Note that Proposed Reg. Sec. 1.1402(a)-2(h) have expired and to date the IRS has not issued new regulations regarding the classification of investors in LLCs. However, the expired regulations do give us some guidance regarding the IRS opinion in these matters.
A, B, and C are members of an LLC that has elected to be taxed as a partnership for federal income tax purposes. The LLC is not a service partnership as defined in the proposed regulations under Section 1402. A and B each own one unit in the LLC; C owns two units. Therefore, A and B are each entitled to share in 25% of the company's profits and losses, but C receives 50%. In addition, B and C perform services on behalf of the LLC. B worked 600 hours in the current year, but C worked 1,000 hours. C, as the managing “partner” of the LLC, has the authority under state law to contract on the LLC's behalf. B and C each received guaranteed payments from the LLC as compensation for services rendered. None of the members has personal liability for entity debts or claims against the entity.
The proposed regulations provide that A, who is not authorized to contract on behalf of the LLC, does not provide services to or on behalf of the LLC, and has no personal responsibility for LLC debts, will be treated as a limited partner. Therefore, his or her distributive share of LLC ordinary income will be excluded from his or her net earnings from self-employment.
Likewise, B will also be classified as a limited partner. Although B performed more than 500 hours of service for the LLC, he or she is not authorized to contract on the LLC's behalf and is not personally liable for LLC debts. Moreover, his or her rights and obligations as a member of the LLC are identical to A's. Because A's interest in the LLC is substantial, and A is treated as a limited partner, B will also be treated as a limited partner. His or her distributive share of LLC income will not be subject to SE tax, although the amounts received as guaranteed payments for services rendered to the LLC will be subject to SE tax.
Unlike A and B, C will not be treated as a limited partner, because he or she has the authority to contract on behalf of the LLC. Accordingly, both his or her distributive share of LLC ordinary income and any amounts received as guaranteed payments for services rendered to the LLC will be classified as earned income.18
These rules appear to be consistent with proposed regulations under IRC Section 469 issued in November 2012. Proposed Reg. Sec. 1.469-5(e)(3)(i) change the rules for determining whether an LLC member should be treated as a limited partner for purposes of the passive loss limitations. Unlike the existing regulations under IRC Section 469, which base the determination of limited partnership status on the issue of whether the partner or LLC member enjoys limited liability for the entity's activities, the proposed regulations base this determination instead on the LLC member's right to “manage” the entity.19 Presumably, an LLC member should be classified consistently regardless of the statute under which his or her status is being evaluated. Therefore, a member of an LLC who does not have the right to participate in management is properly classified as a limited partner whose allocable share of LLC losses will be subject to the passive loss limitations of IRC Section 469, but whose allocable share of profits will not be subject to self-employment taxes. In contrast, if the member does have the right to participate in management (whether or not exercised), his or her allocable share of LLC losses will not be subject to the passive loss limitations and any allocable share of LLC profits will be subject to SE taxes.
Notes
1 1 In many states, only a limited shield of liability protection is available to partners in LLPs. That is, liability protection is available only against losses attributable to acts committed by other partners. In these states, LLP partners retain full, unlimited personal liability for acts of the partnership (for example, defective performance) or acts of non- partner employees of the partnership. This is a primary reason for the popularity of LLCs, which generally carry a full liability shield for owners against liability for acts committed by others, whether or not they have equity stakes in the company.
2 2 Alabama, Alaska, Arizona, Arkansas, Colorado, Delaware, District of Columbia, Florida, Georgia, Hawaii, Idaho, Illinois, Iowa, Kansas, Kentucky, Maine, Maryland, Minnesota, Missouri, Montana, Nevada, New Mexico, North Carolina, North Dakota, Ohio, Oklahoma, Pennsylvania, Rhode Island, South Dakota, Tennessee, Texas, Virginia, Washington, Wyoming, and the U.S. Virgin Islands allow firms to organize in the LLLP form. Although LLLPs cannot be formed in California, those formed in other states are recognized in California.
3 3 A single-owner LLC will not be taxed as a partnership. It is a disregarded entity and will instead be treated as a sole proprietorship, or if owned by a corporation, as a division of the corporation. However, the legal protection afforded to members of an LLC will be available to a single-owner LLC as well, allowing the sole proprietor to receive limited liability protection similar to that of a corporate shareholder without paying corporate income tax.
4 4 An LLC is taxed as a partnership at the federal level unless an election is made to be taxed as a corporation. How the entity is taxed at the state level will depend upon the state(s) in which it is operating.
5 5 By law, an S corporation can have only one class of stock and each share of that stock must have an equal interest to all the other shares in every item of S corporation income, loss, credit, and the like. Section 1361(b)(1)(D).
6 6 The regulations actually identified six corporate characteristics: two or more associates, profit motive, free transferability of interests, limited liability, unlimited life, and centralized management. However, the regulations noted that the first two of these characteristics (associates and profit motive) were common to both partnerships and corporations, and so based the classification criteria on the remaining four characteristics. If the entity possessed more than two of these four remaining characteristics, it was classified as a corporation for federal income tax purposes.
7 7 Note that certain publicly traded partnerships are classified as corporations for federal income tax purposes, regardless of their preference under the check-the-box rules. A publicly traded partnership is one which conducts an active trade or business and the shares of which are traded on an established securities market or a secondary market. See IRC Section 7704 of the Internal Revenue Code and the Treasury Regulations thereunder.
8 8 In some cases, an entity which technically constitutes a partnership may desire not to be recognized as such for federal income tax purposes. Reg. Sec. 1.761-2 provides that such entities can elect not to be taxed as partnerships (and therefore avoid having to file a partnership tax return) if they are formed for investment purposes (rather than to conduct joint business activities) or for the joint production, extraction or use of property, but for the purposes of selling services or property produced or extracted.
9 9 See Reg. Sec. 301.7701-3(g).
10 10 One important exception will apply where one or more partners have a deficit balance in their capital accounts as of the date of the deemed liquidation of the partnership. Partners with deficit capital balances