As a separate taxable entity, a limited liability company (LLC) has the ability to make certain tax elections like any other taxpayer. LLCs can decide which fiscal year end to select, choose an accounting method, and make many other elections under the Code. Specifically, Sec. 703(b) provides that any election affecting the computation of taxable income derived by a partnership (or, in this instance, an LLC) is to be made by the partnership (or LLC) with three exceptions.
The first exception to Sec. 703(b) relates to the nonrecognition of income from debt discharge under Sec. 108. To qualify for nonrecognition treatment, the taxpayer must meet certain conditions (i.e., insolvency, etc.). When Sec. 108 applies, a taxpayer must reduce his or her tax attributes by the amount of debt discharge income not recognized. However, the taxpayer can instead elect to first reduce the basis of his or her depreciable property (Sec. 108(b)(5)). In addition, a taxpayer can elect to have the nonrecognition provisions of Sec. 108 apply to qualified real property business indebtedness (Sec. 108(c)(3)). Although both elections affect the computation of taxable income derived by an LLC, Sec. 703(b) requires they be made at the member level.
The second exception to Sec. 703(b) pertains to elections made under Sec. 617. Under this section, a taxpayer can elect to deduct mining exploration expenditures incurred during a tax year (Sec. 617(a)). Likewise, when any mine for which such expenses were deducted reaches its producing stage, the taxpayer can elect to recapture the amounts into income. Without the recapture election, the taxpayer is barred from deducting depletion until the disallowed depletion equals the mining exploration expenditures deducted (Sec. 617(b)). Sec. 703(b) requires these elections to be made by each member.
Lastly, Sec. 703(b) requires that any election to take a credit for foreign taxes paid by an LLC be made at the member level.
Election Out of the Partnership Tax Provisions
Some business arrangements that would otherwise be classified as partnerships under the Code can elect, under Sec. 761(a), to be excluded from the partnership provisions of the Code (i.e., subchapter K). Most state LLC acts preclude LLCs from electing out by providing that the LLC, not the members, owns the LLC’s property. Additionally, most state acts provide that an LLC member cannot demand a distribution of property. Consequently, unless the applicable state LLC statute treats the members as co-owners of LLC property, the election out of partnership treatment is not available.
The IRS has announced that, if certain conditions and ruling request procedures are met, it will rule whether an undivided fractional interest in rental real estate (other than mineral property) is not an interest in a business entity (Rev. Proc. 2002-22). The conditions include that each co-owner (no more than 35 co-owners can be involved) holds title in the real estate as a tenant in common under local law and that the co-owners must not file a partnership or corporate tax return or conduct business under a common name. Also, each co-owner must retain the right to approve hiring any manager, the sale or other disposition of the real estate, or the lease of some or all of the land.
Observation: While Rev. Proc. 2002-22 does not provide substantive rules and cannot be used for audit purposes, the IRS is not likely to challenge undivided fractional share units that meet its criteria. And, if certainty is desired, the taxpayer can always request a ruling.
The first ruling issued under Rev. Proc. 2002-22 (Letter Ruling 200327003) was requested by a sponsor prior to the actual sale of the undivided fractional shares even though the revenue procedure requires the taxpayer to provide the name and identification numbers for each owner and a description of the property. Presumably, this means the IRS has recognized that a promoter can receive IRS approval for a fractional share arrangement before marketing begins. The letter ruling also provided that the sponsor’s selling and marketing activities would not be taken into account to determine if the co-owners’ activities were limited to those customarily performed in connection with the maintenance and repair of rental real property.
In its second ruling on Rev. Proc. 2002-22 (Letter Ruling 200513010), the IRS expanded on its original ruling, finding that the following may be included in the co-ownership agreements of net-leased property:
- Co-owners may retain the right to partition their interests, or to file a complaint or institute a proceeding at law or in equity to have the property partitioned.
- The co-tenancy agreement may provide that each co-owner grants an option to the other co-owners to acquire its interest at fair market value in the event (a) there is a proposal to sell part or all of the property or to incur debt to be secured by the property, or to modify the lease, and the co-owner votes not to proceed where holders of more than 50% of the ownership interests vote to proceed; or (b) a co-owner provides a notice of termination of the management agreement.
- Co-owners may have the right to provide substitute property management.
- The management agreement may, notwithstanding the requirement that the managers must otherwise obtain unanimous consent for the lease or re-lease of the property, allow the managers to lease or re-lease up to a certain percentage of the total space without the consent of the co-owners if the leases meet certain unanimously approved guidelines.
For additional instances where the IRS has ruled ownership interests were fractional shares under Rev. Proc. 2002-22, see Letter Rulings 200625009, 200625010, 200826005, 200829012, and 200829013.
Electing Large LLCs
Special provisions governing electing large partnerships and LLCs taxed as electing large partnerships are designed to simplify reporting. Electing large LLCs file Form 1065B, U.S. Return of Income for Electing Large Partnerships. Electing large LLCs are required to furnish Schedules K-1 to members on or before the first March 15 following the close of the partnership’s tax year (Sec. 6031(b)).
For any tax year, an LLC can elect to be governed by the electing large partnership rules if it has 100 or more members in the preceding LLC tax year (Sec. 775). The election is not available for LLCs in which the members (1) perform substantial services in connection with the LLC’s activities; (2) are retired members, who had performed such substantial services; or (3) are spouses of members who are performing or had previously performed such services. If an LLC is treated as an electing large partnership on its return, that treatment is binding on the LLC and all of its members, but not on the IRS. Once made, the election applies to the tax year for which made and later tax years unless revoked with IRS consent. An LLC will cease to be treated as an electing large partnership for any tax year that fewer than 100 persons were members.
In determining the taxable income of a member in an LLC treated as an electing large partnership, the member takes into account his or her distributive share of the items listed in Sec. 772.
Under the electing large partnership rules, a member is not permitted to report any LLC items inconsistently with the LLC’s tax return, even if the member notifies the IRS of the inconsistency. The IRS has the right to immediately assess any additional tax against a member for inconsistent treatment.
The taxable income of an LLC treated as an electing large partnership is generally computed in the same way as an individual’s taxable income, except the items referred to in the previous paragraph are separately stated with certain modifications (Sec. 773). In addition, deductions for personal exemptions, net operating losses, and itemized deductions for individuals under Secs. 211–220 (other than Sec. 212 deductions) are not allowed. Charitable deductions are subject to the limitations in Sec. 170(b)(2) that apply to corporations (and are not separately stated), and 70% of miscellaneous itemized deductions are disallowed (versus the 2% disallowed to individuals).
All elections and limitations affecting the computation of taxable income are applied at the LLC level. This general rule has exceptions for the foreign tax credit, election to exclude discharge of indebtedness income, overall limitation on itemized deductions, at-risk limitation, and passive activity limitations.
Other items receive special treatment, including (Sec. 774):
- A member’s distributive share is adjusted to take into account any optional basis adjustment.
- Any credit recapture is taken into account by the LLC, and the amount of recapture is determined as if the credit had been fully used to reduce tax. The credit recapture is taken into account by reducing the amount of the current-year credit; if the credit recapture exceeds the current-year credit, the LLC is liable to pay the excess. No credit recapture is required by reason of any transfer of an interest in an electing large LLC.
- The technical termination rules providing for the termination of an LLC if there is a 50%-or-more change in ownership during a 12-month period do not apply to electing large LLCs.
- The installment sale interest charge is applied at the LLC level. In determining the amount of the interest charge, the LLC is subject to tax at the highest corporate or noncorporate tax rate.
- Special rules included in Sec. 776 apply to LLCs holding oil or gas properties.
This case study has been adapted from PPC’s Guide to Limited Liability Companies, 18th Edition, by Michael E. Mares, Sara S. McMurrian, Stephen E. Pascarella II, Gregory A. Porcaro, Virginia R. Bergman, William R. Bischoff, James A. Keller, and Linda A. Markwood, published by Thomson Tax & Accounting, Fort Worth, Texas, 2012 (800-323-8724; ppc.thomson.com).
Albert Ellentuck is of counsel with King & Nordlinger LLP in Arlington, Va.