LLC lawyers should have at least a basic understanding of the IRC passive activity and at risk rules. Today’s Tax Notes has advised that IRS has just released Publication 925 (rev. 2015), Passive Activity and At-Risk Rules, for use in preparing 2015 returns, discussing the passive activity and at-risk rules that may limit the amount of a taxpayer’s deductible loss from a trade, business, rental, or other income-producing activity.
The copyrighted new CLE outline cited below addresses issues that have great importance in many LLC operating agreements for multi-member LLCs. I download these articles from Westlaw. Others in our group may have other means of obtaining such articles.
Here’s the cite:
TSXW04 ALI-CLE 1
The American Law Institute Continuing Legal Education
ALI-CLE Course Materials
October 29, 2015
Drafting Indemnification & Exculpation Provisions in LLE Agreements
DRAFTING INDEMNIFICATION & EXCULPATION PROVISIONS IN LLC AGREEMENTS
Eric N. Feldman
K&L Gates LLP
Melissa K. Stubenberg
Richards, Layton & Finger PA
Copyright (c) 2015 The American Law Institute; Eric N. Feldman and Melissa K. Stubenberg
The default federal income tax regimen for multi-member LLCs is partnership taxation under Internal Revenue Code Subchapter K, and for many multi-member LLCs, partnership is better than the other main option—namely, taxation under Subchapter S—except for purposes of avoiding Social Security Taxes. Occasionally, prospective members of multi-member LLCs want to obtain at least a basic understanding of partnership taxation if they don’t already have one. I think the nine points below will help them to obtain this understanding.
However, I know there are at least a few members of this blog—and maybe a lot—who know much more about partnership taxation than I do. I know we’d all be grateful for any comment these members may have about the list below.
Chief characteristics of federal partnership taxation
Federal partnership taxation is complex, but its chief features are as set forth below. In the discussion below, “partnership” means an LLC taxable as a partnership and “partner” means a member of this partnership.
- Any person may be a member of a partnership. Any type of individual or entity, whether U.S. or foreign, may be a member of an entity taxable as a partnership.
- Contributions are generally tax-free. Contributions of cash, property and services to partnerships by the partners are generally tax-free both to the contributors and to the partnership.
- Partnership basis may be included in member basis. Each partner can increase his basis in the partnership (and thus the possibility that he will be able to lawfully reduce or avoid tax on his share of certain LLC income) to the extent of his share of any LLC debts, including mortgage debts.
- “Regulatory” special allocations. The LLC must make “special allocations” to the members—i.e., allocations of LLC income that are disproportionate to their shares of that income—to the extent required by U.S. Treasury Regulations. These are called “regulatory” special allocations. For example, the operating agreements of LLCs taxable as partnerships must generally provide that precontribution gain by the partnership from dispositions of property contributed to it must be allocated to the contributing partners.
- “Contractual” special allocations. However, an LLC taxable as a partnership may also make “contractual” special allocations as long as these special allocations are not merely to evade federal taxes. For example, an LLC may allocate a share of the LLC’s profits to a partner even if the partner make no contributions of cash, property or services to the LLC. Under this arrangement, that partner’s interest in the LLC will be called a “profits interest.”
- Only the partners, not the partnership, are subject to partnership federal income tax. The partnership is not subject to federal tax on its profits. However, on their respective shares of partnership income, partners are subject to federal tax. The rate of this tax for each partner is the partner’s individual federal income tax rate. The partners must each withhold and pay this tax on a roughly quarterly basis unless the partnership does the withholding.
- Distributions to partners are generally tax-free. Distributions of cash by the partnership to the partners are generally not subject to federal income tax in the hands of the partners unless they exceed the partners’ bases (i.e., the deemed amount of their investment in the partnership as determined under federal tax rules).
- Requirement to maintain capital accounts for the partners. A partnership must maintain a capital account for each partner in accordance with U.S. Treasury Department rules. These rules are intended to determine each partner’s share of the economic value of the partnership.
- “Zeroing out” of capital accounts. When a partner is bought out by the partnership and when the partnership is dissolved and liquidated, the LLC must pay the affected partners enough to zero out their capital accounts, and the partners must pay the LLC any deficit in these accounts.
For those of you who practice even from time to time in community property states, below is an email from Jay Adkisson to me about community property state issues relating to LLC charging orders. As you may know, Jay is perhaps the leading expert on charging order law and also a first-rate asset protection lawyer who, with Chris Riser, has written an excellent book on asset protection.
There is hardly any decisional law that references any differences, and so the issues are largely theoretical.
In a community property state, if H & W each own 50% in a LLC, but they do not own it as their separate property, then the LLC might be deemed to be owned 100% by the community (and thus liable for the debts of either spouse) and thus treated as a SMLLC. In such case, a judgment against one spouse would allow a charging order to be issued against the non-separate interests of both.
Four of the five states in which I am licensed are community property states, but I’ve never personally seen (or even heard about) a community property issue come up in the charging order context.
FWIW, the more meaty issues involving community property and LLCs go to ownership and management rights, usually where an out-of-state attorney prepares interest assignment documents for a community property resident, but neither specifies that the interest is held as sole and separate property, nor obtains a spousal consent to the terms. The couple later files for divorce. Hilarity ensues.
The theme of the latest issue of ABA Business Law Today is LLCs. You can view it at http://www.americanbar.org/publications/blt/2016/01.html.
Bob Keatinge is a leading national expert on LLC law and tax. In the e-mail below, he’s provided an excellent summary of the above statistics as applicable to LLCs taxable as partnerships. If you’re trying, for your own sake and that of your clients, to understand the LLC form in perspective and from a practical viewpoint, you’ll find Bob’s summary very useful.
On a snowy afternoon, nothing beats reading the statistics of income bulletin by the fire with cognac. The Fall 2015 Issue (https://www.irs.gov/uac/SOI-Tax-Stats-SOI-Bulletin-Fall-20150) , which includes the 2013 partnership return information has just come out.
The highlights of the report are as follows:
- Partnerships filed more than 3.4 million tax returns for 2013, a 2.1-percent increase over the number filed for 2012. These returns represented 27.5 million partners, up 8.5 percent from the previous year.
- Domestic limited liability companies (LLCs) made up the majority (66 percent) of all partnerships, surpassing all other entity types for the 12th consecutive year.
- Domestic limited partnerships represented only 12 percent of all partnerships but reported the most profits (32.4 percent), and the largest share of partners (45.2 percent).
- Real estate and rental and leasing accounted for about half (49.8 percent) of all partnerships and just over a quarter (27.7 percent) of all partners. The finance and insurance sector reported the largest shares of total net income (loss) (41.1 percent), total assets (56.7 percent), and total receipts (21.8 percent) in 2013.
- Total assets increased 9.8 percent between 2012 and 2013, from $22 trillion to $24.2 trillion. Some 18 (out of 20) industrial sectors reported an increase.
- Receipts totaled $7.1 trillion for 2013, up 7.1 percent from the amount reported for 2012. Business receipts made up the majority of total receipts (71.7 percent), rising 8.1 percent for the year.
- Total net income (loss), or profit, decreased 1.2 percent, from $777.9 billion for 2012 to $768.8 billion for 2013. Multiple components accounted for this decline, including ordinary income, interest income, and dividend income.
- Between 2012 and 2013, total income (loss) minus total deductions available for allocation increased from $1,400.8 billion to $1,478.5 billion. Partners classified as partnerships received the largest share of income (loss) allocated to partners, $491.6 billion.
One of the most interesting statements is “For the second consecutive year, partnerships surpassed both corporations and individuals as the top income (loss) recipients.”
If you form a Delaware LLC for your client, you have a duty to explain to the client the Delaware rules governing LLC veil-piercing, and you must explain to the client how to minimize the risk of veil-piercing. The link below summarizes a very recent Delaware corporate veil-piercing case. The veil-piercing doctrine in the case applies equally to Delaware LLCs.
The link below is to a recent blog post by Tom Rutledge, a leading U.S. LLC lawyer and scholar. I think I disagree with Tom on the issue whether LLCs should make S elections, but the issue is an important one for all LLC lawyers, and his post is well worth consideration.
Here’s the link:
The implied contractual covenant of good faith and fair dealing (the “Implied Covenant”) is a looming but often unrecognized factor in any formation of a multi-member LLC. The new Implied Covenant article by leading LLC scholar Dan Kleinberger under the attached link to Peter Mahler’s latest post to his Business Divorce blog will give you an excellent current overview of the Implied Covenant under Delaware law; and the principles of Delaware Implied Covenant law are likely to be influential in many other states.
LLC lawyers sometimes have occasions to assist their clients in finding financing for their businesses. One financing method, newly authorized in the JOBS Act, is crowdfunding. The link below provides a succinct and useful discussion of that subject: