Although regulations require that the determination of the passive or nonpassive status of limited liability company (LLC) income or losses be made at the member level, Form 1065, U.S. Return of Partnership Income, requires a preliminary classification by the LLC. When filling in the "Analysis of Net Income (Loss)" on Form 1065, the practitioner is required to allocate LLC income between active individual members and passive individual members. This requires the LLC to make some assumptions about whether each individual member materially participates in its activities.
These assumptions by the LLC can pose significant problems since the individual member's perception of his or her participation in LLC activities may differ from the perception of the other members of the LLC. When there is potential controversy or the LLC wishes to avoid arguments between members, it should obtain a written representation from the member as to his or her participation or should opt to treat the member as passive.
Example 1. Classifying LLC member losses as active or passive: T LLC has five members, each owning a 20% interest and reporting 20% of LLC income or loss. T's principal activity is a rental real estate activity. T is classified as a partnership for federal taxes. A Inc. is a member and does not actively participate in the rental activity. F is a member and actively participates. M is a member, however, the LLC cannot determine whether he actively participates in the rental activities. The other two members, K and J, did not actively participate in the rental real estate activity. During the current year, the LLC reported a $50,000 taxable loss that is allocated among the members based on their percentage ownership in the LLC.
The Analysis of Net Income (Loss) on Form 1065 should classify the loss of all individual members except F as passive. Since T cannot determine whether M actively participated in the rental real estate activity, M must be classified as passive. There is no requirement to classify the corporation's participation. Consequently, T reports $10,000 as losses allocated to individual active members and $30,000 as losses allocated to individual passive members.General Reporting Requirements
The reporting required of an LLC under the passive loss rules can be as simple as one line item on the member's Schedule K-1 (if the LLC has only one activity) or necessitate the attachment of supplemental schedules to the members' Schedules K-1 (if the LLC has multiple activities). The Form 1065 instructions require the LLC provide an attachment to each member's Schedule K-1 providing LLC income and expenses by activity. This means every line reported on Schedule K-1 must be broken down by activity. The sum of all the items reported on the supplemental schedules should equal the amounts reported on Schedule K-1. The supplemental schedules reporting the separate activities must reflect the:
- Allocation of common expenses among various activities; and
- Allocation of gain or loss on dispositions of passive activities (or property used in passive activities) among various activities.
Note: Because of the net investment income tax, it is more important than ever for practitioners to provide information to members about income and expenses for each LLC activity. The net investment income tax may apply to some of the LLC's activities but not others.Reporting Multiple Activities
If the LLC has more than one activity, schedules showing allocable income and expenses for each activity should be prepared. Since suspended losses must be tracked on an activity-by-activity basis, a detailed activity-by-activity schedule should become part of the K-1 information forwarded to each member.Reporting Self-Charged Interest
Example 2. Reporting member self-charged interest: J and E are equal members in L LLC (a calendar-year LLC), which is classified as a partnership for federal taxes. On Jan. 1, J loans L $40,000 and is paid $6,000 of interest during the year. E loans L $100,000 on Jan. 1 and is paid $15,000 of interest during the year. The total interest expense of $21,000 is allocated $10,500 to J and $10,500 to E. The loan proceeds are used as follows:
- $60,000 is invested in a rental real estate property managed and operated by a third party ($9,000 of interest expense is paid to the members with respect to these funds).
- $80,000 is invested in a stock car racing venture ($12,000 of interest expense is paid to the members with respect to these funds).
J is not active in any activity, but E materially participates in the stock car race business. Both LLC activities are passive to J. For E, however, only the rental real estate activity is passive.
Attached to J's
Schedule K-1 is the statement shown in Exhibit 1
determines his recharacterized self-charged interest
income as show in Exhibit 2 (also below). Accordingly,
J's $6,000 of self-charged interest income is
recharacterized as passive.
An electing large partnership is any partnership with at least 100 partners in any preceding tax year that makes an election to be treated as an electing large partnership. These rules also apply to LLCs taxed as partnerships, if the LLC meets the 100-member requirement. Generally, the rules for reporting income and loss to the members of an electing large LLC require fewer items to be separately stated to the members. The rules for electing large partnerships specifically provide that passive income and loss be reported separately to members (Sec. 772(a) and (d)(1)).
Special rules apply to the passive activity items of limited partners in an electing large partnership. An electing large partnership reports passive activity items to limited partners as if the partnership has only one passive activity. Consequently, items of income, loss, capital gain or loss, and AMT adjustments connected with multiple passive activities are reported as from a single activity. It is not clear if LLC members are treated as limited partners under the passive activity loss rules. An additional rule provides that the net capital gain of an electing large LLC is allocable to passive activities to the extent the net capital gain does not exceed net capital gains in connection with passive activities. A similar rule applies to net capital losses (Sec. 772(d)(4)(B)).
This case study has been adapted from PPC's Guide to Limited Liability Companies, 20th Edition, by Michael E. Mares, Sara S. McMurrian, Stephen E. Pascarella II, and Gregory A. Porcaro, published by Thomson Reuters/Tax & Accounting, Carrollton, Texas, 2014 ( 800-431-9025 ; tax.thomsonreuters.com).
|Albert Ellentuck is of counsel with King & Nordlinger LLP in Arlington, Va..|