Limited Liability Companies (LLC): Electing Partnership vs. S Corporation Status PART 1
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This is Part 1 of a slide deck was presented by the University of Illinois Tax School in conjunction with a textbook entitled Limited Liability Companies: Electing Partnership vs. S Corporation Status. The presentation gives good background on various LLC topics (such as LLC formation, LLC operations, Distributions of an LLC, Sale of a Member Interest, Withdrawal of a Member, and Death of a Member). The textbook itself can be purchased at https://taxschool.illinois.edu/.
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Limited Liability Companies (LLC): Electing Partnership vs. S Corporation Status PART 1
- 1. Part 1 Limited Liability Companies: Electing Partnership vs. S Corporation Status Chapter 1: Introduction Chapter 2: LLC Formation Chapter 3: LLC Operations
- 2. The following slide deck was used in conjunction with a textbook entitled Limited Liability Companies: Electing Partnership vs. S Corporation Status. The following are Chapters 1 – 3; Chapters 4 – 7 are posted in Slideshare as Part 2. The presentation was given over 2-days at multiple locations across the state of Illinois. The textbook is available for purchase at TaxSchool.Illinois.edu.
- 4. Tailoring Taxation of LLCs: S Corporation vs Partnership Chapter 1: Introduction
- 5. Introduction LLCs becoming entity of choice Used more frequently for businesses, not just real estate Used in estate planning
- 6. Income Tax Classification Corporation (C or S) Partnership Disregarded entity LLC[S] or LLC[C] LLC[P] SMLLC p. 2
- 7. LLC Features Pass-through taxation? Limited liability p. 2
- 8. SMLLC v. Sole Proprietorship Liabilities Did owner sign personally? Formation File articles of organization with state Management Manager + owner are the same Tax Form 1040 Termination May require state notification Conversion Not taxable transaction p. 2-3
- 9. LLC[P] Liabilities All members protected Formation Must file organization agreement Management Can be a single member, all members, or outside management Tax Pass-through entity Termination Could have technical termination Conversion p. 3-5
- 10. Limited Liability Partnership (LLP) General partnership with liability protection p. 5
- 11. Limited Partnership Liabilities Limited partners protected Formation Must have 1 general partner Management Limited partner cannot manage Tax Pass-through entity. Limited partner not subject to SE tax Passive activity for limited partner Termination Can have technical termination Conversion Nontaxable if LP to LLC[P] p. 5-6
- 12. C Corporation and LLC[C] Liabilities Shareholders protected Formation Directors appointed, not elected Management Ownership rights may differ Tax Taxed on earnings Termination Continuity of life Conversion Could be taxable p. 6-7
- 13. S Corporation Liabilities Offers liability protection Formation Limited to 100 shareholders Management Flexible Tax Pass-through entity Termination Can lose S status Conversion Same as converting C corp to LLC[C] p. 7
- 14. Series LLC p. 8
- 15. Liability Comparison ENTITY OWNER LIABILITY PROTECTION Sole Prop No C Corp Yes S Corp Yes General P-ship No LP Yes, for Ltd Partners; No, for Gen Partners LLC Yes p. 9
- 16. Fail to follow formalities Misrepresent management Intermingle assets Disregard entity Undercapitalize Use as “alter ego” Transactions not arm’s length Piercing the Corporate Veil PROTECT p. 9
- 19. Tax Issues Creditor responsible for tax on K-1 profit Debtor responsible for tax on K-1 profit p. 11
- 20. Elections How to be taxed? Corporate taxation – Form 8832 S corporation – Form 2553 Disregarded entity p. 11-21
- 22. Business Purpose Anything but: Banking Insurance Dentistry Medicine (unless) IL-2
- 23. Low-Profit LLC (L3C) Charitable or educational purpose Cannot be for income producing or political purposes IL-2
- 24. Powers Sue or be sued Deal in real or personal property Sell, mortgage, convey assets Incur liabilities Conduct business in and out of IL IL-3
- 25. Organization Execute and deliver articles of organization to the Secy. of State. IL-4
- 27. Agent of LLC Each member is an agent of the LLC IL-6
- 28. Management Equal rights IL respects operating agreement IL-7
- 30. Distributions Equal shares required Distribution may not be permitted IL-9
- 31. Assignment of Interests Judgment against member IL-10
- 33. Dissociation Member wants to resign membership IL-13
- 34. Conversions and Mergers P-ship can convert to an LLC IL-15
- 35. Series LLCs Multiple businesses Individual liability protection One LLC fee ($750) IL-17
- 36. Derivative Actions Member cannot sue for the LLC IL-18
- 37. Foreign LLCs Unincorporated entities formed in state other than Illinois IL-18
- 38. Fees States vary in LLC fees – Illinois ranks 3rd in the nation for combined filing fee and annual fee IL-19
- 39. Partnerships - LLC[P] p. 21
- 40. Definitions & Theories Aggregate Theory Entity Theory p. 21
- 41. P-ship – At least 2 partners, agreement may be formal or informal, written or oral. Co-ownership of property DOES NOT mean a p-ship exists. Definitions & Theories p. 22
- 42. H–W Joint Venture p. 24
- 43. Other Partnership Forms Limited Partnership Family Partnership Family Limited Partnership p. 25-26
- 44. Other Partnership Forms p. 27 Limited Liability Company Limited Liability Limited Partnership Professional Limited Liability Partnership
- 45. Other Terms Member Managing Member General Partner Limited Partner p. 27
- 47. Partnership Property Property is owned by p-ship, or…. Property could be owned by partners, and used by p-ship. p. 28
- 48. Taxation Issues Basis calculation At-risk rules Passive loss rules Method of accounting Tax Matters Person SE tax p. 29
- 49. Taxation Issues Accounting method Tax Matters Partner Conversion p. 29-31
- 50. Other Issues Sale of an interest Estate planning Passive activity p. 31-32
- 51. Self-Employment Tax Performance of service income – subject to SE Rent, gain from disposition of property or investment income – NOT subject to SE Limited partner’s share of income – NOT subject to SE p. 32
- 52. Self-Employment Tax First set of regulations regarding LLCs: If member meets 3 qualifications – then NO SE tax applied: Lacked authority to make decisions Could have been formed as LLP Could have qualified as limited partner p. 32 Initial regulations never finalized
- 53. Self-Employment Tax Second Set of Regulations – Jan. 1997: Earnings subject to SE if member met ANY of the 3 tests: Authority to enter into contracts Participated for > 500 hours Personal liability for debts p. 32
- 54. Self-Employment Tax Individual not a limited partner solely because he participates >500 hours – may be treated as limited partner To be treated as a limited partner – member must have identical shares to a member that could be a limited partner p. 34
- 55. Example 4 Member $$ Units Service performed Angela $1,000 1 none Connie $1,000 1 1000 hrs. Can contact for LLC Barbra $2,000 2 600 hrs. p. 35
- 56. Alternative Methods to Avoid S/E Flow earnings through S corporation Split income among family members p. 37
- 57. Family Partnerships Recognized as partners if one of following: Capital material income-producing factor + interest acquired in bona fide transaction Capital NOT a material income-producing factor, join in good faith to conduct business p. 38
- 58. Family Partnerships Gift of capital interest Donee’s share of income is calculated by: Reducing p-ship income by reasonable compensation for services by donor Donee’s share of income must NOT be greater than donor’s share p. 39
- 59. Family Partnerships If partners – report on Form 1065 One considered employee of other – report on Schedule C and issue W-2 to employee/spouse Small Business Tax Act – allow spouses to each report their share of income on their respective Schedules C Husband-Wife P-ships p. 39-40
- 60. Proposed Regulations November 2004 – deal with transactions between partners and p-ships Disguised sale rule changed to 7 years instead of 2 years p. 41
- 61. S Corporations - LLC[S] p. 21
- 62. Benefits p. 44 Liability protection SE tax opportunity Pass-through taxation
- 63. Benefits of S Corporation p. 45 Perpetuity vs. limited life (in some states) Clear corporate statutes Clear distinction between business and personal assets
- 64. S Election Requirements p. 45 No more than 100 S/H One class of stock All S/H are U.S. citizens All S/H are individuals, estates or certain trusts
- 65. S Elections File Form 2553 to make election Maintain election at least 60 mo. unless > 50% change in ownership Members may revoke S election Involuntary termination p. 46
- 66. Basis Issues at Death (Ex. 10) p. 50 Basis of land and stock $100,000 FMV of land + stock on DOD $1,000,000 Capital gain on sale of land $900,000
- 67. Reasonable Salary LLC[P] – Members pay 15.3% SE tax on guaranteed payments and all LLC[P] profits LLC[S] – S/H receive W-2 for reasonable salary, pays 7.65% FICA tax; company matches 7.65% Dividends not subject to SE or FICA tax p. 51-52
- 69. p. 55 Chapter 2: LLC Formation LLC[P]
- 70. The client relies on you! Trusts your advice Annual meeting
- 71. Important Decisions Analyze assets to be contributed Analyze liabilities to be contributed Determine potential tax liability on formation
- 72. Practicing Law? Are you stepping over the line? Are you preparing… Articles of Organization? Operating agreement?
- 73. Articles of Organization Company name? Purpose? Address of company and registered agent? Type of manager? Duration of company? p. 55
- 74. Operating Agreement Formation details Capital contributions Profits, losses and distributions Management Compensation Accounting Transfers of interests p. 56
- 75. Organization Expenses Current deduction? Require amortization? p. 57
- 76. Tax Year Required year IRC §444 p. 59
- 77. Contribution of Assets 1. No gain or loss recognized unless investment p-ship 2. Partner’s basis remains the same 3. P-ship basis in asset remains the same p. 60
- 79. Interest Deduction For purchase of member interest Used to loan to LLC p. 62
- 80. Formation Techniques Start small, increase ownership over time Start new business Purchase assets from senior member, then contribute to LLC Form LLC, then purchase shares from a member p. 64
- 81. Contribution of Services Capital interest? Profits interest? p. 66
- 82. Contribution of Liabilities Outside basis of contributing member: Money contributed Adjusted basis of property Share of liabilities assumed by member Sum of member’s liabilities assumed by LLC p. 68
- 83. Solutions Contribute additional basis Reduce debt contributed Increase LLC ownership p. 69
- 84. Court Cases to Remember Sol Lessinger (1989) Donald Peracchi (1998) p. 71
- 85. Contribution of Liabilities No effect on basis of asset in p-ship Exception if §754 election p. 72
- 86. Related Parties Capital gain limited Ordinary income potential Losses limited p. 73
- 87. C & J Accounting, LLC Situation 1[P] p. 74-76
- 88. LLC [P]- Basis Charles – 1/3 Owner Basis - $16,853 FMV - $95,910 Jane – 2/3 Owner Basis - $87,232 FMV - $191,820 $235,332 minus $148,100 p. 74-76
- 90. Contribution of Assets IRC §351 1. Property must be transferred 2. Solely in exchange for stock 3. Control immediately after exchange p. 77-78
- 91. Basis Issues Transferred basis Exchanged basis Boot gain Built-in loss rule p. 78
- 92. Contributions with Liabilities Liability assumed by corporation is NOT boot Liability is treated as boot in calculating S/H basis p. 82
- 93. Exceptions to Nonrecognition Tax avoidance No bona fide business reason Debt amount exceeds member’s cost basis p. 83
- 94. Conversion Federal Tax Law 1. Liquidate existing entity 2. Contribute assets to new entity 3. Ltr Ruls allow IRC §368 nonrecognition p. 88
- 95. C & J Accounting, LLC Situation 1[S] p. 90-93
- 96. LLC [S] - Basis Charles – 1/3 Owner Basis - $16,853 FMV - $95,910 Jane – 2/3 Owner Basis - $87,232 FMV - $191,820 $235,332 minus $148,100 p. 90-93
- 99. Taxation of Income Separate entity for computing income and deductions Not separate entity for taxation p. 95
- 100. Items required to be listed separately Nonseparately stated income + deductions from operations 2-Step Process p. 96-97
- 101. Elections Taxable year Accounting method Depreciation method §179 Keogh plan p. 98
- 102. §179 Expensing Limited to taxable income Member must be active in order to take §179 expensing deduction p. 100
- 103. Transactions Members may deal with LLC in capacities other than as an LLC member Treated the same as unrelated parties – with some limitations p. 101
- 104. > 50% member may lose capital gain benefit Losses between member and LLC disallowed Farm real estate when material participation is present – income subject to SE Member – LLC[P] Transactions p. 101
- 105. Taxable to member Deductible by LLC Subject to SE tax Members not considered employees Guaranteed Payments p. 102
- 106. Member – LLC[P] Transactions Member’s share of income, gain, loss, deduction based on member’s interest in the LLC[P]; UNLESS… LLC[P] agreement specifies otherwise – BUT, LLC[P] agreement must have substantial economic effect p. 103
- 107. Must be consistent with underlying economic arrangement Economic benefit/burden must correspond to member Economic Effect p. 104
- 108. Capital account is increased/decreased accordingly Liquidating distributions made in accordance with positive capital accounts Member must be unconditionally obligated to restore deficit balances in capital accounts Economic Effect 1. 2. 3. p. 104
- 109. …if there is a reasonable possibility the allocation will substantially affect the dollar amounts received by the members Substantial p. 105
- 110. Tax Reform Act of 1984 Requires allocation of gain/loss back to contributing member To avoid allocation – contributing member could sell asset to LLC[P], sell asset to other members, lease to LLC[P], or reduce FMV p. 106
- 111. Small Disparity FMV does not differ from adjusted basis by > 15% of the adjusted basis AND The total gross disparity does not exceed $20,000 p. 106
- 112. Contributions Use any depreciation method Disregard §704(c) rules Defer application of §704(c) until property’s disposal p. 106
- 113. Allocation Methods Traditional method Traditional method with curative allocations Remedial allocation method p. 106 1 2 3
- 114. Traditional Method Book allocation Tax allocation p. 107
- 115. Transactions Traditional Method • Requires p-ship to make appropriate allocations to partners in order to avoid shifting tax consequences • Allocations subject to ceiling rule p. 107
- 116. Example 8 Book Depreciation $200,000 ÷ 10 years = $20,000 Tax Depreciation $100,000 ÷ 10 years = $10,000 p. 107
- 117. Example 9 Book Cap. Tax Cap. Francine $200,000 $100,000 Depreciation ($10,000) $ -0- $190,000 $100,000 Martha $200,000 $200,000 Depreciation ($10,000) $(10,000) $190,000 $190,000 p. 107
- 118. Loss Limitations
- 119. Basis Calculations Outside Basis Member’s basis in his LLC interest Inside Basis Member’s share of the basis of assets inside the LLC p. 109
- 120. Importance of Basis Able to withdraw cash tax-free Deduct losses on personal return Receive property tax-free Estate receives step up p. 109
- 121. Basis Calculations Gift – carryover of donor’s basis Inheritance – FMV of assets on DOD Purchase – price paid p. 109
- 122. Example 13 p. 109 Father’s basis $10,000 Suspended passive loss $2,000 Cindy’s basis $12,000
- 123. Example 14 p. 110 Cindy’s father’s basis at death $10,000 FMV of assets on DOD $15,000 Suspended passive losses that die with Cindy’s father $2,000
- 124. Basis of any contributed property, +/or Cost basis of any interest transferred or purchased Beginning Basis p. 110
- 125. Increases p. 110 + Taxable LLC income + Tax-exempt LLC income + Excess of deduction for depletion over basis of property being depleted
- 126. Decreases p. 110 - LLC losses - Distributions from the LLC - Prior year losses - Nondeductible LLC expenses - Deduction for depletion that does not exceed basis
- 127. Affect of Liabilities Increase in liabilities is considered a contribution of money by member Decrease in liabilities is considered a distribution of money to the member p. 110
- 128. Types of Liabilities Recourse liabilities – creditor may look to member for satisfaction of liability Nonrecourse liabilities – no members have personal liability p. 111
- 129. Example 15 Basis Beginning of year $3,000 Income $4,000 Basis available for deducting losses $7,000 p. 112
- 130. Liabilities can Increase Basis General P-ship – contributing partner increases basis but reduces basis by other partner’s share of loan. LLC – contributing member is the only one who increases basis because no other member can be held liable for debt. p. 113
- 131. Example 18 Members contribute $30,000 Quincy loans $60,000 to LLC Basis At-Risk Arlo $10,000 $10,000 Bryan $10,000 $10,000 Quincy $70,000 $70,000 p. 114
- 132. Other Loss Limiters At risk – cash, adjusted basis of property contributed, and borrowed funds for which member bears economic risk Passive – determined under material participation rules p. 114-115
- 133. At-Risk Member must be at-risk to deduct LLC losses Debt must be recourse or qualified nonrecourse for losses to be deductible p. 115
- 134. Debt incurred in holding real property Borrowed from a qualified person Real property is sole source of collateral Cannot be convertible from debt to ownership interest Qualified Real Property Debt p. 115
- 135. Passive losses allowed to extent of passive income Losses suspended until passive income occurs or disposition of entire activity Passive Losses p. 116
- 136. Passive loss rules depend on T/P’s participation in activity Limited partner is not defined in statutes Basis Calculations p. 117
- 137. Material Participation Test • > 500 hours participation1 • Constitutes substantially all of the participation2 • > 100 hours participation and no other individual participates more3 p. 117
- 138. Material Participation Test Significant participation activities > 500 hours4 Materially participated in 5 of preceding 10 years5 Service activity + individual participated in any 3 preceding years6 Facts and circumstances7 p. 117
- 139. Example 22 Alice contributes $10,000 in cash and guarantees a loan for $50,000 but does not materially participate in activity Basis At Risk Passive $60,000 $60,000 -0- p. 118
- 140. Can I Deduct the Loss? What is my basis in the LLC[P]?1 Is the initial basis at risk?2 Am I a passive investor?3 p. 118
- 141. Example 23 Ben contributes $10,000 cash; is a 50% member LLC borrows $60,000– no guarantee from members Ben loans $40,000 to LLC; does not materially participate LLC incurs loss in first year of $50,000 p. 119
- 142. Example 23 – continued BASIS Cash $10,000 Personal loan $40,000 Nonrecourse debt $30,000 $80,000 p. 119
- 143. Example 23 – continued AT RISK Cash $10,000 Personal loan $40,000 Nonrecourse debt -0- At-risk amount $50,000 p. 109
- 144. Example 23 – continued Passive Loss Rule Because Ben does not materially participate, none of the $50,000 loss is deductible p. 119
- 145. Example 24 p. 119 Same facts EXCEPT… $100,000 loss passed through Has $30,000 of passive income from other sources
- 146. Example 24 – continued Ben’s basis is still $80,000 at beginning of year $20,000 of loss pass-through – suspended due to lack of basis At-risk basis is still $50,000 $30,000 of loss pass-through – suspended due to at-risk rules $30,000 of remaining $50,000 – allowed under passive loss – $20,000 suspended. p. 119
- 147. Example 25 2nd year, Ben has $50,000 of K-1 income Ben’s basis Beginning of year -0- Income $50,000 Carryover loss ($20,000) End of year $30,000 p. 120
- 148. Example 25 – continued Ben’s at-risk basis: Beginning of year $ -0- K-1 Income $50,000 Yr. 1 loss suspended ($30,000) End of year $20,000 p. 120
- 149. Example 25 – continued Passive loss allowed Ben takes $20,000 of basis suspended from Year 1 Ben takes $30,000 of at-risk basis suspended from Year 1 Therefore, $20,000 suspended for passive from Year 1 still suspended p. 120
- 150. Example 26 Ben receives $25,000 distribution in Year 2 Entire distribution taxable because his basis is $0 At-risk and passive do not affect distributions p. 121
- 151. Capital Accounts Book capital accounts are based on FMV – most T/Ps maintain capital accounts on tax basis Book capital accounts need to be maintained for special allocations of income, gain, loss, and depreciation p. 123
- 152. Tax Return Due on 15th day of 3rd month Automatic 6-month extension; Form 7004 p. 124
- 153. Tax Return Must have EIN First return due when p-ship has income and deductions Final return due 15th day of 3rd month following close of business p. 124
- 154. Tax Return Income and Deduction Section Schedule K Balance Sheet Schedule K-1 p. 126
- 155. Tax Return Preparation Situation 2[P] p. 129
- 156. p. 129
- 157. p. 130
- 158. p. 130
- 159. Special Allocations on Contributed Property Situation 3[P] p. 131
- 161. p. 132
- 163. Taxation of Income No federal tax unless BIG or excessive passive income rules apply May have state tax liability p. 133
- 164. Separately Stated Items Sale/exchange of corporate capital assets Sale of §1231 assets Charitable contributions Foreign tax credit Investment income/expense Tax-exempt income AMT adjustments p. 134
- 165. Tax Forms Schedules K and K-1 Schedules L and M-1 Late filings p. 135-139
- 166. Loss Limitations General basis Rules – IRC §1366 At-Risk Rule – IRC §465 Passive Loss Rules – IRC §4693. 2. 1. p. 140
- 168. Basis Adjustments INCREASES Separately stated income Nonseparately stated income Depletion deductions in excess of basis p. 142
- 169. Basis Adjustments DECREASES Distributions Nondeductible expenses Depletion deductions Separately stated loss or deduction Nonseparately stated loss p. 142
- 170. Special Elections Allow nondeductible expenses to be moved after nonseparately stated loss in hierarchy of basis adjustment Treas. Reg. §1.1367-1(g) Charitable contributions p. 143
- 171. At-Risk Rules 1. Amount of money plus adjusted basis of property contributed 2. Amount loaned to entity by member if: a. Personally liable b. Member pledged property as security for debt p. 145
- 172. PASSIVE
- 173. For more information for the University of Illinois Tax School, visit TaxSchool.Illinois.edu