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Federal
Income Taxation of LLC Members
By
Charles R. Beaudrot, Esquire
Morris, Manning & Martin, LLP
crb@mmmlaw.com
404.504.7753
Overview
If
an LLC is treated as a partnership for federal income tax purposes,
the entity itself will not be subject to federal income tax. Instead,
each member will be taxed on the member's allocable share of the
LLC's taxable income. Generally, the character of an item of income
or loss will be the same for a member as it is for the LLC. Each
member of an LLC must take into account the member's distributive
share of an LLC's income and loss as determined by the LLC's operating
agreement, unless the operating agreement does not provide for such
allocations or such allocations under the operating agreement do
not have "substantial economic effect," in which case
such member's distributive share will be determined in accordance
with the member's interest in the LLC. In addition, income, gain,
loss, and deductions with respect to contributed property must be
allocated among the members to take account of any difference between
the tax basis of the property and its fair market value at the time
of contribution. A member will be entitled to deduct its share of
an LLC's tax losses to the extent of the tax basis in its LLC interest.
Any loss in excess of such tax basis may be carried over indefinitely
and deducted, subject to various limitations (e.g., passive activity
and at-risk rules), in any subsequent year in which the tax basis
in such member's LLC interest is increased above zero.
Generally,
no gain or loss is recognized to either the contributing member
or the LLC on a member's contribution of property to the LLC. Similarly,
no gain or loss is generally recognized by the LLC or the distributee
member on the distribution of property to such member, except to
the extent that any money distributed exceeds the tax basis of such
member's LLC interest immediately before the distribution. On a
sale of an LLC interest, the selling member will recognize gain
or loss based on the difference between the amount realized and
the member's tax basis in its interest.
Tax
Basis in LLC Interest
In
general, the initial tax basis of a member who acquires an LLC interest
from the LLC will be equal to the amount of money and the tax basis
of any property that the member contributes to the LLC in exchange
for such interest. The tax basis thus determined will be increased
by such member's share of the LLC's liabilities, by its share of
the LLC's income, and by any subsequent capital contributions. The
member's tax basis will be reduced (but not below zero) by the member's
share of LLC distributions and losses and also by any decrease in
such member's share of the LLC's liabilities.
IRC
§ 752 embodies the statutory rules for sharing LLC liabilities.
That Section provides that any increase in a partner's share of
a partnership's liabilities, or any increase in a partner's individual
liabilities by reason of assuming a partnership's liabilities, will
be considered a contribution of money by such partner to the partnership.
Conversely, any decrease in a partner's share of a partnership's
liabilities, or any decrease in a partner's individual liabilities
by reason of a partnership assuming such liabilities, will be considered
a distribution of money to the partner by the partnership. Unfortunately,
the statute does not provide for the manner in which a partner's
share of liabilities will be determined. Instead, one must look
to the Regulations.
The
§ 752 Regulations treat all liabilities as either recourse or nonrecourse.
A partnership liability is a recourse liability to the extent that
any partner (or a person related to that partner) bears the economic
risk of loss for that liability. A partner's share of a recourse
partnership liability equals the portion of that liability, if any,
for which that partner or a related person bears the economic risk
of loss with respect to such liability. Basically, a partner is
treated as bearing the economic risk of loss for a partnership liability
to the extent that the partner or related person would be obligated
to make a contribution or payment with respect to a partnership
liability (and would not be entitled to be reimbursed for the contribution
or payment by another partner, a person related to another partner,
or the partnership), if the partnership constructively liquidated.
The following events are deemed to occur in a constructive liquidation:
(1) all of the partnership's liabilities become due and payable
in full; (2) with the exception of property contributed to secure
a partnership liability, all of the partnership's assets (including
money) become worthless and have a value of zero; (3) the partnership
disposes of all of its assets in a fully taxable transaction for
no consideration (other than relief from liabilities for which the
creditor's right to repayment is limited solely to one or more assets
of the partnership); (4) all items of income, gain, loss, and deduction
for the year are allocated among the partners; and (5) the partnership
completely liquidates.
A
partnership liability is a nonrecourse liability to the extent that
no partner or related person bears the economic risk of loss for
that liability. A partner's share of the nonrecourse liabilities
of a partnership equals the sum of the amounts determined under
the following three tiers: first, the partner's share of "partnership
minimum gain" determined pursuant to Code § 704 (b) and the
Regulations thereunder; second, the amount of any taxable gain that
would be allocated to such partner under Code § 704 (c) principles
if the partnership disposed of all partnership property subject
to one or more partnership nonrecourse liabilities in full satisfaction
of such liabilities and for no other consideration; and third, such
partner's share of any partnership nonrecourse liabilities in excess
of those allocated pursuant to the first two tiers, as determined
in accordance with such partner's share of partnership profits taking
into account all facts and circumstances relating to the economic
arrangement of the partners.
Capital
Accounts and Their Role in LLC Taxation
The
partnership agreement may specify the partners' interests in profits
for purposes of allocating excess nonrecourse liabilities, provided
the interests so specified are reasonably consistent with valid
allocations under the § 704 (b) Regulations of some other significant
item of partnership income or gain. The Regulations also provide
an alternative under which excess nonrecourse liabilities may be
allocated among the partners in accordance with the manner in which
it is reasonably expected that the deductions attributable to those
nonrecourse liabilities will be allocated. Excess nonrecourse liabilities
are not required to be allocated under the same method each year.
It
is important to recognize that a member's interest in an LLC is
separate and distinct from the member's capital account. A capital
account is basically a measure of a member's equity in an LLC. Computation
of the capital account begins with the amount of money and the fair
market value (not the tax basis) of other property contributed by
such member to the LLC (net of liabilities secured by such contributed
property that the LLC is considered to assume or take subject to
under IRC § 752), and is increased by the member's share of the
LLC's income and gain. The member's capital account is decreased
by the amount of money and the fair market value of property (again,
not the tax basis) distributed to such member (net of liabilities
secured by such distributed property that such member is considered
to assume or take subject to under Code § 752), and such member's
share of the LLC's losses, deductions, and nondeductible expenditures.
A
member's capital account does not reflect such member's share of
the LLC's liabilities except to the extent that such liabilities
are actually assumed by the member and the creditor is aware of
such assumption and can directly enforce the member's obligation.
Thus, while there will be an increase in the member's tax basis
in its LLC interest for the increase in the member's share of the
LLC's liabilities, generally there will be no corresponding increase
in the member's capital account.
The
Regulations also permit an adjustment to the members' capital accounts
to reflect the revaluation of LLC property on the LLC's books, provided
that the adjustments are made principally for a substantial nontax
business purpose either (1) in connection with a contribution or
distribution of money or other property (other than a de minimis
amount) as consideration for the acquisition or relinquishment of
an interest in the LLC; (2) under generally accepted industry accounting
practices, provided that substantially all of the LLC's property
(excluding money) consists of stock, securities, commodities, options,
warrants, futures, or similar instruments that are readily tradable
on an established securities market; or (3) in connection with a
liquidation of the LLC. Such adjustments must be based on the fair
market value of LLC property on the date of adjustment and must
reflect the manner in which the unrealized income, gain, loss, or
deduction inherent in such property (that has not been previously
reflected in the capital accounts) would be allocated among the
members if there were a taxable disposition of such property for
such fair market value on that date. The members' capital accounts
must be subsequently adjusted for book depreciation, depletion,
amortization, and gain or loss with respect to the booked-up value
of the property. The members' distributive shares of tax depreciation,
depletion, amortization, and gain or loss with respect to the property
must also be determined to take into account the resulting book/tax
disparity according to the rules of Code § 704(c). Generally,
under IRC § 704(c), certain tax allocations must be made to the
contributing member with respect to the difference between the book
value (fair market value) of contributed property and its tax basis,
so that the difference between tax basis and book value at the time
of contribution is ultimately recognized by the contributing member.
Allocation
of Profits and Losses
Each
member of an LLC must take into account the member's distributive
share of all items of the LLC's income, gain, loss, deduction, and
credit for federal income tax purposes. In general, an LLC's operating
agreement determines a member's distributive share of these items,
unless the agreement does not provide for such allocations or such
allocations under the agreement do not have "substantial economic
effect," in which case such member's distributive share of
these items will be determined in accordance with its interest in
the LLC, taking into account all facts and circumstances. If the
operating agreement provides for the allocation of such items to
a member, the Regulations state that there are three ways in which
such allocation will be respected under IRC § 704 (b) and the Regulations
thereunder: the allocation can have substantial economic effect;
the allocation can be in accordance with the member's interest in
the LLC, taking into account all facts and circumstances; or, the
allocation can be deemed to be in accordance with the member's interest
in the LLC.
Substantial
Economic Effect
The
determination of whether an allocation to a member has substantial
economic effect is a two-part analysis: first, the allocation must
have economic effect, and second, the economic effect must be substantial.
In order for an allocation to have economic effect, it must be consistent
with the underlying economic arrangement of the members -- if there
is an economic benefit or burden that corresponds to an allocation,
the member to whom the allocation is made must receive such economic
benefit or bear such economic burden.
Generally
under the Regulations, an allocation will have economic effect if,
and only if, throughout the full term of the LLC, the operating
agreement provides that (1) the members' capital accounts will be
maintained in accordance with the Regulations; (2) positive capital
account balances will determine the distribution of an LLC's assets
in liquidation of the LLC (or any member's interest in the LLC);
and (3) each member will be required to restore any deficit in his
or her capital account that remains after the distribution of liquidation
proceeds, and such amount will be paid to creditors of the LLC or
distributed to other members in accordance with their positive capital
account balances. If the first two requirements are met but the
member to whom an allocation is made is not required to restore
a deficit balance in its capital account, such allocation will be
considered to have economic effect to the extent such allocation
does not cause or increase a deficit balance in such member's capital
account (in excess of any limited amount of such deficit that such
member is obligated or deemed to be obligated to restore), provided
there is a "qualified income offset" provision in the
operating agreement. Such an allocation will be considered to have
economic effect under what the Regulations refer to as the alternate
test for economic effect. A qualified income offset is a provision
that requires a member who unexpectedly receives an adjustment,
allocation, or distribution described in the Regulations that causes
or increases a deficit balance in such member's capital account
(in excess of any limited amount of such deficit that such member
is obligated or deemed to be obligated to restore), to be allocated
income and gain in an amount and manner sufficient to eliminate
such deficit balance as quickly as possible. Because most LLCs will
not require any of their members to restore negative capital account
balances, an operating agreement will need to include a qualified
income offset provision.
The
Regulations provide that, in general, the economic effect of an
allocation will be "substantial" if there is a reasonable
possibility that the allocation will substantially affect the dollar
amounts that the partners will receive, independent of tax consequences.
If an allocation has economic effect, but the economic effect is
not substantial, such allocation must be based on the members' interests
in the LLC.
The
Regulations contain a safe harbor test in regard to losses and deductions
attributable to nonrecourse debt secured by partnership property
("nonrecourse deductions"). Allocations of nonrecourse
deductions cannot have substantial economic effect because the creditor
alone bears any economic loss attributable to those deductions.
Thus, nonrecourse deductions must be allocated in accordance with
the members' interests in the LLC. The Regulations provide that
allocations of nonrecourse deductions will be deemed to be made
in accordance with the members' interests in the LLC so long as
the following four requirements are met: (1) Capital accounts are
properly maintained in accordance with the § 704 (b) Regulations,
liquidating distributions are required to be made in accordance
with positive capital account balances, and members with deficit
capital account balances have a deficit restoration obligation or
the operating agreement contains a qualified income offset; (2)
the operating agreement provides for allocation of nonrecourse deductions
in a manner that is reasonably consistent with allocations that
have substantial economic effect of some other significant LLC item
attributable to the property securing the nonrecourse debt; (3)
the operating agreement contains a "minimum gain chargeback";
and (4) all other material LLC allocations and capital account adjustments
under the operating agreement are recognized under the § 704 (b)
Regulations. Allocations of nonrecourse deductions not qualifying
under this safe harbor must be made in accordance with the members'
overall economic interests in the LLC, as determined under the Regulations.
The
704(c) regulations are extraordinarily complex and must be studied
carefully in many situations.
At-Risk
Rules
IRC
§ 465 provides that in the case of individuals and certain closely
held C corporations, a loss from certain activities is allowable
only to the extent the taxpayer is at-risk for such activity at
the close of the taxable year. The at-risk rules apply to all activities
engaged in by a taxpayer in carrying on a trade or business or for
the production of income.
A
taxpayer is at-risk with respect to an activity to the extent of
(1) the amount of money and the adjusted basis of other property
contributed by the taxpayer to the activity, plus (2) amounts
borrowed for use in the activity to the extent the taxpayer is personally
liable for the repayment of such amounts, or has pledged property,
other than property used in such activity, as security for the debt
(to the extent of the net fair market value of the taxpayer's interest
in such pledged property). In addition, a taxpayer is considered
at-risk with respect to the taxpayer's share of any "qualified
nonrecourse financing" that is secured by real property used
in the activity. Qualified nonrecourse financing is any financing
(1) that is borrowed by the taxpayer from a qualified person (i.e.,
generally an unrelated entity actively engaged in the business of
lending money), or that represents a loan from any federal, state,
or local government or instrumentality thereof (or is guaranteed
by any federal, state, or local government or instrumentality thereof),
with respect to the activity of holding real property; (2) with
respect to which no person is personally liable for repayment; and
(3) which is not convertible debt. A member's share of any qualified
nonrecourse financing is determined on the basis of that member's
share of LLC liabilities incurred in connection with such financing,
within the meaning of Code § 752.
If
an LLC is engaged in an activity that is subject to the at-risk
rules, the at-risk limitation is applied at the member level, not
at the LLC level. Thus, some members may be subject to the at-risk
rules while others are not. Each member is required to determine
the amount he or she has at-risk in the LLC at the end of each taxable
year. Generally, a member will be at-risk for the amount of money
and the tax basis of other property contributed to the LLC by such
member, plus amounts borrowed by the LLC for which such member is
either personally liable for the repayment thereof or has pledged
property (other than its LLC interest or assets owned by the LLC)
as security for the loan, to the extent of the fair market value
of such pledged property. In addition, if a member is contractually
obligated to make additional contributions to the LLC, such member
may be entitled to increase its at-risk amount by a portion of the
LLC's liabilities, provided they are the types of liabilities that
would increase the members at-risk amount if he or she were a general
partner in a partnership. A member's share of LLC profits will increase
its amount at-risk .
If
a member's share of the LLC's loss for a taxable year is less than
the amount it has at-risk at the end of such year, the deduction
for such loss is not limited by Code § 465. However, the member
must then reduce the amount considered at-risk by the amount of
the loss that has been deducted, and the reduced at-risk amount
is carried over to the next taxable year.
If
a member's share of an LLC's loss for a taxable year is greater
than the amount at-risk, the deduction in that year is limited to
the amount at-risk at the end of the year, and the amount at-risk
is reduced to zero. The member's share of the LLC's loss that is
not allowable as a deduction by reason of Code § 465 in any taxable
year may be carried over and deducted in succeeding taxable years
to the extent its at-risk basis has increased above zero.
When
a member's at-risk basis is reduced below zero at the end of any
taxable year (for example, by distributions to such member), the
member will recognize income to the extent the at-risk basis is
reduced below zero. This recapture income, however, is limited to
the excess of the losses previously allowed to such member over
any amounts previously recaptured, and will be treated as a deduction
allocable to the activity for the first succeeding taxable year.
It
is important to note that the at-risk limitation does not affect
the tax basis of a member's interest or the amount of gain or loss
realized by a member; it merely limits the amount of loss that may
be deducted by a member in a particular year.
Passive
Activity Rules
Individuals,
estates, trusts, closely held C corporations, and personal service
corporations are subject to the passive activity rules of IRC §
469, which generally prohibit those taxpayers from using losses
from passive activities to offset nonpassive income. A passive activity
loss is the amount by which a taxpayer's passive activity deductions
for the taxable year exceed his or her passive activity gross income
for the year. A passive activity generally is (1) any activity that
involves the conduct of a trade or business and in which the taxpayer
does not materially participate, and (2) any rental activity, regardless
of the extent to which the taxpayer participates, except for interests
in rental real estate owned by certain real estate operators. In
addition, an individual who "actively" participates in
a rental real estate activity of which he or she owns at least a
10 percent interest may use up to $25,000 of passive losses per
year to offset nonpassive income; however, this amount is reduced
by 50 percent of the taxpayer's adjusted gross income in excess
of $100,000.
In
applying the passive loss rules, a taxpayer's income and losses
are separated into three categories or baskets: (1) passive income;
(2) portfolio income (e.g., interest, dividends, and certain royalties);
and (3) active income (e.g., salary and wages). Losses from passive
activities are allowed to the extent of the taxpayer's passive income,
and they cannot be used to offset either portfolio income or active
income. Credits arising with respect to passive activities may be
used to offset tax attributable to net passive income. Disallowed
passive losses and credits are carried over and used to offset future
passive income and tax attributable thereto. Upon the fully taxable
disposition of the taxpayer's entire interest in a passive activity,
all suspended losses (but not credits) attributable to that activity
can be used without regard to the passive loss limitation.
"Material
participation" in an activity is defined as active involvement
in the operations of the activity on a regular, continuous and substantial
basis. Generally, an individual is treated as materially participating
in an activity for a taxable year if he or she meets one of the
following seven tests:
- The individual participates in the activity for more than 500
hours during such year;
- The individual's participation in the activity for the taxable
year constitutes substantially all of the participation in such
activity of all individuals for such year;
- The individual participates in the activity for more than 100
hours during the taxable year, and that participation is not less
than that of any other individual for such year;
- The activity is a significant participation activity for the taxable
year, and the individual's aggregate participation in all significant
participation activities during such year exceeds 500 hours;
- The individual materially participated in the activity for any
five taxable years during the ten immediately preceding taxable
years;
The activity is a personal service activity, and the individual
materially participated for any three preceding taxable years;
or
- Based on all the facts and circumstances, the individual participates
on a regular, continuous and substantial basis during such taxable
year.
A
limited partner will not be treated as materially participating
in the activities of a limited partnership unless specifically permitted
by the Regulations. The IRS has issued temporary Regulations which
provide that a limited partner will be deemed to materially participate
by qualifying under tests (1), (5), or (6) above. Thus, a limited
partner either must participate for more than 500 hours or must
have materially participated during five of the last ten years or,
if the activity is a personal service activity, any three preceding
years. By contrast, an S corporation shareholder will be deemed
to materially participate by satisfying any of the seven tests.
The
determination of whether an activity will be a passive activity
is a complex and relatively uncharted area. For a discussion of
these complexities see Bryant, Jones & Beaudrot, Georgia LLC/LLP
Handbook pps. 128 to 132.
Accounting
Methods
Under
Code § 446 (c), a taxpayer generally may use either the cash method
or the accrual method of accounting. Code § 448 (a), however, precludes
a "tax shelter" from using the cash method of accounting.
A tax shelter is any of the following entities: (1) 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; (2) any "tax shelter"
as defined in Code § 6662 (d)(2)(C)(ii); and (3) any "syndicate"
within the meaning of Code § 1256 (e)(3)(B). Although not apparent
on first blush, this statute can be read as applying to many LLC's.
The
IRS has issued several private letter rulings dealing with this
issue. In Priv. Ltr. Rul. 9321047 (Feb. 25, 1993), a cash-method
law firm operating as a general partnership decided to convert into
an LLC. First, the IRS found that the LLC was not an "enterprise"
so long as it did not offer interests in itself for sale in an offering
required to be registered, which the law firm represented it had
never done and would never do. The IRS also found that the LLC was
not a "syndicate," noting that this issue depends on how
the LLC's members are classified and how its losses are allocated.
The IRS found that the members of the LLC were not limited entrepreneurs,
based on the law firm's representations that all of the members
of the LLC would continue to engage in the practice of law and that
all of the members would be required to vote in order for the LLC
to take certain actions. Subsequent private letter rulings have
included similar representations. Although not discussed, the IRS
apparently did not view members of the LLC as being limited partners
simply because they would have limited liability.
Finally,
the IRS found that the LLC was not a "tax shelter" within
the meaning of Code § 6662 (d)(2)(C)(ii), based on the law
firm's representations that the partners would participate in the
management of the LLC, that the LLC would be organized to engage
in the practice of law, and that the LLC would not be organized
for any federal income tax avoidance motive. Thus, the IRS ruled
that the law firm could retain the cash method of accounting after
it converted to an LLC.
In
Priv. Ltr. Rul. 9415005 (Jan. 10, 1994), the IRS also allowed a
law firm converting into an LLC to retain the cash method of accounting,
but did not base the ruling on the members' active participation
in firm management activities. The IRS found that for purposes of
Code § 461 (i)(3)(A), the law firm would not be an enterprise so
long as it did not offer interests in itself for sale in any offering
required to be registered. The IRS also found that the LLC would
not be a syndicate, although no representations were included in
the ruling concerning management or the active participation of
members; however, based on representations that the firm consistently
reported taxable income rather than a loss, the IRS ruled that the
LLC would not be a syndicate for any year in which it does not incur
losses. The IRS declined to determine whether the LLC would be a
tax shelter as defined in Code § 6662 (d)(2)(C)(ii), but did find
that the LLC would not be treated as a tax shelter under that Code
Section solely as a consequence of its organizational structure
as an LLC.
Self-Employment
Tax
In
computing net earnings from self-employment, the distributive share
of any item of income or loss of a limited partner (other than guaranteed
payments) is excluded. This exclusion was added because of the concern
that investors might use limited partnerships as a means to become
insured for Social Security benefits, undermining the basic principle
of the Social Security program that benefits are designed to partially
replace lost earnings from work. Thus, if all LLC members are treated
as limited partners, regardless of participation in the business,
all of the LLC's income or loss would be excluded from self-employment
tax.
In
subsequent responses to criticism from various commentators, the
Service publicly acknowledged that the solution contained in the
Proposed Regulations was too formalistic and would not be implemented.
In response to this criticism, the Service has now proposed revised
Proposed Regulations under § 1402 (26 CFR Part 1) published in the
Federal Register on January 13, 1997. The new Proposed Regulations
would apply to all entities taxable as partnerships (not only LLCs,
but also LLPs, LLLPs and General Partnerships). The general rule
under the new Proposed Regulations is that an individual be treated
as a limited partner unless (1) that person have personal liability
as defined in Regs. 301.7701-3(b)(2)(ii); (2) has authority to contract
under the applicable statute or law on behalf of the entity; or
(3) participates in the partnership’s trade or business for
more than 500 hours per year.
For
professional firms (i.e. law, medicine, engineering and other firms
traditionally _____________ as the professional firms) any distributable
income will be subject to self-employment income tax.
Perhaps
most important under the Proposed Regulations, however, they do
permit the bifurcation of interest as between a interest which would
be characterized as limited partner interest and a general partner
interest. Accordingly, it is now possible to properly structure,
particularly if the service partner member is compensated using
a guaranteed payment format, to bifurcate that portion of the interest
which is attributable to the service interest and separate that
from the financial interest, thus permitting the distributions with
respect to the financial interest to qualify as not self-employment
income.
The
___________ to Proposed Regulations also acknowledges that logically
these rules are still inconsistent with other pass-through entities,
with notably S corporations. However, the Service reached the conclusion
that it was beyond the scope of the regulatory project to correct
these disparities. Accordingly, this is one area where an S corporation
continues to enjoy slight benefits in the Service firm situation,
enabling owners to withdraw some of the net profits as S corporation
dividends which are subject to self-employment income tax.
State
Tax Considerations
An
area of increasing importance for planning in the use of LLC's is
state tax characterization. Although most states treat LLC's for
state tax purposes the same as for federal purposes, there are notable
exceptions. For example, Florida subjects LLC's to its Florida corporate
tax while Texas applies its corporate franchise tax to LLC's. Similarly,
as number of states now impose entity level withholding on distributions
to non-resident owners of LLCs, see, e.g. O.C.G.A. § 48-7-129.
Tax
Considerations for LLPs
As
discussed in Chapter One of Part Two, an LLP is a general partnership
that records a limited liability partnership election. The principal
difference between a Georgia general partnership that is an LLP
and one that is not, is that a partner in a LLP is liable only for
such partner's own errors, omissions, negligence, malpractice, wrongful
acts, incompetence or misconduct. A Georgia LLP will lack continuity
of life because it will be dissolved "[b]y the express will
or withdrawal of any partner . . .", and this cannot be varied
by agreement. A Georgia LLP should also lack centralized management.
In most situations a general partnership will also lack free transferability
of interests, although this can be modified by agreement. A Georgia
LLP would appear to possess a modified form of the corporate characteristic
of limited liability since each partner is liable for his or her
own errors, omissions, negligence, malpractice, wrongful acts, incompetence
and misconduct. The IRS takes the position that this will not be
enough for the partnership to lack limited liability. Thus, a Georgia
LLP should always be classified as a partnership for federal tax
purposes.
Other
Tax Issues
Most
of the partnership tax rules discussed above will apply to LLPs
in the same manner that they apply to LLCs, with the possible exceptions
of the passive activity rules and self-employment tax. Concerning
the passive activity rules, while an LLC interest arguably would
be limited partnership, interest for purposes of the material participation
test, because the liability of a partner in a Georgia LLP is not
limited to a determinable fixed amount, there is a substantial argument
to the contrary.
With
respect to self-employment tax, Code § 1402(a) provides that "net
earnings from self-employment" include an individual's "distributive
share (whether or not distributed) of income or loss described in
section 702(a)(8) from any trade or business carried on by a partnership
of which he is a member. . . ." Code § 1402(a)(13) excludes
from the definition of net earnings from self-employment the distributive
share of any item of income or loss of a limited partner, other
than guaranteed payments under Code § 707(c). Thus, a limited partner
will not be subject to self-employment tax.
Under
the proposed Regulations, it appears possible that a partner in
a Georgia LLP could be considered to be a limited partner for purposes
of the self-employment tax. The proposed Regulations provide that
a member of an LLC will be treated as a limited partner if the three
tests contained therein are met. A member is any person who owns
an interest in an LLC, and an LLC is defined as an organization
formed under a law that allows limitation of the liability of all
members for the organization's debts and other obligations within
the meaning of Regulation § 301.7701-2(d), and is classified
as a partnership for federal tax purposes. It appears that the IRS's
position is that an LLP will have limited liability under Regulation
§ 301.7701-2(d). Thus, because an LLP will be treated as a partnership
for federal tax purposes, and a partner meets the three tests contained
in the proposed Regulations, it is possible that partners will be
treated as a limited partner for self-employment tax purposes.
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