In recent years, the use of single-member limited liability companies by individual taxpayers has gained popularity since SMLLCs can offer valuable legal protection for various assets, including commercial real estate. However, while the Internal Revenue Service considers SMLLCs disregarded entities for income tax purposes, taxpayers should understand that they are not disregarded for all tax purposes.
Taxpayers can utilize SMLLCs for a variety of reasons; however, one of the most common purposes involves using SMLLCs to own partnership interests. For example, an individual may form an SMLLC to own an interest in another limited liability company that is taxed as a partnership. Legal entities also can establish SMLLCs to hold different assets to protect each asset from liabilities involving the entity’s other assets or businesses.
Regardless of their use, all SMLLCs have one thing in common — they are not treated as separate legal entities distinct from their owners for income tax purposes unless certain elections are made to treat them as separate tax entities. Despite not being respected as separate legal entities for income tax purposes, there are three primary areas where the use of an SMLLC to own a partnership interest can have negative tax ramifications.
Partnership Tax Losses
Commercial real estate investors often incur taxable losses in the early years of real estate projects. The amount of such losses depends on many factors, including the amount of deductible depreciation, the size of the property’s debt, and the building’s occupancy rate.
In many cases the taxable losses incurred in the earliest years of a real estate investment exceed the equity invested in the deal. If an individual has invested directly in a partnership, he generally may deduct losses up to the amount of his equity investment plus his allocable share of any partnership liabilities. Thus, the individual taxpayer often can claim losses greatly in excess of his equity investment.
The taxpayer can deduct these losses on his personal tax return under the rationale that since the individual investor ultimately is responsible for payment of the partnership’s liabilities, he should receive tax basis for his share of those liabilities. There is a presumption by the IRS that the individual partner will pay those liabilities if he ultimately is responsible for their payment. Whether or not the individual has sufficient assets to repay those liabilities is disregarded.
This same presumption does not exist when an individual places an SMLLC between himself and the partnership. Once the SMLLC becomes the partnership’s owner, the individual taxpayer only receives tax basis for the partnership’s liabilities up to the SMLLC’s assets’ fair- market value. In other words, the presumption that the liabilities ultimately will be satisfied by the partnership’s owner goes away. The net impact is that the SMLLC’s owner only may deduct losses flowing from the partnership up to his equity investment in the SMLLC plus the fair-market value of other assets the SMLLC owns. In most cases, the individual only can deduct losses up to the amount of his equity investment.
Partnership Interest Contributed to an SMLLC
The second major tax issue occurs when an individual who owns a partnership interest contributes that interest to an SMLLC. If the individual has claimed tax losses in excess of his equity investment in the partnership, the contribution of the partnership interest to the SMLLC may create a taxable gain.
For example, assume that an individual owned a partnership interest directly and his initial investment was $100,000. Over the years, he has been allocated taxable losses of $1.1 million and has not made additional contributions nor received any distributions. Also assume that the individual’s allocable share of partnership liabilities was $1 million as of the preceding year’s end. At that time, his tax basis in the partnership interest would have been zero: the $100,000 contribution plus $1 million of allocable liabilities less $1.1 million of allocable losses.
If on the first day of the next year he contributes his partnership interest to an SMLLC and the SMLLC does not own any other assets, his allocation of liabilities may be decreased by $1 million. The net result is that he may recognize a $1 million gain.
Distributions in Excess of Equity
The third major tax issue occurs when an individual wishes to take distributions out of the partnership that are in excess of his equity investment.
Normally an individual can take distributions out of the partnership up to the amount of his tax basis without creating a taxable gain. The tax basis is equal to the equity investment plus allocable liabilities adjusted for earnings and losses of the partnership and prior distributions. When an SMLLC is interposed between the individual and the partnership, the distribution amount that can be taken from the partnership may be much more limited.
Tax Planning Opportunities
The primary driver of the issues that arise in such scenarios is the ability to treat a partner’s share of the partnership’s liabilities as tax basis in the partnership interest. There are a number of ways that liabilities will continue to be treated as basis even when using SMLLCs as a vehicle for owning a partnership interest. To determine what liabilities will be considered for calculating the partner’s basis in the partnership interest, each partnership liability must be analyzed to determine if it is a recourse or nonrecourse liability.
Recourse Liabilities. Recourse liabilities are liabilities for which one or more partners (or related persons of a partner) bear the economic risk of loss with respect to the liability. If a partner has an economic risk of loss with respect to a liability, that partner will receive an allocation of that liability, resulting in an addition to the partner’s tax basis in his partnership interest. If more than one partner bears the economic risk of loss with respect to a liability, the liability is allocated among the partners based on the amount for which they are responsible.
The most common example of a recourse liability when it is payable by a limited liability entity is when the partner has guaranteed the liability. Therefore, when considering whether or not to utilize an SMLLC to own a partnership interest, the SMLLC owner must determine whether or not he will continue to be liable or bear the economic risk of loss with respect to partnership liabilities. If the purpose of utilizing the SMLLC is to protect the owner from unknown liabilities but the SMLLC owner still must guarantee the partnership’s debt, the use of an SMLLC should not have a negative impact on receiving basis for the guaranteed debt.
Another example of a recourse liability is when the partnership is indebted to a partner. Although the partnership may not look to the partners for debt repayment, the partner who loaned the money to the partnership is allocated that liability as he ultimately bears the economic risk of loss with respect to the liability.
Nonrecourse Liabilities. The other type of liability that may exist within the partnership is a nonrecourse liability. A nonrecourse liability is a liability for which no partner bears the economic risk of loss. The majority of a partnership’s liabilities fall into this category if the partnership legally is formed as an LLC, LLP, or similar entity that limits its owners’ liability under state law. Since no partner bears an economic risk of loss with respect to nonrecourse liabilities, generally no tax basis is created as a result of a partner’s share of nonrecourse liabilities. As noted above, a partner may convert what otherwise would be a nonrecourse liability to a recourse liability by guaranteeing the liability.
In the commercial real estate context there also is a special type of nonrecourse liability — qualified nonrecourse liability — that creates tax basis for a partner’s allocable share of the liability. The instructions to the U.S. Return of Partnership Income define qualified nonrecourse financing to include “financing for which no one is personally liable for repayment that is borrowed for use in an activity of holding real property and that is loaned or guaranteed by a federal, state, or local government or that is borrowed from a qualified person. Qualified persons include any person actively and regularly engaged in the business of lending money, such as a bank or savings and loan association.”
If an SMLLC is interposed between a partner and a partnership that has qualified nonrecourse liabilities, the use of the SMLLC generally should not affect the allocation of those liabilities. Since the partner was not economically at risk prior to the transfer to the SMLLC, no change in economic risk should result from the transfer, so there should be no unfavorable tax consequence.
If a partner is not fortunate enough to have allocable qualified nonrecourse financing and chooses not to personally guarantee the partnership’s liabilities, there still may be an opportunity to utilize an SMLLC without creating adverse tax consequences. As noted, the key difference in owning a partnership interest directly rather than through an SMLLC is that interests owned directly are given the presumption that sufficient assets exist to repay any liabilities for which the owner is economically at risk.
That presumption does not exist for SMLLCs. Since the only way to receive basis within an SMLLC for liabilities is to have sufficient assets to repay those liabilities, one method to create that basis would be to contribute sufficient assets to cover any economic risk of loss associated with partnership liabilities. Although this is a reasonable alternative for tax purposes, it somewhat defeats the reason the owner likely is contributing the partnership interest to an SMLLC in the first place.
Perhaps a more practical alternative is not to utilize an SMLLC and instead utilize a multimember LLC. The multimember LLC could be formed by the existing partner contributing a partnership interest and a related or unrelated person contributing a nominal amount for a 1 percent interest in the LLC. The use of a multimember LLC will result in the partners being allocated their respective share of liabilities without assets being required in the multimember LLC to support the allocation.
There certainly are other ways to work around these issues with SMLLCs, and the aforementioned alternatives may not work in every situation. The key to any successful venture is to consult with a qualified tax adviser before entering into a new ownership structure. Good planning before entering into any transaction helps to ensure all parties are financially protected.