Taxation Essentials of LLCs and Partnerships. Larry Tunnell

Unlike the LLP, which is a general partnership that registers in the LLP form, an LLLP is a limited partnership in structure that registers with the state in LLLP form. Therefore, the primary difference between an LLLP and the more familiar LLP is the extent to which the partners participate in management. An LLLP is essentially a limited partnership in which all partners, including the general partner(s), have limited liability. Therefore, unlike an LLP, not all partners in an LLLP can participate in management. All do, however, have limited liability for losses incurred as a result of the actions of other partners.

A final type of entity which can be treated for tax purposes as a partnership is the limited liability company (LLC). An LLC, like an LLP or LLLP, extends liability protection to all partners without requiring that they forfeit their ability to participate in management or act as the firm's representative in dealings with parties outside the partnership. Moreover, LLCs, like general partnerships, can elect to be taxed as either partnerships or corporations (including S corporations). In all states and the District of Columbia, an LLC can exist with only one owner. In contrast, LLPs and LLLPs, like all other partnerships, are required to have two or more partners.³

      Knowledge check

      1 Which is not a difference between a limited liability company and a limited liability partnership?An LLC, unlike an LLP or LLLP, can exist with only one owner.All members of an LLC have limited liability, without requiring that they forfeit their ability to participate in management.An LLC has members rather than partners, and does not have a general partner.An LLC does not have a general partner.

       Example 1-4

Bonnie and Roy started a delivery service last year, which they organized as a limited liability company. This year, one of their drivers was driving recklessly and caused an accident. Although the company can be sued, and all its assets forfeited in the resulting lawsuit, Bonnie and Roy's personal assets will be protected because they were not personally involved in the accident. Therefore, like limited partners (or corporate shareholders), the couple's risk of loss is limited to their net investment in the company. Assets held outside the company are not subject to claims against the company.

      Knowledge check

      1 What is the difference between a limited partnership and a limited liability limited partnership?Limited partners in a limited partnership do not participate in management, whereas those in a limited liability limited partnership do.General partners in a limited liability limited partnership have limited personal liability.All the partners in a limited liability limited partnership have more protection from the liabilities of the partnership than in a limited partnership.Limited partners in a limited liability limited partnership have limited personal liability.

      Layers of taxation

From a tax perspective, the primary benefit of forming as a partnership (or an LLC treated as a partnership) rather than a corporation is that partnership income is subject to only one layer of taxation at the federal level.⁴ Partnership income is allocated to the partners each year and taxed on their returns. It is important to note that partners must pay tax on their shares of partnership income whether or not that income is distributed to them. Indeed, because partnership or LLC income is taxed to the partners or investors as it is earned by the entity, subsequent distributions of that income are tax-free. This scheme is quite unlike the corporate tax system in which corporate income is taxed at the corporate level, and subsequent distributions of that income are taxed again to the shareholders as dividend income.

       Example 1-5

Dawn is a one-half partner in Sunrise Partnership. This year, the partnership reported taxable income of $100,000, of which Dawn's share was $50,000. The partnership made monthly distributions to Dawn of $2,000 ($24,000 total). When Dawn files her individual tax return for the current year, she will include her $50,000 share of the partnership's income (on Schedule E of her Form 1040). The distributions will not affect her taxable income. Therefore, her involvement with the partnership will increase her taxable income by her full $50,000 share of partnership income, even though only $24,000 of this income was distributed to her during the year. In effect, the remaining $26,000 of undistributed taxable income has been reinvested by Dawn in the partnership's business activities.

      Losses also flow through to the partners and can be deducted by them on their own tax returns. Again, this is a departure from the corporate tax scheme, in which losses can be carried forward to offset future corporate income but provide no tax benefits until actually offset against positive corporate taxable income. In contrast, partnership losses are reported by the partners on their own tax returns, and if deductible, provide immediate tax benefits in the form of a reduced tax burden on the partners' other income in the year of the loss.

       Example 1-6

      Robert is an attorney with current-year income from his law practice of $175,000. In addition, he owns a 25% general partnership interest in an oil and gas partnership. The oil and gas partnership drilled a number of dry holes this year and reported a net taxable loss of ($200,000). Robert's one-fourth share of this loss is ($50,000). Assuming his share of the loss is fully deductible, and that he is in the 35% tax bracket this year, the loss will reduce his current-year tax liability by $17,500 ($50,000 × 0.35). He does not have to carry the loss forward to be offset against partnership income which may be reported in a future year. Rather, he can deduct the loss this year against his other business or personal income. As a result, he receives the full benefit of the partnership loss in the current year, when the loss was actually incurred.

      Flexibility

Another important advantage of the partnership and LLC form of business is its flexibility. Unlike the corporate form of organization, in which each share of stock (within classes) must provide for its owner an identical interest in the corporation's assets and income, investors in a partnership or LLC can share in entity assets, or entity income, in any way they see fit. Investors' interests in different partnership assets or activities may differ, and these differences may change from one year to the next.

       Example 1-7

J, D, and R are individual general partners in an oil and gas drilling partnership. The partners each own one-third of the first well drilled by the partnership, which was successful. However, when D and R wanted to invest a portion of the income from well 1 to drill an additional well on an adjacent property, J opted not to participate. As a result, he or she has no interest in the second well, or in any income generated by that well. That is, J has a one-third interest in the first well and zero interest in the second one. D and R each have one-third interests in the first well, and one-half interests in the second well. If the partners decide to drill a third well, they may have still different interests in that well. They might even decide to bring in another partner to the partnership to participate in drilling the third well, and the new partner may or may not be allowed to share in the profits associated with the first two wells. Each partner's share of partnership profit or loss in each property will be governed by the partnership agreement signed by all the partners. This agreement can be changed with the consent of the partners, and the sharing ratios of the partners can be revised after the fact. This degree of flexibility would be very difficult to obtain if the company had been organized as a corporation and would not be possible at all if the corporation opted to be taxed