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USES OF THE
LIMITED LIABILITY COMPANY
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I.
Introduction
A. Review of Characteristics Affecting Tax Classification
1.
Limited Liability - Always Present
2.
So, for "partnership" classification, can only
have one more of the following
characteristics:
a.
Free Transferability of Interests - heavily
facts & circumstances
(1)
all but 20% can be freely transferable
(2) may
exist if a small group actually
controls the entity
(a) IRS
suggests that documents can
provide for restricted transfer
rights &/or dissolution on
attempted transfer and avoid free
transferability
even if the entity
is controlled by a small group
b.
Centralized Management
(1) Requires
that management be concentrated
in a small group
(a) IRS
current view is if entity is
manager managed, it has centralized
management
(b) possible
to have a smaller group
actually carry out management
activities so long as all members
have
actual management authority
c.
Continuity of Life
(1) can
be avoided even if only a small
group of events will be an act of
dissociation
and less than all members
can approve continuation
II. General
Considerations.
A. An LLC should be considered for most types of business
ventures.
1.
Some types of business activities cannot be
conducted by LLCs such as insurance and
banking
and some professions
a.
If business will operate multi-state, must
check all states.
2.
LLC can offer many of the desirable features of
corporations with the operating flexibility
and
tax benefits of partnerships.
3.
Prime candidates are:
a.
Any business which currently uses a
partnership form of business
b.
Businesses which use a limited partnership
with either a C or S corporation as a
general
partner
c.
Informal ownership arrangements (eg. tenants
in common)
4.
Caveat - business operating in states which have
not adopted an LLC statute should be viewed
cautiously
a.
If limited liability is not important, this
may still be satisfactory
(1) eg.
primary risk is easily insured
b.
uncertainty re licensing (who gets license),
ability to sue, etc. - may make use
impractical
III. Characteristics of the LLC Affecting
How It Is Used
A. Limited Liability
1.
All members shielded from personal liability
a.
like corporation
b.
uncertainty in some states
B. Flexible Management
1.
All members can actively participate - member
managed
a.
no loss of limited liability as in the case
of a limited partnership
2.
Management can be restricted:
a.
"manager managed"
(1)
can be by members or non-members
b.
member managed, but leave authority to manage
in all members but have smaller group of
members actually administer it
c.
Those without expertise need not be involved
in management
C. Flexible Ownership
1.
Generally there are no restrictions
a.
Different than S corporation's restrictions
on ownership
(1) eliminates
constant monitoring and/or
complex agreements restricting ownership
b.
No legal restriction on number of owners
(1) May
get unwieldy if too large
(2) May
have more complex securities rules
and fall into special tax rules re large
and/or publicly traded partnerships
c.
Generally, no legal restriction on nature of
owners
(1) foreigners
(resident or non-resident),
corporations, partnerships, trusts,
charitable institutions, pension plans,
estates, and other LLCs may all be
members.
(2) An
S corporation can use an LLC
(a) may
give it some of the same
advantages that C corporations can
get from owning a subsidiary
(b) can
insulate some assets from the
remaining assets
(c) Since
need two members, must be
another person or entity involved
i)
S corporation should be able
to own almost 99%
ii)
Could structure arrangement to
allow S corporation's
shareholder(s) to own
remaining interests.
d.
Sometimes, licensing requirements of a
particular business or profession will
require limitations on ownership which are
not
required by LLC law or tax rules
D. Ownership Easily Controllable
1.
Statute restricts ability to transfer ownership
and/or management rights
a.
Can not become a member without the approval
of at least some others
(1) Fewer
negotiations may be needed as the
statutory default may be ok
b.
May be able to pre-approve transfer of some
interests and still avoid IRC "free
transferability" characteristic.
E. Flexible Organization Structure
1.
May be simple
a.
All ownership interests can be identical
b.
No need for general and limited partners
2.
May be complex
a.
Can differ the economic and voting rights of
members and create numerous classes of
ownership rights
(1) flexibility
in allocation of rights:
(a) on liquidation
(b) profits
& losses
(c) cash
flow
(d) priorities
in dissolution
(2) Watch
IRC 704(b) allocation Regs.
F. Flexibility In Types of Capital Contributions
1.
Capital contributions can be in cash, property,
services, promissory notes or other
obligations to
contribute
cash or property or to render services
in the future
G. Readily Transferable Economic Interests
1.
Statute allows assignment of rights to profits,
losses,
and all distributions without any
approvals
2.
Free transferability of interests will still not
exist.
H. LLCs Can Have "Subsidiaries"
1. LLC may own other
entities, including:
a.
corporation,
b.
general partnership
c.
limited partnership
d.
another LLC
2.
Allows protection of limited group of
assets
a.
Use corporation or another LLC
3.
May allow "consolidation" of profits and losses
for tax purposes
a.
Use another "pass through" entity
4.
May allow preservation of limited liability in
states without a limited liability statute
a.
use corporation
I. Familiar to Foreign Investors
1.
Similar to a GmbH and other entities used
through out Europe and South America
J. Uncertainty As to How Treated Under Substantive State
&
Federal Law
1.
Questions exist regarding:
a.
Will the limited liability provisions
contained in the state of organization's LLC
statute
be accepted in the other states in
which the LLC operates?
b.
Can an LLC sue or be sued in its own right in
such other states?
c.
Since there is little law regarding LLCs, how
will the organizational state and other
states apply case law or legal precedent in
other areas to LLCs, since there is little
authority actually pertaining to LLCs
d.
How will state securities laws apply to the
transfer of an LLC?
(1) Transfer
of interest as member?
(2) Transfer
of interest in economic rights
only?
K. Uncertain State Tax Treatment
1.
Some uncertainty as to how the organizational
state will handle some tax issues.
2. Great uncertainty
as to how states without LLC
statutes will handle taxation issues.
3.
Some issues are:
a.
How will the entity be treated for multi-
state tax allocation purposes?
b.
Will a sale of an interest be treated as
intangible personal property, similar to the
sale of stock, so that gain is taxed to the
members state of residency?
(1) Most
LLC statutes classify an LLC
interest
as personal property so expect
similar treatment to that of stock
(2) Liquidation
of the LLC and distribution
of assets to the members can avoid LLC
level taxation and can change the source
of the intangible assets
(a) How
will LLCs be treated?
(b)
Will it be effected by whether
state taxes LLC as a corporation?
(3) Many
other issues.
IV. Some
Tax Considerations Affecting Use
A.
General
1.
To claim a deduction for a loss generated by a
pass-through entity on his or her individual
income tax return, taxpayers must have the
loss
allocated
to them by either operation of law or by
agreement.
However, in addition, certain types of
taxpayers (it varies with the statute)must
meet
additional requirements.
More specifically:
a.
his or her basis in the investment must be
sufficient to allow the use of the
deduction,
b.
he or she must be at risk with regard to the
amount of the loss
c.
and if the loss is a passive activity loss,
it may only be used to offset income from
passive activities.
B.
Allocation of Profits and Losses - IRC 704
1.
Generally, the Wisconsin LLC statute provides that
profits and losses will be divided between
members
in proportion to the respective values of
their
interests as required to be maintained in
the
records of the LLC.
It also allows the members to
vary that arrangement in any way they wish
in an
operating agreement,
2.
However, sections 704(a) and (b) of the IRC sets
forth very lengthy and complex rules
regarding the
allocation of profits and losses between
partners.
These rules allow IRS to disregard the
agreed upon
allocation if they do not have a
"substantial
economic effect" - that is, an economic
loss
consistent
with the allocated loss. (Essentially,
a safe harbor exists if certain criteria are
met
and either a deficit restoration agreement
exists
or qualified income offset will be made. A
discussion of these rules is beyond the
scope of
these materials.)
3.
Since the basic set of "substantial economic
effect" rules contained in the
regulations do not
apply to non-recourse debt, it is necessary
to
distinguish between categories of debt.
In this
instance, several different categories of
debt,
other than recourse debt, are considered by
the
regulations.
All of them have a bearing on LLCs
and their members.
a.
Essentially, debt is divided into non-
recourse and recourse liabilities, as tested
by reference to the members and certain
related persons - not the LLC.
(1)
Non-recourse liabilities are then
subdivided into:
(a) secured
non-recourse liabilities
and
(b) exculpatory
liabilities
(2) Recourse
liabilities are divided into
(a) partnership
non-recourse
liabilities and
(b)
other recourse liabilities
4.
Because of the limited liability attribute of the
LLC, it will generally be considered as
having
non-recourse debt. If, however, a member
guarantees
the LLC's debt or the LLC borrows the
funds from a member or a person related to
the
member, the debt will be treated as partner
non-
recourse debt.
See Treas. Reg.
1.752-2.
a.
Non-recourse liabilities are treated as not
having actual economic effect since only the
creditor bears any economic risk. Thus, the
regulations artificially allocate non-
recourse debts to the members as if they had
economic effect if certain requirements are
met,
including the minimum chargeback
requirement which allocates to those
receiving the deductions, gains from the
sale
of the asset or the repayment of the debt,
etc.
b.
If there is partner nonrecourse debt, the
rules allocate the deductions attributable
to
the liability to the person who bears the
economic risk of loss.
Rules similar to the
minimum chargeback rules also apply.
5.
Although the rules are detailed and complex, the
important thing to
remember is that the
allocations of losses and gains, etc., will
be
influenced by the categorization of the debt
and
compliance with the allocable rules.
Because most
debt of an LLC will likely be non-recourse
debt,
the negotiation of the terms of a bank loan
will
take on greater significance to members than
they
might to partners,
etc.
C. At Risk Rules - IRC 465
1.
In general, a person is "at risk" for the amount
of money they contributed to the entity, the
adjusted basis of any property they
contributed to
the entity, and the amount of any debt of
the
entity for which they are personally liable.
(IRC
465(a) and (b)).
This amount is also increased by
any income allocable to the person plus any
additional contributions made by him or her.
It
is reduced, however, by the amount of any
losses
taken and distributions
received.
2.
Under normal conditions, the owner of an LLC will
not be liable for the debt of the LLC
because of
the limited liability attribute of LLCs.
3.
While it is not completely certain, a loan by a
partner to a partnership should be treated
as at
risk to the extent of their allocable share
of the
debt.
Prop. Reg. 1.465-7
a.
It is not clear, however, what the rule is in
the case of a limited partnership or LLC,
where the members or limited partners have
no
direct liability for the debt and the member
making the loan may bear all of the actual
risk.
b.
Similarly, it is not clear what the result is
if the member of the LLC guarantees the debt
of the LLC.
(1) Logic
would say that the member is at
risk, however, subchapter S shareholders
are not treated as at risk when they
guarantee the corporation's loan. See
Prop. Reg. 1.465-24.
c.
This issue is important since in many small
business operations, the bank will require a
personal guarantee of the loan.
It might be
wise to make the loan to the members rather
than the entity if the member will not be at
risk for the guaranteed amount.
4.
Another issue arises in connection with the
financing of real estate and pertains
what is
referred to in the at risk rules as
qualified non-
recourse financing."
a.
Under this rule, if an entity incurs debt in
connection
with a real estate activity and
the financing is qualified non-recourse
financing, then the owners may be treated as
being at risk for a share of the debt even
though none of the owners are actually
liable.
In general, qualified non-recourse
financing is financing borrowed from a bank
or other similar qualified lender for which
no one is personally liable and which is
secured by the real estate.
b.
The issue that arises in connection with LLCs
is the question of whether the LLC is a
"person" which may be liable on
the debt or
whether it should be disregarded.
(1)
Susan Hamill, a member of the staff of
the IRS Office of the Chief Counsel,
while expressing her own personal views,
indicated that if the loan were only
secured by the real estate being
financed, the members of the LLC would
likely be treated as at risk with
respect
to the debt. However, she
expressed uncertainty as to the result
if the LLC secured the loan with all of
its assets.
D. Passive Activity Rules - IRC 469
1.
There are at least four "issues" involving the
"passive loss" provisions of the
IRC which are
unique to LLCs.
All four turn on the meaning of
the term "limited partner" or
"general partner"
within the context of the various sections
of IRC
469. Three
of them pertain to rental real estate
activities
and are discussed, below, in that
section.
2.
The first issue is, "What level of participation
must an LLC member have in order to be
treated as
"materially participating" under IRC 469(h)(2)."
(1) Generally,
IRC 469 provides that for
certain specified persons and entities,
passive activity losses
and credits will
not be allowed. IRC 469(a)(1).
(2) IRC
469 (c)(1) requires that the conduct
of a trade or business will be passive
if the taxpayer does not "materially
participate" in it .
(3) IRC
469(h) defines material
participation. It provides that "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.
(4) Treas.
Reg. 1.469-5T expands upon this
general rule and provides that, with two
exceptions which are found in paragraphs
(e) and (h)(2) of the regulation, one of
seven
(7) conditions must be met in
order for an individual to be treated as
materially participating.
Those 7 tests
are:
"(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, and 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 materially participated in
the activity for any three taxable years
(whether or not consecutive) preceding
the
taxable 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.
(5)
Thus, it would appear that whether a
general or limited partner for tax
purposes, meeting any of the above 7
tests would cause a taxpayer to meet
the "material "
participation"
requirement.
(6) However,
IRC section 469(h)(2) also
provides that:
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 (Emphasis
added).
The
term limited partner is not defined
in the IRC and other sources must be
looked to for assistance.
(7) Treas.
Reg. 1.469-5T(e) provides that,
except as provided in paragraph
(e)(3)(ii) of 1.469-5T, for purposes of
section 469(h)(2) and paragraph (e) of
that regulation, a
partnership interest
will be treated as a "limited
partnership" interest if either:
(a) the
interest is designated a
limited partnership interest in the
limited partnership agreement or
the certificate of limited
partnership (whether or
not there
is actual limited liability under
state law), or
(b) there
is actual limited liability
under
state law.
(8) Under
this definition of a limited
partnership interest, all interests of
members of an LLC would appear to be
"limited partnership interests"
for
purposes of section 469(h)(2) and (e) of
Treas. Reg. 1.469-5T and a member would
not
be treated as "materially
participating", even if one of the 7
tests described above were met. IRC
469(h)(2) and Treas. Reg. 1.469-
5T(e)(1)(i).
(9) Treas.
Reg. 1.469-5T(e)(2) provides some
minimal relief, however, to holders of a
"limited partnership interest" by
providing that the holder will still be
treated as materially participating if
they meet tests (1), (5) or(6) set forth
above.
Those tests are:
(1) The individual participates in
the activity for more than 500
hours during such year;
(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
materially participated in the
activity for any three taxable
years
(whether or not consecutive)
preceding the taxable year;
These tests are very restrictive; much
more so than those provided in the
remainder of the 7 tests, and
substantially restricts the use of
losses. etc. by holders of "limited
partnership
interests." Fortunately,
other relief is, perhaps, available.
(10) Treas. Reg. 1.469-5T(3)(ii) provides
that:
A
partnership interest of an individual
shall not be treated as a limited
partnership interest for the
individual's taxable year if the
individual is a general partner in the
partnership at all times during the
partnership's taxable year ending with
or
within
the individual's
taxable year (or the portion of the
partnership's taxable year during which
the individual (directly or indirectly)
owns such limited partnership interest).
(11) No definition of "general
partner",
however, appears in either the IRC or
the
regulations.
(12) Rev. Pro. 89-12, dealing with the
classification of an entity, provides in
section 1.02 that:
Any
reference to a "limited
partnership" includes an
organization formed as a limited
partnership under applicable state
law and
any other organization
formed under a law that limits the
liability of any member for the
organization's
debts and other
obligations to a determinable fixed
amount. References to "general
partners" and "limited
partners"
[apply] also to comparable members
of an organization not designated
as a partnership under controlling
law
and documents; the "general
partners" of such an organization
will ordinarily be those with
significant management authority
relative to the other members.
(Emphasis and underlining added.)
(13) This definition, or the lack of a real
definition, leaves a great deal of
uncertainty regarding which of the
requirements of the 7 tests must be met
by a
member of an LLC. However, some
additional analysis may be useful.
Consider the following:
(a) The
IRC 469(h) requirement that
persons
holding limited partnership
interests be treated as not
materially participating in an
activity, and the more restrictive
position taken by the IRS in the
regulations, are both consistent
with the general state law
requirements
which prevent a
limited partner from actively
participating in the management of
the limited partnership.
(b) IRC
469(h) and its legislative
history specifically contemplate
that IRS will promulgate
regulations
which handle these
situations.
However, no such
regulations have been drafted.
(c) IRC
469(h), by its language, also
addresses only limited
partnerships.
The legislative
history suggests that it is the
management
characteristic, not the
limited liability characteristic,
which is pertinent to the issue of
"material participation".
(d) Treas.
Reg. 1.469-5T(e)(2), Treas.
Reg. 1.469-5T(3)(ii) and Rev. Proc.
89-12 all look to the level of
management
activity which is
attached to the interest in
determining the difference between
a general partnership interest and
a limited partnership interest.
Even where the interest is a
"limited partnership interest",
material
participation is found and
the passive loss allowed when the
amount of activity is significant.
(e) Perhaps
more importantly,
shareholders in Subchapter S
corporations need only meet any of
the seven tests to qualify for the
use
of the passive loss and there
seems no reason to distinguish
between a Sub. S corporation and an
LLC.
(f) Members in a member managed LLC
would seem more like general
partners than do Subchapter S
shareholder.
(g) LLC
members in a manager managed
LLC should be more cautious since
they have restricted management
authority
(but not necessarily
compared with other members, if
none are managers) and come more
readily within the concepts of
Rev.Proc. 89-12.
(h) Notwithstanding
the fact that there
may be no logical reason for
distinguishing between Sub. S
corporation shareholders and LLC
members, LLC members in a manager
managed LLC whose managers are
members
but consist of less than
all of the members, fall almost
squarely within the description of
the relationships
contained in Rev.
Proc. 89-12 and are most readily
separated into categories of
general and limited partnership
interests under the existing
available guidelines.
(14) Regardless of the possible arguments
regarding why LLC members should not be
treated as holders of limited liability
interests, until there is clarification
caution would dictate that any LLC
member
desiring to avoid losses being
characterized as passive should have at
least 500 hours of activity or meet one
of the other two more restrictive
tests.
Those desiring to ensure that losses
will be treated as passive should make
sure that they do not exceed 100 hours
of participation and avoid any of the 7
other tests.
3.
For further confusion on this subject, see the
discussion of "limited
entrepreneur" under the
topic of "Agriculture", below.
This concept,
introduced in IRC 464, defines a
"limited
entrepreneur" as a person who:
(A) has
an interest in an enterprise other
than as a limited
partner, and
(B) does not actively participate in the
management of such enterprise.
V.
Use In Real Estate Industry
A. General
1.
LLCs have many favorable attributes useful in real
estate transactions.
Some of them are:
a.
limited liability for all members
b.
flow through of items of income, expense,
etc. to members
c.
ability to distribute out property to members
without recognition
of gain (even if property
is highly appreciated)
d.
No double taxation
e.
may be able to transfer future interest in
profits to
member solely for services without
recognition of gain
f.
Avoids full disclosure of owners in public
records (183.0202 Wis. Stat)
2. They
also have some disadvantages:
a.
An LLC's lack of continuity of life makes it
difficult to use if there are a large number
of members
b.
Some title insurers may not have fully
developed systems for dealing with real
property transactions involving LLCs,
including:
(1)
specifically designating an LLC as such
on the record
(2) determining
the authority of members to
convey and encumber real estate
(3)
determining the proper handling of LLCs
operating under a fictitious name or
assumed name
c.
Significant issues may exist regarding title
to real property or personal property, and
authority to transfer it, when an LLC
desires
to buy or sell real estate in a state which
has
no LLC statute.
d.
There are issues regarding whether a member
is "at risk" under IRC 465.
See discussion,
above, regarding "at risk" issues.
B. Renting
a.
Can an LLC member qualify to use up to
$25,000 of passive activity losses
attributable to rental real estate in which
they
"actively" participate. IRC
469(i)
(1) As
discussed above, IRC 469 provides
that for certain specified persons and
entities, passive activity losses and
credits will not be allowed. IRC
469(a)(1).
(2) IRC
469(c(2), makes it clear that
"Except as provided in paragraph (7),
the term "passive activity"
includes any
rental activity.
(3) However,
even though rental real estate
activities
are passive activities,
natural persons may use up to $25,000 of
such losses if they actively
participate.
IRC 469(i).
(4) IRC
469(i)(6)(C) provides that, except
as provided in regulations, "no
interest
as a limited partner in a limited
partnership
shall be treated as an
interest with respect to which the
taxpayer actively participates."
No
regulations under this section, however,
have been issued. See Treas. Reg.1.469-9
(reserved).
(5) So,
the determination of whether $25,000
of such losses are available to members
of an LLC turns on what the meaning of a
"limited partnership interest in a
limited partnership' means within the
context
of IRC 469(h).
(6) While
the definition of "limited
liability interest" contained in Treas.
Reg. 1.469-5T(e), discussed extensively
above in connection with passive
activities, was specifically limited by
IRS to only subsections (e) and h(2) of
that
regulation and does not cause a
problem in applying subsection (i), the
statutory language upon which that
regulation is based is still of concern
as is the language of Rev.Proc. 89-12.
(The language found in IRC 469(h)(2)
suggesting that limited partnership
interests
are not interests in which
there can be "material
participation" is
identical with that found in IRC
469(i)(6)(c) which provides that such
interests may not be interests in which
there can be "active
participation".
(7) Thus,
there is even less clarity with
regard to what the "correct"
treatment
of a member of an LLC is with regard to
the "active participation"
requirement.
(a)
On the one hand, the lack of a
specific regulation defining a
limited partnership interest in a
manner which encompass LLCs is
helpful because an LLC is not,
absent such definition, what is
typically thought of as a limited
partnership.
Furthermore, the
meritorious counter arguments and
policy considerations used to
support the proposition that LLC
members should be treated in a
manner similar to Subchapter S
shareholders, not limited partners,
have
as much merit in connection
with the "active participation"
standard as they do in connection
with the "material participation"
standard.
(b) On
the other hand, the legislative
history of 469 suggests that
Congress may have been concerned
about the potential tax shelter
aspects of both limited
partnerships and LLCs when they
drafted
469(h), dealing with
material participation, and the use
of the identical statutory language
would suggest an identical
legislative intent.
(c) While
there is, perhaps, a
reasonable basis for taking the
position
that LLC members may claim
up to $25,000 of deductions under
IRC 469(i), such members should be
aware that IRS may disagree and
that there is uncertainty as to how
a court may resolve the issue.
b.
Will LLC members qualify for the new (1993)
relief
from the "passive activity" rules
relating to rental real estate which
Congress
granted people actively engaged in the real
estate industry?
(1) If
an LLC member interest is a limited
partnership interest, the use of an LLC
may be undesirable for those engaged in
real
estate rental as their primary
activity.
(2) As
adopted, IRC 469 (c)(7) provides
that:
(a) if
more than one-half of the
personal services performed in
trades or businesses by a taxpayer
are performed in real estate
businesses
in which the taxpayer
materially participates, and
(b) during
the year the taxpayer
performs more than 750 hours of
services in real property trades or
businesses in which the taxpayer
materially participates, then that
taxpayer's
rental real estate
activities for the year are not
automatically characterized as
passive activities since IRC
469(c)(2) (making rental activities
passive) will not apply to it.
(Hereinafter called the "Service &
Hour Test".)
(3) A
real property trade or business is
defined to include development,
redevelopment, construction, reconstruc-
tion,
acquisition, conversion, rental,
operation, management, leasing, or
brokerage trade or business.
IRC
469(c)(7)(C).
(a)
In the case of a joint return, at
least one spouse must separately
meet the service criteria.
IRC
469(c)(7)(B).
(b) Services
as an employee in real
property trades or businesses will
not be counted unless the employee
is
a 5-percent owner in the
employer as described in IRC
416(c)(1)(B).
IRC 469(c)(7).
(See discussion below).
(c) The
new law is to be applied to
each interest of the taxpayer in
rental real estate as if it were a
separate
activity unless the
taxpayer elects to treat all of the
interests as one activity.
(4) IRC
469(c)(7)(A) specifically provides
that it is not to 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.
(a) This
suggests that the standard 3
tests
regarding material
participation which are generally
applied to limited partners (eg.
500 hour per year) are to still
apply to limited partners in
determining whether they materially
participate in the activity.
i) The discussions above
pertaining to "material
participation" and "active
participation" as they apply
to member interests in LLCs
are applicable.
(b) However,
the issue of whether a
member's interest in an LLC is a
limited partnership interest may be
of even more important since the
750 hour criteria and one-half time
requirements are only measured
against interests in which the
taxpayer "materially
participates".
IRC
469(c)(7)(A). The significance
of the requirement is potentially
compounded because of an ambiguity
in the statute.
i) While the taxpayer may
aggregate the interests for
purposes of applying the
passive loss rule (IRC
469(c)(7)(A)), the statute is
ambiguous as to whether they
may be aggregated for purposes
of
testing whether a taxpayer
is a qualifying person - one
who meets the Service & Hour
Test.
ii) The
ambiguity exists because
provision 469(c)(7)(B)
provides that "This paragraph
shall
apply to a taxpayer if"
-- the Service & Hour Test is
met. IRC
469(c)(7)(A)
provides that the application
of the aggregation provision
in 469(c)(7)(A) only applies
"If this paragraph applies to
any taxpayer . . .."
This
suggests that the requirements
of the Service & Hour Test
must
be tested and satisfied
before the right to aggregate
arises.
However, the
ambiguity exists because the
reference to "this paragraph"
which appears in both sub-
paragraphs (A) and (B) are
phrased
in a manner such that
they may apply to all of IRC
469(c)(7).
a)
Thus, if a person had 4
limited partnership
interests and worked 450
hours each year in
connection
with each
interest, if the
aggregation rule could
not be applied to test
whether
the Service &
Hour Test were satisfied,
the taxpayer would fail
the
Service & Hour Test
even if all of the
activities were real
estate activities in
which
the taxpayer was
involved full time. The
result seems to be
different if one
spent
900 hours in each of two
activities. Perhaps the
statute will be construed
as allowing the
aggregation of interests
for the purpose of
satisfying
the Service &
Hour Test.
iii) If the statute applies, the
ability to aggregate the
interests
would seem to allow
the combining of services
performed in different
capacities for the purpose of
satisfying the material
participation test (500 hours
etc.).
c. Is
there any particular advantage to using an
LLC if we want to have "personal services of
an employee" be considered as qualify for the
special 1993 relief granted under new IRC 469
(c)(7)(D)(ii) (which was discussed in the
immediately preceding section.)
(1) As stated above, an
employee's
performance
of services for his/her
employer will not be taken into account
in determining the amount of his/her
participation in real estate activities
which will qualify the person for the
1993 relief unless the employee is a 5-
percent owner of the employer. IRC
469(c)(7)(D)(ii). This provision refers
to the definition of 5-percent owner
under IRC 416(i)(1)(B), which pertains
to both employees of corporations and
employees of non-corporate enterprises
in which the "employee" owns more than
five percent of the capital or profits
of
the organization. IRC
416(B)(i)(II).
(2) At least one commentator
has indicated
that there may be an argument that a
"partner" is not an employee and, thus,
the use of an LLC would eliminate this
requirement for members of an LLC.
However, this argument seems to beg the
question in that the language of IRC
section 416(i)(1(B) talks of profits and
capital interests in non-corporate
entities and such terminology is
consistent with partnerships.
C. Low Income Housing
1. Low Income Housing
a. IRC
42(h)(5)(A) requires each state to
allocate at least ten percent of their low -
income housing credits to projects in which
qualified non-profit organizations materially
participate. In order to
constitute a
qualified low income housing project, "a
qualified non-profit organization must own an
interest
in the project (directly or through
a partnership) and materially participate
(within the meaning of 469(h)) in the
development and operation of the project
throughout the compliance period."
(1) Can an LLC be used to
meet this
requirement?
(2) Will the various
departments of housing
and community development be
sufficiently knowledgeable to draft
rules which take into consideration the
IRC
definitions?
(a) How will those
departments even
know what the classification of the
entity is?
(b)
What happens if the classification
changes in the middle of the
project
D. Miscellaneous
1. Real Estate
Transfer Fees - Statute was modified
when LLC Act passed
a. "Mergers of
corporation" now includes
combining 2 or more LLCs under a plan of
merger, 77.21 (le), Wis. Stats.
b. Transfer fee
exemption for conveyances of
real property between an LLC and one or more
of its members if all of the members are
related to each other as spouses, lineal
ascendants, lineal descendants, siblings, or
spouses of siblings and if the transfer is
for no consideration other than the
assumption of debt or an interest in an LLC.
77.25(15s), Wis. Stats.
2. Title Insurance
Problem - In some states, an LLC,
like
a general partnership, may have difficulty
obtaining meaningful title insurance commitments,
and there may be difficulty with regard to certain
other types of insurance, because a change in the
membership of the general partnership or the LLC
can result in a technical dissolution, with a
concurrent change in the identity of the
partnership
and, thus, the disappearance of the
named insured. (An endorsement is frequently
available to eliminate the problem.)
VI. Natural Resources
A. Not surprisingly, the LLC form has significant benefits
as a form of organization for development of oil, gas,
and mineral properties. (Remember, Wyoming was the
first state to adopt an LLC statute and that was for
the benefit of an oil and gas company.)
In addition to
the benefits associated with pass-through tax entities,
the LLC may provide some additional benefits in oil,
gas and other mineral transactions.
B. Oil, gas and other mineral properties may be held in a
variety of forms. However, the two most common
ownership arrangements are undivided interests as co-
tenants and partnership.
1. Undivided co-tenant
arrangements are frequently
used when the property is held under a joint
operating agreement. The
primary advantage of
this arrangement is that the parties are usually
only severally liable for their proportionate
share of claims with respect to the property,
instead
of jointly and severally liable.
2. A properly
structured LLC should be able to pass
through tax benefits with results substantially
the same as an undivided co-tenancy or a
partnership. would. Furthermore, reasonable
allocations of intangible drilling costs and other
items may be made among the members (Subject to
IRC
704).
C. A "Farm Out" is a name given to a fairly
common type of
arrangement pursuant to which an operator will receive
an interest in the operation for little or no capital
contribution.
1. The arrangement may
typically be implemented
either through a co-tenancy arrangement or a
partnership.
2. Since an LLC can
issue an interest for services
and/or a written promise for future services, it
can accomplish the same objectives as a typical
farm out. Furthermore, the
fact that a profits
interest in the LLC may be granted in exchange for
future services without an immediate income tax
impact makes the use of an LLC even more
attractive.
D. The limitations on the use of passive activity losses
are not applicable to most common oil and gas
arrangements because IRC 469(c)(3) provides that
working interests in any oil and gas property which the
taxpayer holds directly or through an entity which does
not limit the liability of the taxpayer with respect to
such interest, does not constitute a passive activity.
1. However, since an
LLC will limit the liability of
the members, the working interest exception will
not be applicable and the owners will have to meet
all
of the standard requirements applicable to
LLCs with regard to complying with or avoiding
active or material participation in the venture.
The entire discussion set forth with regard to
LLCs will be applicable.
E. Election Out of Subchapter K.
1. Treas. Reg. 1.761-2
provides that owners of an
organization used for the joint production,
extraction, or use of property, but not for the
purpose of selling services or property produced
or extracted may elect out of the Subchapter K
provisions.
Often times, oil, gas and other
mineral extraction will be the subject of a joint
operating agreement for the joint production,
extraction, or use of property.
2. More particularly,
Treas. Reg. 1.761-2 provides in
section (a)(3) that:
Where the participants in the joint
production, extraction, or use of property:
(i) Own the property as co-owners,
either in fee or under lease or other
form of contract granting exclusive
operating
rights, and
(ii) Reserve the right separately to
take in kind or dispose of their shares
of any property produced, extracted, or
used, and
(iii) Do not jointly sell services or
the property produced or extracted,
although each separate participant may
delegate authority to sell his share of
the property produced or extracted for
the time being for his account, but not
for
a period of time in excess of the
minimum needs of the industry, and in no
event for more than 1 year, then such
group may be excluded from the
application of the provisions of
subchapter K under the rules set forth
in paragraph (b) of this section.
However,
the preceding sentence does not
apply to any unincorporated organization
one of whose principal purposes is
recycling, manufacturing, or processing
for persons who are not members of the
organization.
3. There is no clear
answer regarding whether or not
an LLC may elect out of Subchapter K.
Presumably,
if all of the criteria were met, an election out
should be possible.
F. Substantive state laws regarding the ownership of real
estate, particularly out of state properties, and the
taxation of co-owners or partners by multiple states is
more well settled when it comes to co-tenancy
relationships and partnerships than it is with regard
to LLCs.