLC that is not a member-manager is treated as a partner other than a general partner. The regulations define a member-manager as a member of the LLC who, alone or together with others, is vested with the continuing exclusive authority to make the management decisions necessary to conduct the business for which the organization was formed. This approach is adopted because, if a member of the LLC has such continuing exclusive management authority, the member should have the necessary authority and access to partnership records needed to function as a tax matters partner. The regulations also provide that if there are no elected or designated member-managers (as described above), each member will be treated as a member-manager.
        1. Contribution of Property to LLC - Under § 704(c), an LLC is required to allocate income, gain, loss and deduction with respect to LLC property contributed by a member so as to take into account any variation between the adjusted basis of the property and its fair market value at the time of contribution. Under Reg. § 1.704-3, if property is contributed to an LLC and at the time of the contribution the book value of the property differs from the contributing member's adjusted tax basis in such property, the difference between the book value and the adjusted basis is required to be taken into account under the provisions of § 704(c). (The difference between book value and tax adjusted basis is referred to as "built-in gain" or "built-in loss".) Under Reg. § 1.704-3, there are now four different ways in which such built-in gain or loss may be accounted for by the contributing member and the LLC. These include:
          1. Small Disparity - The provisions of § 704(c) do not apply if there is a small disparity between book value and tax adjusted basis of the contributed property (See Reg. § 1.704-3(e) for the definition of a small disparity).
          1. Traditional Method Described in Reg. § 1.704-3(b) - Under the traditional method, the built-in gain or loss is required to be specially allocated to the contributing partner when the partnership subsequently sells the property in a taxable sale or exchange. In addition, under the traditional method, if the contributed property is depreciable property, the tax depreciation deduction on such contributed property is allocated first to the non-contributing members, with any excess then allocated to the member who contributed such property to the LLC.
          1. Traditional Method with a Curative Allocation as Described in Reg. § 1.704-3(c) - The traditional method with a curative allocation is used when the ceiling rule of § 704(c) applies. Under Reg. § 1.704-3(c), to correct distortions created by the ceiling rule, an LLC may make reasonable curative allocations of other partnership tax items of income, gain, loss or deduction so that equal allocations of book and tax items may be made to non-contributing partners, using tax items that would have the same effect on the members as the tax items affected by the ceiling rule. For example, if depreciation deductions that would be allocated to a non-contributing partner are limited by the ceiling rule, a curative allocation of capital gain items to the contributing partner is not reasonable. Thus, if a curative allocation is used, the LLC must allocate not only a sufficient amount, but also the correct type of item of income, gain, loss or deduction to equalize the allocations of book and tax items.
          1. Remedial Allocation Method of Reg. § 1.704-3(d) - Under the remedial allocation method, if the ceiling rule results in a book allocation to a non-contributing partner different from the corresponding tax allocation, the LLC makes a remedial allocation of income, gain, loss, or deduction to the non-contributing member equal to the full amount of the limitation caused by the ceiling rule in a simultaneous, off-setting remedial allocation of deduction, loss, gain or income to the contributing member.
            1. If the remedial allocation method is adopted and the contributed property is depreciable property, the portion of the book basis in the property equal to the tax basis in the property at the time of contribution is recovered in the same manner as the tax basis (generally over the property's remaining recovery period under § 168(i)(7)). The remainder of the LLC's book basis in the property (the amount by which the book basis exceeds adjusted tax basis) is recovered using any applicable recovery period and depreciation (or other cost recovery) method available to the LLC for newly purchased property placed in service at the time of contribution.
            1. In addition, a remedial allocation is reasonable only to the extent it equals the amount necessary to offset the effect of the ceiling rule for that taxable year and only if it has the same effect on each member's tax liability as the item limited by the ceiling rule. Thus, if the item limited by the ceiling rule is depreciation or other cost recovery, the offsetting remedial allocation of income to the contributing member must consist of the same type of income that the contributed property produces. Similarly, if the item limited by the ceiling rule is capital loss from the sale of contributed property, the offsetting remedial allocation to the contributing member must be capital gain from the sale of that property.
        1. Allocation of LLC Debt - It must be kept in mind that all LLC debt is treated as nonrecourse debt for federal income tax purposes, even though such debt under state law may be considered as recourse debt. Since all LLC debt is nonrecourse debt for federal income tax purposes, the provisions of Reg. § 1.752-3 must be dealt with in the allocation of such debt among the members. In general, a member's share of nonrecourse liabilities of an LLC equals the sum of:
          1. The member's share of LLC minimum gain determined in accordance with the substantial economic effect regulations;
          1. The amount of any taxable gain that would be allocated to the member under § 704(c) (or in the same manner as § 704(c) in connection with a revaluation of LLC property) if the LLC disposed of (in a taxable transaction) all LLC property subject to one or more nonrecourse liabilities of the LLC in full satisfaction of the liabilities and for no other consideration; and
          1. The member's share of excess nonrecourse liabilities (those not allocated under (1) or (2) above) of the LLC as determined in accordance with the member's share of LLC profits.
        1. Special Allocations Under § 704(b) - If the LLC agreement specially allocates an item of income, gain, loss or deduction to one member away from another member, the LLC operating agreement must comply with the substantial economic effect provisions of § 704(b). In addition, if the LLC wants to make sure that it does comply with the special allocation provisions of § 704(b), the LLC must comply with the requirements set forth in Reg. § 1.704-2(e) for the allocation of nonrecourse deductions. Until the LLC has nonrecourse deductions, the special allocation of the item of income, gain, loss or deduction must be allocated to that member who bears the economic risk of loss (See Reg. § 1.704-1(b)(2)(ii), § 1.704-1(b)(2)(iii), and § 1.704-1(b)(3) for the economic effect test, the alternate economic effect test, the substantiality test, and the facts and circumstances test). Once the LLC has nonrecourse deductions, Reg. § 1.704-2(e) provides that the following requirements must be satisfied:
          1. Capital account maintenance provisions and liquidating distribution requirements.
          1. Beginning in the first taxable year of the LLC in which there are nonrecourse deductions and thereafter throughout the full term of the LLC, the LLC agreement provides for allocations of nonrecourse deductions in a manner that is reasonably consistent with allocations that have substantial economic effect of some other significant partnership item attributable to the property securing the nonrecourse liabilities.
          1. Beginning in the first taxable year of the LLC that it has nonrecourse deductions or makes a distribution of proceeds of a nonrecourse liability that are allocable to an increase in LLC minimum gain, and thereafter throughout the full term of the LLC, the LLC agreement contains a provision that complies with the minimum gain chargeback requirement.
          1. All other material allocations and capital account adjustments under the LLC agreement are recognized under Reg. § 1.704-1(b).
        1. Limitation on Deductibility of Losses - Not only must a member of an LLC comply with the provisions of § 704(d) in determining the amount of loss that is deductible, the member must also contend with the provisions of § 465, dealing with the at-risk rules, and § 469, dealing with passive activity losses.
          1. The maximum amount of loss that a member is entitled to deduct in any one taxable year is limited to that member's basis in its interest determined as of the close of the taxable year, and before taking into account the loss.
          1. If the member has a sufficient basis to absorb the loss, the amount of loss that is then deductible is subject to the at-risk provisions of § 465.
          1. The only activity that is excepted from the at-risk rules of § 465 is a real estate activity.
          1. If the member has a sufficient amount at-risk to deduct its share of the loss, such loss is then only deductible if the activity is either not a passive activity or the member has a sufficient amount of passive income to absorb the passive loss.
          1. No guidance has been issued regarding the extent to which an LLC member must participate in management in order to be considered as materially participating in the endeavor and able to avoid the passive activity loss limitations. Although limited partners generally must devote at least 500 hours to the activity during the taxable year in order to be considered as materially participating in the enterprise (Reg. § 1.469-5T(a) and (e)). It is unclear whether LLC members should be treated as limited partners and required to maintain a similar level of involvement. In the past, the IRS ruled that partners who have significant management authority relative to other members were to be treated as general partners (Rev. Proc. 89-12, 1989-1 C.B. 798). If this concept applies in the LLC context, certain LLC members could be treated as general partners and subjected to less stringent material participation rules.
        1. Self-Employment Income - Is a member's distributive share of the income or loss generated by an LLC considered as self-employment income for purposes of determining that member's net income subject to the self-employment tax? Section 1402(a)(13) provides that a limited partner's distributive share of any item of income or loss is excluded from that individual's net earnings from self-employment. Is a member considered the same as a limited partner for purposes of computing its self-employment income or is the member considered the same as a general partner in a partnership where the general partner's distributive share is automatically considered as self-employment income or loss as the case may be? Does it depend upon the level of participation by the member in the LLC operations, or does it depend on whether the member participates in the management activities of the LLC? Prop. Reg. § 1.1402(a)-2(g) answers these questions. (But see TRA 97.)
          1. Prop. Reg. § 1.1402(a)-18 issued in 1994 provided that, generally, a member's net earnings from self-employment included the member's distributive share (whether or not distributed) of income or loss from any trade or business carried on by an LLC. However, a member was treated as a limited partner and, thus, exempt from self-employment taxes under § 1402(a)(13), if: (a) the member was not a manager and (b) the entity could have been formed as a limited partnership rather than an LLC in the same jurisdiction and the member could have qualified as a limited partner in that limited partnership under applicable law. If a member of an LLC was treated as a limited partner under Prop. Reg. § 1.1402(a)-18, then the member's distributive share of income or loss from the LLC was not included in net earnings from self-employment, except for guaranteed payments for services.
            1. A manager was defined as "a person who, alone or together with others, has the continuing exclusive authority to make the management decisions necessary to conduct the LLC's business". If there were no designated or elected managers of the LLC, then all of the members were treated as managers, even if some members had greater management authority than others under the applicable LLC statute and the LLC's controlling documents.
            1. The second requirement, i.e., the entity could have been formed as a limited partnership rather than an LLC in the same jurisdiction and the member could have qualified as a limited partner in that limited partnership under applicable local law, was intended to address two concerns. First, some states prohibit the conduct of certain activities through partnerships generally or limited partnerships in particular (such as practicing law as a limited partnership). Thus, one purpose was to make clear that a business operating through an LLC did not obtain a result for self-employment tax purposes that it would not be able to achieve by operating as a limited partnership. Another purpose of the requirement was to ensure that LLC members and limited partners who participated in the management or control of the entity to the same extent were treated in the same manner for self-employment tax purposes.
            1. One effect of Prop. Reg. § 1.1402(a)-18 was to prevent members of an LLC formed in a jurisdiction which did not authorize limited partnerships from obtaining an exemption from self-employment taxes under § 1402(a)(13) as limited partners.
          1. On January 13, 1997, the IRS issued additional regulations and revoked the 1994 regulations.
            1. The proposed regulations (Prop. Reg. § 1.1402(a)-2(g)) define which partners of a federal tax partnership are considered limited partners for § 1402(a)(13) purposes. These proposed regulations apply to all entities classified as a partnership for federal tax purposes, regardless of the state law characterization of the entity. Thus, the same standards apply when determining the status of an individual owning an interest in a state law limited partnership or the status of an individual owning an interest in an LLC. In order to achieve this conformity, the proposed regulations adopt an approach which depends on the relationship between the partner, the partnership, and the partnership's business. State law characterizations of an individual as a "limited partner" or otherwise are not determinative.
            1. Generally, an individual will be treated as a limited partner under the proposed regulations unless the individual (1) has personal liability (as defined in Reg. § 301.7701-3(b)(2)(ii)) for the debts of or claims against the partnership by reason of being a partner; (2) has authority to contract on behalf of the partnership under the statute or law pursuant to which the partnership is organized; or, (3) participates in the partnership's trade or business for more than 500 hours during the taxable year. If, however, substantially all of the activities of a partnership involve the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, or consulting, any individual who provides services as part of that trade or business will not be considered a limited partner.
            1. By adopting these functional tests. the proposed regulations ensure that similarly situated individuals owning interests in entities formed under different statutes or in different jurisdictions will be treated similarly. The need for a functional approach results not only from the proliferation of new business entities such as LLCs, but also from the evolution of state limited partnership statutes. When Congress enacted the limited partner exclusion found in § 1402(a)(13), state laws generally did not allow limited partners to participate in the partnership's trade or business to the extent that state laws allow limited partners to participate today. Thus, even in the case of a state law limited partnership, a functional approach is necessary to ensure that the self-employment tax consequences to similarly situated taxpayers do not differ depending upon where the partnership organized.
            1. The proposed regulations allow an individual who is not a limited partner for § 1402(a)(13) purposes to nonetheless exclude from net earnings from self-employment a portion of that individual's distributive share if the individual holds more than one class of interest in the partnership. Similarly, the proposed regulations permit an individual that participates in the trade or business of the partnership to bifurcate his or her distributive share by disregarding guaranteed payments for services. In each case, however, such bifurcation of interests is permitted to only to the extent the individual's distributive share is identical to the distributive share of partners who qualify as limited partners under the proposed regulation (without regard to the bifurcation rules) and who own a substantial interest in the partnership. Together, these rules exclude from an individual's net earnings from self-employment amounts that are demonstrably returns on capital invested in the partnership.
            1. Proposed Effective Date - These regulations are proposed to be effective beginning with the individual's first taxable year beginning on or after the date these regulations are published as final regulations in the Federal Register.
          1. Proposed Reg. § 1.1402(a)-2, which was to go into effect if and when it became a final regulation, would have provided that a partner would not be treated as a limited partner if he had personal liability for partnership debts, had authority to contract on behalf of the partnership, or participated in the partnership's trade or business for more than 500 hours during the taxable year. In addition, the proposed regulation would have provided that an individual who met one of these criteria would have been treated as a general partner and net earnings from self-employment would have included the partner's distributive share of partnership income and loss. TRA 97 provides that no temporary or final regulations can be issued or made effective by the IRS on the definition of a limited partner under § 1402(a)(13) before July 1, 1998.
          1. Earlier, the IRS issued PLR 9432018 (May 16, 1994) which characterized a member's distributive share of the income generated by the LLC as income for self-employment taxes. Essentially, the IRS stated that the LLC is characterized as a state law partnership for federal tax purposes, not a state law limited partnership; therefore, an LLC member's distributive share of the income is subject to self-employment tax as a general partner in a partnership and not as a limited partner in a partnership.
            1. PLR 9432018 involved a general partnership converting to an LLC. Regarding self-employment tax on the LLC, the IRS explained its position as follows:
              The language at the beginning of § 7701(a) of the Code provides that the definitions of "partnership" and "partner" contained in § 7701 apply when used in Title 26 (the Internal Revenue Code) where not otherwise distinctly expressed or manifestly incompatible with the intent thereof. Section 1.1402(a)-2(f) of the regulations provides that for the purpose of determining net earnings from self-employment, a partnership is one which is recognized as such for income tax purposes. Therefore, the classification of the LLC as a partnership under § 7701 means that the members of the LLC will be partners for SECA tax purposes. Also, the members' distributive shares of income are not excepted from net earnings from self-employment by § 1402(a)(13). Therefore, {an LLC member's} distributive share of the income and loss described in § 702(a)(8) from any trade or business carried on by LLC shall be includable in computing the net earnings from self-employment of {such LLC member}.
          1. This IRS logic--which treats LLC members like "limited partners" should also extend to other areas, such as the passive loss rules, where the Code or Regulations set forth distinct treatment for "limited partners".
        1. Discharge of Indebtedness Income - When a partnership has income from discharge of indebtedness, generally to determine whether each individual partner is required to recognize discharge of indebtedness income under § 108, the determination is required to be made at the individual partner level. For example, if a partner is insolvent before and after its proportionate share of the debt is forgiven, that partner recognizes no discharge of indebtedness income; if the individual partner has filed a petition for bankruptcy and the debt is forgiven as part of the bankruptcy proceeding, the individual partner does not recognize discharge of indebtedness income; and if the individual partner is neither bankrupt nor insolvent, the individual partner is required to recognize discharge of indebtedness income under § 108 (§ 108(d)(6)).
          1. In addition, if a borrower defaults on a recourse loan and the lender forecloses on the collateral, the borrower remains liable to the lender to the extent that the foreclosure proceeds are insufficient to satisfy the recourse debt. If the lender chooses not to pursue the borrower for the deficiency, the borrower will have discharge of indebtedness income. For tax purposes, the transaction is treated as two separate transactions. First, the borrower is treated as if it sold the property for the foreclosure proceeds, i.e., fair market value. The borrower recognizes gain or loss equal to the difference between the sales price for the property and the borrower's adjusted basis in the property. Second, the borrower recognizes income from discharge of indebtedness to the extent that the balance of the recourse loan exceeds the sales proceeds. If the borrower is insolvent, it may exclude the income from discharge of indebtedness, but not the gain from the sale or exchange, from its taxable income.
          1. If the borrower deeds the property to the lender in lieu of foreclosure, the results are the same. The borrower has gain or loss from the sale or exchange of the property. The gain or loss is calculated by the difference between the fair market value of the property and the borrower's adjusted basis in the property. If the lender chooses not to pursue the borrower for the deficiency, the borrower has income from discharge of indebtedness equal to the difference between the balance of the loan and the fair market value of the collateral. If the borrower is insolvent, the income from discharge of indebtedness is excluded from its taxable income, but the gain from the sale or exchange is not.
          1. If a loan is nonrecourse, the borrower has no personal liability for the loan. The lender's sole recourse is the property. For tax purposes, the fair market value of property securing a nonrecourse loan cannot be less than the balance of the debt (§ 7701(g)). Consequently, upon the foreclosure or deed in lieu of foreclosure, there is no income from discharge of indebtedness. The borrower has gain or loss from the sale or exchange of the property equal to the difference between the fair market value of the property (which by definition cannot be less than the face amount of the note) and the borrower's adjusted basis in the property. All of this gain is required to be recognized for tax purposes and the discharge of indebtedness rules of § 108 do not apply.
          1. In the LLC context, the question that remains to be answered is whether the debt of the LLC is considered as recourse debt or nonrecourse debt for tax purposes. For purposes of determining a member's basis in its LLC interest, all debt of the LLC is considered as nonrecourse for tax purposes, even if the debt is recourse for state law purposes. It seems that a consistent application of the definition of recourse and nonrecourse is required to be followed for tax purposes. Consequently, all debt of an LLC should be considered as nonrecourse debt both for purposes of § 752 and the allocation of debt to each individual member and for purposes of § 108 which deals with the discharge of indebtedness provisions. As a result, if debt of an LLC is forgiven or discharged, the debt should be considered as nonrecourse debt and no discharge of indebtedness income should result and no individual member should be able to exclude its distributive share of the income or loss which results from the sale or exchange of the property equal to the difference between the face amount of the debt and the LLC's tax adjusted basis in the property. There is no exception to each individual member to exclude this gain under § 108 and no discharge of indebtedness income results under § 108.
        1. Classifying Payments Under § 736.
          1. Payments made by a partnership, including the assumption of liabilities, to a retiring partner or a deceased partner, are generally divided into two categories, § 736(b) payments, and § 736(a) payments (Reg. § 1.736-1(a)(2)). Section 736 (b) payments include payments for the value of the partner's interest in partnership assets, including inventory, and for the partner's interest in partnership goodwill if specifically provided for in the partnership agreement (Reg. § 1.736-1(b)). In addition, as amended by the Revenue Reconciliation Act of 1993, § 736(b) payments also include payments to a retiring or deceased partner where capital is a material income producing factor for the partnership and the retiring or deceased partner was a general partner in the partnership (§ 736(b)(3)). Payments that qualify as § 736(b) payments are treated as distributions subject to the normal distribution rules, including § 751(b).
          1. Section 736(a) payments include all other payments to be made by the partnership to the retiring partner or deceased partner. Generally, § 736(a) payments include payments for the retiring or deceased partner's share of unrealized receivables, goodwill if not specifically provided for in the partnership agreement, and any other payments not in exchange for the retiring or deceased partner's interest in partnership property under § 736(b) (Reg. § 1.736-1(a)(2) and -1(a)(3)). Section 736(a) payments are taxed either as a § 702 distributive share (if the amount depends on partnership income) or as § 707(c) guaranteed payments (if the amount is fixed). Thus, § 736 serves primarily to classify the components of a liquidating payment; the tax consequences are determined under other substantive provisions.
          1. The Revenue Reconciliation Act of 1993 amended § 736 effective for all partners dying or retiring on or after January 3, 1993. Section 736(b)(3) generally repeals the special treatment of liquidation payments made for goodwill and unrealized receivables. Thus, such payments are to be treated as made in exchange for the partner's interest in partnership property, and not as a distributive share or guaranteed payment that could give rise to a deduction or its equivalent. However, the Revenue Reconciliation Act of 1993 did not change § 736 with respect to payments made to a general partner in a partnership in which capital is not a material income producing factor. The determination of whether capital is a material income producing factor is to be made using a facts and circumstances test (See for example, § 401(c)(2), § 911(d), and old § 1348(b)(1)(A)). For purposes of § 736, capital is not a material income producing factor where substantially all of the gross income the business consists of fees, commissions, or other compensation for personal services performed by an individual. The practice of his or her profession by a doctor, dentist, lawyer, architect, or accountant will not, as such, be treated as a trade or business in which capital is a material income producing factor even though the practitioner may have a substantial capital investment in professional equipment or in physical plant constituting the office from which such individual conducts his or her practice so long as such capital investment is merely incidental to such professional practice. In addition, § 736 does not affect the deductibility of compensation paid to a retiring partner for past services.
          1. If capital is a material income producing factor, or if the retiring or deceased partner is not a general partner, then all payments made to the retiring person or the decedent are considered as § 736(b) payments, i.e., payments for partnership property, and are therefore subject to the rules regarding distributions in liquidation, including the disproportionate distribution rules of § 751(b). If the payments are considered as a payment made to a partner for the retiring or deceased partner's interest in partnership property, any payments made to the retiring or deceased partner for either stated or unstated goodwill are not deductible by the partnership. In addition, any payments made by the partnership for any unrealized receivables as defined in § 751(c) are not deductible by the partnership.
          1. Determining whether capital is a material income producing factor for the partnership and/or LLC is a facts and circumstances test. The more important issue is whether a member in an LLC is the same as a general partner in a partnership. If a member is not considered the same as a general partner, all payments to the retiring or deceased member are payments for LLC property, and § 736 does not apply. If the member is considered the same as a general partner, then the provisions of § 736 apply. As to whether a member in an LLC is the same as a general partner, as of today, there is no answer to this question. A strict interpretation of the statute would result in a member of an LLC not being construed the same as a general partner, with the result being that the provisions of § 736 do not apply and all payments made to the retiring or deceased member are for that member's interest in LLC property. However, the better solution would be to apply the test for determining whether the member's distributive share is self-employment income. If it is, then § 736 will apply; if not, then § 736 does not apply.