Benefit Using the LLC

For taxation purposes, the IRS classifies an LLC like a partnership and the income/losses realized by a partnership are distributed to the partners.  It is important to understand the potential tax benefits of utilizing an LLC to real estate investors and individuals involved in real estate ventures.

LLCs benefit from the greater flexibility of the Subchapter K provisions of the Internal Revenue Code. Under Subchapter K, losses are deductible only to the extent of a partner’s basis of his partnership interest.  A partner’s basis may be increased through his share of recourse liability or the economic risk of loss of an LLC liability to the extent he would bear the loss out of his non-partnership assets.   The Internal Revenue Code uses the concept of  “economic risk of loss” to classify a liability of an LLC.

An “economic risk of loss” could result in the allocation of a loss that can be used to offset ordinary income. The Income Tax Regulations employ a “doomsday” liquidation analysis to determine the allocation of such a loss. Basically, the Income Tax Regulations assume that all LLC assets are worthless. They also assume all the LLC liabilities are due and payable in full for no consideration.  Finally, the Treasury Regulations question whether partners would be obligated to make a payment to a creditor or a contribution to the LLC. In determining a partner’s payment obligations, the regulations take into account all statutory and contractual obligations related to the partnership liability, such as guarantees or obligations imposed by state law. For this purpose, guarantees, indemnifications, and other reimbursement arrangements are taken into account.

Applying the aforementioned rules to a typical venture, if the contractual obligations of the LLC could expose any of the partners to liability (i.e. recourse liability such as a mortgage, contract with a developer, etc.) the LLC could make an allocation of a loss equal to the amount of the potential exposure.  This is the case even if the contractual agreement has not been satisfied or even if the partner is not individually liable for the agreement. This potentially is a significant tax benefit because it could result in the allocation of losses that could be utilized to offset the ordinary income of each partner such as wages, interest income, or dividends. It should be noted that the partner must recognize income tax liability in the amount of the losses allocated from the LLC when it dissolves or when the partner leaves the entity.

In order for one to be able claim any of the losses allocated to him from the LLC, a partner must satisfy the passive loss rules of the Internal Revenue Code. These rules were enacted to restrict taxpayers from using deductions and other losses generated from certain passive investment activities. The rule is applied on a partner-by-partner basis, not at the LLC level. Under the passive loss rules, a partner must “materially participate” in an LLC.

These rules are beyond the scope of this article. However, under the passive loss rules, the partner must participate in the LLC more than 500 hours during the year of the loss allocation. It should be noted that further restrictions may apply to real estate professionals. The Internal Revenue Code does not impose any particular recordkeeping requirements to substantiate the passive loss rules. However, the Treasury Regulations do suggest that appointment books, calendars, and narrative statements may be used to establish the approximate hours devoted to an activity. As such, anyone considering utilizing the above-mentioned strategy should keep a detailed log of the hours they participate in the LLC. This may assist him to establish that he satisfies the passive loss rules in the event of an IRS audit. Given the complexities of Section K of the Internal Revenue Code, anyone considering utilizing an LLC for tax purposes should consult with a qualified tax attorney.

Stephen Moskowitz of San Francisco, California, Senior Partner of the Law Offices of Stephen Moskowitz, LLP, specializes in business and individual tax law for over 35 years.  Among his accomplishments:  Fox TV Legal Analyst for seven years and University Instructor. He holds  LLM, MBA and BS degrees, and licensing includes State Bar of California and New York, the United States Tax Court, Federal Appeals Court,  and the United States Supreme Court.