Ensuring that allocations of LLC tax items are respected

Allocations of limited liability company (LLC) tax items (assuming the LLC is classified as a partnership for federal income tax purposes) must be made under one of two allocation methods to be valid under Sec. 704(b) and the related regulations (Regs. Sec. 1.704-1(b)(1)(i)):

• The allocations must be in accordance with the members’ interests in the LLC (technically called PIP — for partners’ interests in the partnership); or
• The allocations must be made in accordance with the substantial-economic-effect safe-harbor rules.

These two methods of validating allocations are separate alternatives. The tax allocations need not have substantial economic effect; it is only necessary that the tax allocations be in accordance with the PIP. The substantial-economic-effect rules are strictly a safe harbor.

Substantial-economic-effect safe harbor

Because the rules for determining members’ interests in the LLC are broad and general, the regulations provide an alternative safe harbor — the substantial-economic-effect rules — with which an LLC can comply. These safe-harbor allocation rules contain the capital account bookkeeping rules for recording the economic (not tax) results of LLC operations. Once the economic bookkeeping has been properly done, the allocation of tax results among the members must be made in a manner consistent with the allocation of the corresponding economic results.

For example, assume two equal members own LLC interests all year and have identical book capital accounts. If the operating agreement allocates the overall economic gain and loss between the two members 50/50, it cannot allocate the tax results differently. Likewise, if the members agree to specially allocate one item for economic purposes, they must allocate the associated tax results for that item in the same way.

Following the safe-harbor rules may require a considerable amount of additional recordkeeping and analysis to maintain separate book (economic) capital accounts and make required revaluations of LLC property and member capital accounts.

Certain tax allocations do not have any corresponding economic element. Examples include allocations of tax credits, percentage depletion in excess of cost, and deductions related to nonrecourse liabilities. Safe-harbor allocations of these items must be made in accordance with PIP under special rules set forth in Regs. Sec. 1.704-1(b)(3).

Sec. 704 is not the exclusive test for determining the validity and consequences of a tax allocation. Other tax principles also must be considered, such as whether the allocation involves an assignment of income, misallocation of income among related parties (see Sec. 482), LLC interests created by gift (including a purchase by a family member) (see Sec. 704(e)), employee compensation (see Secs. 83 and 707(a)), a gift (see Sec. 2501), or a sale (see Secs. 707(a) and 1001). In other words, while an allocation may satisfy the Sec. 704(b) rules, other Code sections and related IRS guidance may still affect the tax treatment of that allocation.

Economic substance requirement and anti-abuse regulations

Not only must an LLC member have a profit motive in entering into an LLC arrangement, but the LLC transactions themselves must also have economic substance. Otherwise, the IRS can disregard the LLC for tax purposes. Furthermore, the IRS has the authority to recast a transaction if the LLC violates the anti-abuse regulations.

Anti-abuse regulations

A purported LLC can be disregarded, in whole or in part, if the LLC is formed or availed of in connection with a transaction having a principal purpose of substantially reducing the present value of the members’ aggregate federal tax liabilities and the transaction is inconsistent with the intent of Subchapter K (the partnership section of the Internal Revenue Code). The intent of Subchapter K is set forth in five tests, all of which must be met (Regs. Sec. 1.701-2(a)):

• The entity must be bona fide;
• Each transaction must have a bona fide and substantial business purpose;
• The transaction must be respected under substance-over-form principles;
• The tax consequences must accurately reflect the members’ economic agreement; and
• The tax consequences must clearly reflect the members’ income.

Failure to pass these tests opens the door for the IRS to disregard transactions, disregard one or more members, disregard the LLC, or otherwise ignore or change the transactions to reflect reality.

The regulations also give the IRS the power to treat any LLC as an aggregate of the members, in whole or in part, if necessary to carry out the purpose of a Code provision or regulation (Regs. Sec. 1.701-2(e)).

In Countryside Limited Partnership, T.C. Memo. 2008-3, however, the Tax Court denied the IRS’s attempt to use the economic substance doctrine and the anti-abuse regulations to recharacterize a partnership transaction. The case involved a liquidating distribution that was structured to defer tax by distributing property rather than cash to the partners. The partners conceded that tax avoidance was the sole motivation for the structure of the transaction. However, the court found that the transactions had economic substance and the anti-abuse regulations could not be applied. While the employed means were designed to avoid recognition of gain by the liquidated partners, those means served a genuine, nontax business purpose (i.e., to convert the liquidated partners’ investments in Countryside into 10-year promissory notes, an economically distinct form of investment).

Particular attention should be paid to LLCs involving related parties, since one of the facts and circumstances that the IRS will scrutinize involves related parties. However, the regulations point out that all of the facts and circumstances must be considered in determining the validity of the transaction. No special weight should be given to the presence or absence of any particular factor.

Regs. Sec. 1.704-3(a)(10) provides that the anti-abuse regulations take into account the tax liabilities of both the members of the LLC and certain direct and indirect owners of those members. Regs. Sec. 1.704-3(a)(10)(ii) provides that indirect owners include any direct or indirect owner of a partnership, an LLC classified as a partnership or as an S corporation, an S corporation, or a controlled foreign corporation that is a member in the LLC. Also included are a direct or indirect beneficiary of a trust or estate that is a member in the LLC and any consolidated group of which the member in the LLC is a member.

Example. Application of the anti-abuse regulations: K, B, and J, all brothers, form the M LLC to operate a restaurant. The LLC is classified as a partnership. K, B, and J each contribute one-third of the LLC’s capital. J has had some serious financial problems and has $500,000 of net operating losses (NOLs) that are about to expire. The LLC’s operating agreement provides that all members are to receive a $35,000 guaranteed payment and that J is to then receive 80% of the net income or loss for managing the restaurant, with K and B each receiving 10%. The goal is to make the business profitable, then sell to a national chain. The profits on the sale will be split equally.

These LLC allocations may be challenged by the IRS. First, the allocations are suspect because the parties are related and most of the income is allocated to J, who is effectively exempt from tax by virtue of the large NOL. This substantially reduces the present value of the taxes due from what it would be if the profits were allocated equally. Additionally, the stated goal is to eventually sell the restaurant, at which time all of the parties will share the profit equally.

The IRS, by invoking the anti-abuse regulations, could reallocate the income to the members or treat J as an employee (or independent contractor) rather than a member.

Economic substance doctrine

The economic substance doctrine is a common law doctrine under which tax benefits related to a transaction are disallowed if the transaction does not have economic substance or lacks a business purpose. Although the doctrine originated in case law, Sec. 7701(o) codifies it. Sec. 6662 imposes an accuracy-related penalty on transactions that lack economic substance. The codified rules apply only to transactions to which the economic substance doctrine is “relevant.” Sec. 7701(o)(5) provides that the determination of whether the doctrine is relevant to a transaction or series of transactions is made as if the Code section had never been enacted, in other words, under the old rules.

Sec. 7701(o)(1) provides that a transaction is treated as having economic substance only if (1) the transaction changes in a meaningful way the taxpayer’s economic position beyond tax benefits (objective test) and (2) the taxpayer has a substantial nontax business purpose for entering into the transaction (subjective test). Changes in the taxpayer’s federal and/or state and local taxes (including financial accounting benefits originating from a reduction of income taxes) are not considered meaningful and do not constitute a substantial purpose.

A transaction’s potential for profit can be taken into account to determine its economic substance only if the present value of the reasonably expected pretax profit from the transaction is substantial in relation to the present value of the expected net tax benefits that would be allowed if the transaction were respected. Fees and other transaction expenses must be taken into account to determine pretax profits.

In Sala, 613 F.3d 1249 (10th Cir. 2010), which was decided soon after Sec. 7701(o) was enacted but does not mention that provision, the Tenth Circuit held that “an investment program that included an initial phase designed primarily to generate a tax loss so as to offset over $60 million in income [the taxpayer] earned during the 2000 tax year” lacked economic substance. The loss “was structured from the outset to be a complete fiction” because the transaction was designed to create a tax loss that would almost entirely offset the taxpayer’s 2000 income “with little actual economic risk.” Furthermore, the taxpayer was aware that the partnership would have to be liquidated by year end to generate a large enough tax loss to offset his income.

Observation: Sala is important because it is an appellate decision and because it addresses many of the issues underlying Sec. 7701(o). While the district court found the long and short options had a profit potential of $550,000 over a one-year period, the expected tax benefit was nearly $24 million, which “dwarf(ed) any potential gain from” the taxpayer’s participation in the transaction. Furthermore, any economic benefit from participating in the transaction for a few weeks, and then liquidating the partnership by year end, was negligible in comparison to the $24 million tax benefit.

The economic substance doctrine has been used in several other cases to deny taxpayer losses. For example, in Fidelity International Currency Advisor A Fund LLC, 661 F.3d 667 (1st Cir. 2011), a transaction involving the contribution of offsetting options to a partnership, where the purchased option was treated as an asset and the sold option was not treated as a liability, was deemed to have no economic substance. Similarly, in Nevada Partners Fund, LLC, 720 F.3d 594 (5th Cir. 2013), the “sale” of suspended losses largely resulting from foreign currency transactions was deemed to have no economic substance. The court held that any profits the taxpayer would recognize from the series of transactions were insignificant in relation to the tax benefits generated.

The Third Circuit overturned a Tax Court decision that originally found economic substance in a transaction involving rehabilitation credits (Historic Boardwalk Hall, LLC,694 F.3d 425 (3d Cir. 2012)). The Tax Court determined that an LLC formed by New Jersey Sports and Exposition Authority (NJSEA) and an investment corporation allowed the corporate member to invest in the rehabilitation of a historic hall and obtain rehabilitation credits under Sec. 47. The Tax Court found economic substance to the transaction because the corporation did not become a member of the LLC solely for the tax credits but also to invest, with the realistic possibility of earning a profit. The corporate member’s investment provided NJSEA with more money than it otherwise would have had; the development fee involved was a legitimate expense; and real risks were involved. The Tax Court also felt that the members had a common rehabilitation goal and would receive a net economic benefit if the project proved successful.

The appeals court, however, found that the overall facts and circumstances showed the intent of the transaction was the sale and purchase of rehabilitation tax credits. The corporation was not in substance a member because it had no downside risk of investment due to the operative agreements and associated tax benefit guaranty in place. Similarly, there was no upside to the corporation’s investment. Consequently, in substance, the corporation was not a bona fide member because it had no meaningful stake in either the LLC’s success or failure.

Notice 2010-62 states that the IRS will continue to rely on relevant case law in applying the two-prong test in Sec. 7701(o)(1) and in determining if the transaction’s potential for profit is taken into account in determining economic substance. Notice 2014-58 provides additional guidance regarding the definition of “transaction” for applying the economic substance doctrine under Sec. 7701(o).

This case study has been adapted from PPC’s Guide to Limited Liability Companies, 26th edition, by Michael E. Mares, Sara S. McMurrian, Stephen E. Pascarella II, and Gregory A. Porcaro, published by Thomson Reuters/Tax & Accounting, Carrollton, Texas, 2020 (800-431-9025; tax.thomsonreuters.com).