Chapter I

Check-the-Box Classification System

Effective January 1, 1997, the Internal Revenue Service (the “Service”) promulgated
regulations which allowed multi-member limited liability companies (“LLCs”) to be
treated as a partnership or as an association taxed as a corporation for federal income tax
purposes.1 For single-member LLCs, such could elect to be treated as a sole
proprietorship or as an association taxed as a corporation.2 These regulations came to be
known as the “check-the-box” regulations. As a result of the promulgation of these
regulations, taxpayers need no longer engage in the analysis of the corporate
characteristics as set forth in former Treas. Reg. § 301.7701-2.

Section I.1Historical Corporate Classification Analysis.

Prior to the check-the-box regulations, the taxpayer was required to look to various
sections of the Internal Revenue Code3 and the regulations (the “Kintner regulations”) to
determine the proper classification of an entity, be it a corporation, a partnership, or a
sole-proprietorship. With many taxpayers preferring partnership classification, thus
avoiding the double-taxation of corporate classification, the game became an attempt to
infuse as many corporate attributes into the entity without actually causing the entity to
be treated as a corporation. Treasury Reg. § 301.7701-2 listed six attributes: (i) the
presence of associates, (ii) an objective to carry on a business for the purpose of dividing
the resulting gains, (iii) continuity of life, (iv) centralized management, (v) limited
liability and (vi) free transferability of interests. With the first two inherent in both
partnerships and corporations, the focus turned to the final four.

Pursuant to Service Notice 97-1,4 the Service declared the Kintner regulations to be
obsolete to the extent they conflicted with the contemporaneously promulgated “check-
the-box” regulations.

1
Treas. Reg. § 301.7701-1 to -3; T.D. 8697, 1997-1 C.B. 215.
2
Treas. Reg. § 301.7701-1(a)(4).
3
The Internal Revenue Code of 1986, as amended, and hereinafter the “Code”.
4
I.R.B. 1997-2, at 22.
Section I.2Federal Check-the-Box Regulations

Generally, the check-the-box regulations permit entities to elect to be treated as an

association taxed as a corporation, or with pass-through tax treatment, i.e., a partnership
or a sole-proprietorship.

Section I.1Per Se Corporate Entities.

An exception exists for certain ineligible entities, which are treated as per se corporations
for federal tax purposes. Such ineligible entities include the historically corporate entities,
such as a corporation formed pursuant to the state laws of the United States, a Canadian
corporation, the British public limited company, and Brazil’s sociedade anônima, among
many others. These per se entities are listed by the regulations.5

Foreign entities which are on the per se list but which were not treated as corporations
prior to May 8, 1996 are grandfathered with the prior entity classification.6 However,
should the partnership status of such entity ever cease, such entity forfeits its
grandfathered status and is thereafter treated as a corporation by the Code.7

Section I.2Eligible Entities

In contrast, entities which do not appear on the per se list may choose their federal tax
classification via a simple election.8 A sole-member LLC may therefore elect to be treated
as an association taxable as a corporation, or as a sole proprietorship which is disregarded
as an entity separate from its owner (a “Disregarded LLC”). Similarly, an LLC with two
more members may elect to be treated as either an association taxable as a corporation (a
“Corporate LLC”)9 or as a partnership (a “Partnership LLC”). Absent the taxpayer’s
election, the regulations treat a sole-member LLC as a sole proprietorship which is

5
Treas. Reg. § 301.7701-2(b)(8).
6
Treas. Reg. § 301.7701-2(d).
7
Treas. Reg. § 301.7701-2(d)(3).
8
Treas. Reg. § 301.7701-3.
9
Similarly, the members may elect to be treated as a subchapter S corporation by filing Form 2553 (see
Appendix B) Recently, the filing of a Form 2553 by the members of an LLC is sufficient to also elect to tax
such LLC as an association taxable as a corporation, making the filing of Form 8832 superfluous.
disregarded as an entity separate from its member10 and a multi-member LLC as a
partnership.11 Thus, an entity which prefers the default classification need do nothing.
Therefore, while Texas law treats an LLC as an entity separate from its owners, which
provides the owners of the LLC benefits for general liability purposes, under federal tax
law the LLC is essentially one and the same as the owners – funneling all tax
consequences directly to the LLC owners. The reasoning behind such default treatment
lies with the assumption that LLCs are typically formed with the intent to obtain
partnership tax treatment, and avoid corporate double taxation.12

In the case of foreign entities, the default treatment turns on whether there is limited
liability.13 Thus, where an eligible foreign entity has limited liability, absent an election
by such entity it is treated as an association taxable as a corporation for federal tax
purposes. The regulations define limited liability as whether “the member has no personal
liability for the debts of or claims against the entity by reason of being a member.” 14
Where the “underlying statute or law allows the entity to specify in its organizational
documents whether the members will have limited liability, the organizational documents
may also be relevant” in determining the default classification.15 Obviously, whenever
there is any doubt as to the default classification the taxpayer should elect classification,
rather than leave it open to the Service’s interpretation.

An entity makes its election by filing Form 8832, the “Form 8832—Entity Classification
Election,” attached as Appendix A.16 Either each member of the LLC must sign the Form
8832, or consent to the election with such consent manifest via execution by an officer,
manager or member of the LLC authorized to make the election under penalty of
perjury.17 For retroactive filings, each person who was a member between the effective

10
Treas. Reg. § 301.7701-3(b)(1)(ii).
11
Treas. Reg. § 301.7701-3(b)(1)(i).
12
Notice 95-14, 1995-1 C.B. 297 (Mar. 29, 1995).
13
Treas. Reg. § 301.7701-3(b)(2).
14
Treas. Reg. § 301.7701-3(b)(2)(ii).
15
Id.
16
Treas. Reg. § 301.7701-3(c)(1)(i).
17
Treas. Reg. § 301.7701-3(c)(2).
date and the date the Form 8832 is filed must also sign the election form.18 Until recently,
where the LLC was required to file a tax or information return, it was also required to
attach a signed copy of the Form 8832 to such return. For LLCs that were not required to
file a return, any direct or indirect owner was required to attach a copy of the signed form
to his income tax or information return. As a result of the Service’s desire to facilitate
electronic filing, Treas. Reg. §301.7701-3T permits the Form 8832 to be unsigned. While
failure to attach the required copy of Form 8832 to the appropriate return does not
invalidate an otherwise valid election, the Service may impose penalties.19

The effective date is that specified on the Form 8832 or, in the absence of a specified
date, on the date of filing. A specified date must be no more than 75 days before, or
twelve months after, the date of filing. If an election specifies an effective date more than
75 days prior to the date on which the election is filed, it becomes effective 75 days prior
to the date it was filed. If an election specifies a date more than twelve months after the
date of filing, the effective date is that date which is twelve months after filing. 20

(i)Changes in the Number of Members of an Eligible Entity

If the number of members of an entity changes, the entity classification is generally

unaffected.21 Thus, when an eligible entity taxed as an association falls to one member, it
retains its classification.22 There is no state-law statutory concern in the case of a Texas
LLC as state law recognizes single-member LLCs.23 Similarly, where an eligible entity is
taxed as a partnership and it falls to one member, it is still taxed as a pass through, only it

18
Treas. Reg. § 301.7701-3(c)(2)(ii). Interestingly, the regulations do not specify whether persons who are
no longer members at the time of filing of the Form 8832 can authorize an officer, manager or member to
sign on his behalf. Therefore, it seems prudent to obtain the signature of all such members in the case of a
retroactive filing.
19
Treas. Reg. §301.7701-3T.
20
Treas. Reg. § 301.7701-3(c)(1)(iii).
21
Treas. Reg. § 301.7701-3(f).
22
Treas. Reg. § 301.7701-3(f)(1).
23
“A limited liability company may have one or more members. Except as provided by this section, a
limited liability company must have at least one member.” V.T.C.A., Business Organizations Code §
101.101.
changes from a partnership to a “single member entity disregarded as an entity separate
from its owner.”24

(ii)Election to Change Classification

An eligible entity may also elect to change its classification, provided such election is not
made more than once per any 60-month period.25 If an LLC makes an election to change
its classification, it cannot make another change of such classification within sixty
months following the original election’s effective date.26 However, the Service may
permit the entity to change its classification by election within sixty months of a change
of classification if the members holding more than fifty percent of the ownership interests
in the entity as of the effective date of the subsequent election are owned by persons that
did not own any interests in such entity on both the filing date and on the effective date of
the prior election.27 For the purposes of this rule, a change in the number of members of
an entity does not result in the creation of a new entity. 28 Because members both before
and after the change in classification of an entity are affected by the deemed transactions,
the entity must acquire approval of all such members for the change in classification to be
effective.29

Where an election to change the classification of an entity occurs, the tax consequences
take effect at the start of the effective date of such election is effective.30 Any transactions
that are deemed to occur as a result of the change in classification are treated as occurring
immediately before the close of the day before the effective date of the election. For
example, if an election is made to change the classification of an association to a
partnership effective January 1, the deemed transactions specified in the regulations, as
referred to below, are treated as occurring immediately before the close of business on

24
Treas. Reg. § 301.7701-3(f)(2).
25
Treas. Reg. § 301.7701-3(c)(1)(iv).
26
Id.
27
Id.
28
Treas. Reg. § 301.7701-3(f)(3).
29
See Treas. Reg. § 301.7701-3(c)(2)(iii).
30
Treas. Reg. § 301.7701-3(g)(3)(i).
December 31. Thus, the last day of the association’s taxable year will be December 31,
and the first day of the partnership’s taxable year will be January 1.31

Treasury Reg. § 301.7701-3(g)(2) further provides that the tax treatment of an elective
change in classification “is determined under all relevant provisions of the Internal
Revenue Code and general principles of tax law, including the step transaction doctrine.”
Thus, the check-the-box regulations preserve the tax consequences of an elective change
such that the taxpayer is taxed had he actually taken the steps described by the
regulations.

a.Qualified Stock Purchase

Where a corporation makes a qualified stock purchase of an eligible entity, it may make
an election to change the classification of the target eligible entity provided it otherwise
meets Code § 338. If it makes this election, the transactions deemed to occur pursuant to
the Treas. Reg. § 301.7701-3(g) are deemed to occur immediately after the deemed asset
purchase by the new target corporation under Code § 338.32

b.Tiered Situations

Where elections under the regulations for a series of tiered entities are effective on the
same date, the eligible entities may specify the order of the elections on Form 8832. If no
order is specified for the elections, any transactions that are deemed to occur under the
regulations as a result of the classification change are treated as occurring first for the
highest tier entity’s classification change, then for the next highest tier entity’s
classification change, and so forth down the chain of entities until all the transactions
deemed to occur.33

31
Id.
32
Treas. Reg. § 301.7701-3(g)(3)(ii).
33
Treas. Reg. § 301.7701-3(g)(3)(iii).
Section I.3Texas Conversion.
Texas permits an entity organized under the laws of Texas to convert to another form of
entity, what could be viewed as the Texas “check-the-box” election34 (or a “Texas
Conversion”), by simply making a filing with the Texas Secretary of State. Thus, a Texas
LLC can elect to be treated as a partnership, or any other entity, by following the
statutory requirements of V.T.C.A. Business Organizations Code § 10.101. 35 This statute
offers significant advantages over the traditional use of a merger or conveyance of assets:
(i) in the case of a merger there is no need to form a second entity; and (ii) in the case of a
conveyance of assets there is no need to convey or assign the assets and liabilities to a
new entity. Arguably, there would be no need to obtain consent of any third party for the

34
This is not to be confused with the federal check-the-box regulations which permit an entity to elect
different tax treatment. In the case of statutory conversions pursuant to Texas law, the entity actually
converts from one legal entity form to another, taking with it the tax consequences of the entity it converts
into. Thus, a partnership converting to a corporation will be treated as a corporation for all state law
purposes, including the Texas franchise tax.
35
V.T.C.A. Business Organizations Code § 10.101 reads as follows:

CONVERSION OF DOMESTIC ENTITIES. (a) A domestic entity may convert into a

different type of domestic entity or a non-code organization by adopting a plan of
conversion.

(b) To effect a conversion, the converting entity must act on and the owners or members
of the domestic entity must approve a plan of conversion in the manner prescribed by this
code for the approval of conversions by the domestic entity or, if not prescribed by this
code, in the same manner as prescribed by this code for the adoption and approval of a
plan of merger by the domestic entity when the domestic entity does not survive the
merger.

(c) A domestic entity subject to dissenters’ rights must provide the notice required by
Section 10.355.

(d) A conversion may not take effect if the conversion is prohibited by or inconsistent
with the laws of the converted entity’s jurisdiction of formation, and the formation,
incorporation, or organization of the converted entity under the plan of conversion must
be effected in compliance with those laws pursuant to the plan of conversion.

(e) At the time a conversion takes effect, each owner of the converting entity, other than
those who receive payment of their ownership or membership interest under any
applicable provisions of this code relating to dissent and appraisal, has, unless otherwise
agreed to by that owner or member, an ownership or membership interest in, and is the
owner or member of, the converted entity.

(f) A domestic entity may not convert under this section if an owner or member of the
domestic entity, as a result of the conversion, becomes personally liable, without the
consent of the owner or member, for a liability or other obligation of the converted entity.
transfer of assets and filings, with such considered to be owned or filed by the converted
entity by operation of law.

Unfortunately, the Service has failed to provide guidance on the tax consequences of
making a Texas Conversion. However, it stands to reason that the same rules promulgated
under the check-the-box regulations would follow. Thus, where a Texas Partnership LLC
elects to convert to a Texas partnership, presumably as an “eligible entity” it retains the
same tax classification of a partnership.

Similarly, where a Texas Corporate LLC elects to convert to a Texas partnership, it could
retain the same tax classification, only it would likely be required to file a Form 8832 to
protect such classification (as the default rules for a partnership is to treat such entity as a
partnership for federal tax purposes). Concerning the tax consequences on such
conversion, presumably the conversion would qualify as a type “F” reorganization under
Code § 368(a)(1)(F), such that the transaction is tax free for both federal and state tax
purposes.

Where a Texas Corporate LLC converts to a Texas corporation, it would no longer

qualify as an eligible entity having adopted the form of a per se entity, and presumably
would be taxed as a corporation for federal tax purposes.

Chapter II
State Tax Classification

In contrast to the Code and the regulations promulgated thereunder, Texas treats all
limited liability companies as a corporate-type of entity for purposes of the state franchise
tax.36 Texas ignores both the historical corporate attributes, as well as the more recent
check-the-box elections.

36
Tex. Tax Code Ann. §171.001(a) which reads: “A franchise tax is imposed on: (1) each corporation that
does business in this state or that is chartered in this state; and (2) each limited liability company that does
business in this state or that is organized under the laws of this state.”
 Chapter III
Conversions from Other Entities

Obviously, tax consequences follow a change of entity classification, and the Service
provides for such treatment pursuant to Treas. Reg. § 301.7701-3.

Section III.1Effect of the Acquisition of an Interest in a Disregarded LLC

Where a person purchases an interest in a Disregarded LLC and the seller retains an
interest in the Disregarded LLC, whether or not the seller recognizes gain or losses
depends on the transaction. Furthermore, the regulations deem certain transactions to
have occurred. If the seller accepts property from the buyer and does not contribute that
property to the Disregarded LLC, the seller will recognize gain or loss. However, if the
buyer contributes the property to the Disregarded LLC, with such consideration
remaining inside the Disregarded LLC, no gain or loss is recognized. See Treas. Reg. §
301.7701-3(f)(2) and Revenue Ruling 99-5.37 The transactions are deemed to occur as of
the date it has more than one member.38

Section I.3Seller Retains Consideration

37
1999-5 I.R.B. 8.
38
Treas. Reg. § 301.7701-3(f)(2).
In the case of consideration being given to the seller for an interest in a Disregarded LLC,
Situation 1 of Revenue Ruling 99-5 provides that the buyer is assumed to purchase a pro
rata share of the Disregarded LLC’s assets directly from the seller (with the situation
using a purchase amount of 50%), followed by a contribution of those assets by each
party to a converted Partnership LLC. Pursuant to Code § 1001, the seller recognizes gain
or loss on the deemed sale of his 50% share in each asset sold to the buyer. Under Code §
721(a), neither the buyer nor the seller recognizes gain or loss on the transfer of the assets
to the Partnership LLC. Code § 722 provides that the buyer’s basis in the Partnership
LLC is the purchase price, while the seller’s basis is 50% of the former Disregarded
LLC’s assets. Under Code § 723, the basis of the contributed property in the Partnership
LLC is the basis of each partner immediately prior to contribution, with the holding
period by the seller in his partnership interest to include the holding period of the
contributed assets prior to the contribution, while the buyer’s holding period begins the
day following the date of the buyer’s purchase of 50% of the Disregarded LLC’s assets
pursuant to Code § 1231(1).39 The Partnership LLC’s holding period for its assets
includes the holding period of the seller and the buyer for those assets.40

Section I.4Target LLC Retains Consideration

In contrast, Situation 2 of Revenue Ruling 99-5 provides for no gain or loss by the seller.
The buyer’s contribution to the Disregarded LLC of property is treated as a contribution
to a new partnership (the Partnership LLC) in exchange for the buyer’s acquisition of an
interest in the Partnership LLC. Meanwhile, the seller is treated as having contributed all
of the Disregarded LLC’s assets (immediately prior to the buyer’s contribution) to the
Partnership LLC in exchange for an interest in the Partnership LLC. Code § 721(a)
provides that neither the buyer nor the seller recognize gain or loss. The buyer’s basis in
his Partnership LLC interest is the amount he contributed to the same, while the seller
takes a carryover basis of the Disregarded LLC assets which were contributed to the

39
See Rev. Rul. 66–7, 1966–1 C.B. 188 (providing that the holding period of a purchased asset is computed
by excluding the date on which the asset is acquired).
40
Code § 1223(2).
Partnership LLC.41 Under Code § 723, the basis of the contributed property in the
Partnership LLC is the basis of each partner immediately prior to contribution, with the
holding period by the seller in his partnership interest to include the holding period of the
contributed assets prior to the contribution, while the buyer’s holding period begins the
day following the date of the buyer’s purchase of 50% of the Disregarded LLC’s assets
pursuant to Code § 1231(1).42 The Partnership LLC’s holding period for its assets
includes the holding period of the seller and by buyer for those assets.43

Section III.2Effect of One Person Acquiring Sole Interest in a Partnership LLC

As explained previously, where an eligible entity is taxed as a partnership and it falls to

one member, it is still taxed as a pass through, with the shift from taxation as a
partnership to a single member entity disregarded as an entity separate from its owner.
The regulations deem certain transactions to have occurred. The tax treatment is different
depending on whether the acquisition is from a fellow member, or whether the
acquisition is by a person outside the Partnership LLC. The transactions are deemed to
occur as of the date the Partnership LLC falls to one member.44

Section I.5Acquisition of a Fellow Member’s Interest in a Partnership LLC

Where the transaction involves the purchase by one member of his fellow member’s
interest in a Partnership LLC, the Service treats the Partnership LLC as having terminated
via a liquidating distribution to each member, followed by a sale by the selling member
of his distributed assets to the buying member. The selling member recognizes gain or
loss on such sale,45 with the buying member receiving a step-up (or down if a loss) in
basis of the purchased assets.46

Regarding the Partnership LLC assets distributed to the buyer member, Code § 731(a)(1)
applies, requiring the buying member to recognize gain to the extent that money is
41
Code § 722.
42
See Rev. Rul. 66–7, 1966–1 C.B. 188.
43
Code § 1223(2).
44
Treas. Reg. § 301.7701-3(f)(2).
45
Code § 741.
46
See Rev. Rul. 99-6, 1995-5 I.R.B. 6, Situation 1.
distributed to the buying member in excess of his basis in his interest in the Partnership
LLC. The buying member potentially will recognize loss if solely money, unrealized
receivables and inventory are distributed, with a difference existing between the buying
member’s basis in his interest in the Partnership LLC and the value of such property
distributed.47 The buying member’s basis in the distributed assets is calculated pursuant to
Code § 732(b), which is defined as a carryover basis as reduced by any money distributed
to the buying member by the Partnership LLC. The buying member’s holding period for
these assets begins the day after acquisition.48 In contrast, the buying member’s holding
period for his one-half of assets deemed distributed to him in liquidation of his interest in
the Partnership LLC is tacked on to those assets as they are recontributed to the
Disregarded LLC.49

Section I.6Acquisition of All of the Members’ Interests in a Partnership LLC by a Third-

Person Buyer

Where a third-person buyer purchases all of the members’ interests in a Partnership LLC,
the Partnership LLC terminates and becomes a Disregarded LLC absent an election to the
contrary, applying Code § 708(b)(1).50 The members of the Partnership LLC are deemed
to cause a liquidating distribution of the Partnership LLC’s assets. The third-person buyer
is then treated as having purchased these distributed assets of the Partnership LLC, and
contributing such to a Disregarded LLC.51 The third-person buyer’s basis in these assets
is the fair value paid for such.52 Finally, the buying member’s holding period for these
assets begins the day after acquisition.53

Section III.3Conversion of an LLC To or From a Corporation

Treasury Reg. § 3301-3(g)(1) provides guidance as to the tax consequences of a

conversion of an LLC to or from a Corporate LLC. Any transactions that are deemed to
47
Code § 731(a)(2).
48
See Rev. Rul. 66–7, 1966–1 C.B. 188.
49
Code § 735(b).
50
See Rev. Rul. 99-6, Situation 2.
51
Id.
52
Code § 1012.
53
See Rev. Rul. 66–7, 1966–1 C.B. 188.
occur as a result of the change in classification are treated as occurring immediately
before the close of the day before the effective date of the election.54

Section I.7Partnership LLC to a Corporate LLC

Where a Partnership LLC elects to be classified as a Corporate LLC, the regulations

provide for the following deemed transactions: (i) the Partnership LLC contributes all of
its assets and liabilities to the Corporate LLC in exchange for all of the stock of the
Corporate LLC, and (ii) the Partnership LLC liquidates and distributes the stock of the
Corporate LLC to the members.55 Revenue Ruling 84-11156 lists three situations which
could arise in such conversion:

1. The Partnership LLC transfers all of its assets to the Corporate LLC in exchange
for the Corporate LLC’s stock, followed by a distribution of such stock by the
Partnership LLC to its members in liquidation of the Partnership LLC;

2. The Partnership LLC liquidate and distributes all of its assets to its members,
followed by the members contributing such assets to the Corporate LLC; and

3. The members contribute their Partnership LLC interests to the Corporate LLC in
exchange for its stock, causing the Partnership LLC to liquidate into the
Corporate LLC since the Corporate LLC becomes the sole member of the
Partnership LLC.

Depending on the structure of the conversion, the transactions may or may not constitute
a tax-free transaction. A careful analysis is required in making this determination.

Section I.8Corporate LLC to a Partnership LLC

If a Corporate LLC elects to be classified as a Partnership LLC, the Corporate LLC is

deemed to distribute all of its assets and liabilities to its members in liquidation of the

54
Treas. Reg. § 301.7701-3(g)(3)(i).
55
Treas. Reg. § 3301-3(g)(1)(i).
56
1984-2 CB 88.
Corporate LLC, followed immediately by the contribution by all the members of the
57
distributed assets and liabilities to a newly formed Partnership LLC. Generally, the
liquidation is a taxable event pursuant to Code § 331, while the formation of the
Partnership LCC is tax free pursuant to Code § 331. Exceptions exist to these rules, thus
requiring a careful analysis prior to making the conversion.

Section I.9Disregarded LLC to a Corporate LLC

If a Disregarded LLC elects to be classified as a Corporate LLC, the owner of the

Disregarded LLC is deemed to contribute all of the assets and liabilities of the
Disregarded LLC to the Corporate LLC in exchange for stock of the association. 58 The
tax consequences are similar to those discussed above in converting from a Partnership
LLC to a Corporate LLC, with the form of the transaction guiding the tax treatment.

Section I.10Corporate LLC to a Disregarded LLC

If Corporate LLC elects to be classified as a Disregarded Entity, the Corporate LLC is

deemed to distribute all of its assets and liabilities to the sole member in liquidation of the
Corporate LLC.59 The tax consequences are similar to those discussed above in
converting from a Corporate LLC to a Partnership LLC.

Chapter IV
Distributions and Allocations

Calculating the tax treatment of distributions of a Disregarded LLC is straight forward,

being treated as a sole proprietorship, with no allocations to be made as a result of the
single member. Similarly, a Corporate LLC is taxed as a corporation, with distributions
being made pursuant to the operating agreement (similar to the bylaws of a traditional
corporation) and the Corporate LLC directly taxed as opposed to acting as a pass through.
In contrast, a Partnership LLC is subject to Subchapter K of the Code. As such, the
Partnership LLC is not directly subject to income tax, but must report the income (and

57
Treas. Reg. § 3301-3(g)(1)(ii).
58
Treas. Reg. § 3301-3(g)(1)(iv).
59
Treas. Reg. § 3301-3(g)(1)(iii).
deductions thereto) having made the appropriate distributions and allocations among the
members.

Section IV.1Distributions

Partnership LLC income is taxable to the members in accordance with their distributive
shares. Unlike the Corporate LLC, whether or not the income is distributed to the
members is mostly irrelevant to the taxation of such members.

Section I.11Non-liquidating Distributions

Non-liquidating distributions of cash or property by Partnership LLC to a member are

generally60 not taxable to either the Partnership LLC or the distributee member.61 Rather,
such distribution causes the distributee member to reduce his outside basis in his
Partnership LLC interest. Where a distribution of cash to a member exceeds the
member’s basis in his Partnership LLC interest, he must recognize gain.62 Further, a
member cannot recognize loss in a non-liquidating distribution.

The amount received by a member in excess of his basis in the Partnership LLC interest
is recognized as gain from the sale or exchange of an interest in the Partnership LLC. The
distributee member takes the distributed property with a basis equal to the lesser of (i) the
carryover basis of such property (i.e., the Partnership LLC’s basis in the property
immediately prior to the distribution) or (ii) the distributee member’s basis in his
Partnership LLC interest, less any money distributed to the member.63 The holding period
of the member includes the period of time the Partnership LLC held the asset.64

60
For example, an exception exists on the distribution of certain marketable securities to a member of a
Partnership LLC. Code § 731(c)(3).
61
Code § 731(b).
62
Code § 731(a).
63
Code § 732(a).
64
Code § 735(b).
 (i)Exceptions

a.Disguised Sales

Where a member contributes property to a Partnership LLC and thereafter receives a

distribution of cash or property, the Service may be able to recharacterize the transaction
as a disguised sale of the contributed property, rather than a non-recognized distribution.65
A disguised sale is deemed to have taken place if, based on all facts and circumstances,
(i) the transfer of money or consideration by the transferee of property would not have
been made but for the transfer of property, and (ii) the subsequent transfer is not
dependent on the entrepreneurial risks of Partnership LLC operations. In the case of
simultaneous transfers of property and distributions from the Partnership LLC, the latter
requirement does not apply.66

b.Built-in Gain/Loss Rules

If a member contributes property to a Partnership LLC and that property is distributed by

the Partnership LLC to a member other than the contributing member within seven years
of the date of contribution, the contributing member must recognize the gain or loss that
would have been specially allocated to him under Code § 704(c)(1)(A) had the property
been sold for its fair market value on the date of distribution.67

Additionally, if a member contributes appreciated property to a Partnership LLC and

within seven years after the contribution he receives a distribution of property other than
that contributed by him, such contributing member must recognize gain equal to the
lesser of (i) the excess of the fair market value of the property received in the distribution
over the member’s basis in his LLC interest immediately before the distribution as
reduced (but not below zero) by the amount of cash received as part of the distribution, or
(ii) the contributed property’s pre-contribution built-in gain.

Section I.12Liquidating Distributions

65
Code § 707(a)(2)(B).
66
Treas. Reg. § 1.707-3(b)(1).
67
Code § 704(c)(1)(B).
A liquidating distribution is one made to a member who is terminating his entire interest
in a Partnership LLC. As in the case of a current distribution, a member recognizes gain
when the cash received exceeds the member's basis in the Partnership LLC. The member
takes a basis of the distributed property equal to his outside basis in the Partnership LLC
less any cash received. In contrast to the non-liquidating distribution, the member may
recognize loss so long as solely cash, inventory, and unrealized receivables are distributed
to the extent the basis of the distributed property to the Partnership LLC is less than the
member’s basis in his Partnership LLC interest.68 As with the gain, such loss is treated as
realized in connection with the sale of the member’s interest in the Partnership LLC, and
results in a capital loss.69 The holding period of the member for the distributed asset
includes the period of time the Partnership LLC held such asset.70

Section I.13Ordinary Income

If a member receives a distribution by the Partnership LLC of unrealized receivables, any

gain or loss on a subsequent disposition of the property by such member is ordinary
income pursuant to Code § 735(a)(1). Similarly, a disposition of distributed inventory
within five years of the distribution from a Partnership LLC by a distributee member also
generates ordinary income so long as such disposition occurs within five years of the
original distribution by the Partnership LLC to the member.71

Section IV.2Allocations

Section I.14Allocations of Profits and Losses

Code § 704(b) provides that a member’s distributive share of Partnership LLC income,
gain, loss, deduction, or credit (or item thereof) is determined either in accordance with
(i) the member’s interest in the Partnership LLC (taking into account all facts and
circumstances) if either the operating agreement72 fails to provide for allocations or the
68
Code § 731(a)(2).
69
Code § 731(a).
70
Code § 735(b).
71
Code § 735(a)(2).
72
The Partnership LLC’s operating agreement substitutes for the partnership agreement as referred to in the
regulations.
allocations provided for in the operating agreement lack “substantial economic effect” or
(ii) the relevant allocation provisions of the Partnership LLC’s operating agreement.
Thus, so long as the members of a Partnership LLC carefully structure the operating
agreement, they are able to conform the allocations of income and losses to the financial
needs of the members, so long as the operating agreement is carefully structured.
Whether allocations provided for in an operating agreement have substantial economic
effect is a two-part analysis: (i) whether the allocation has economic effect and (ii)
whether the allocation is substantial.73

(i)Economic Effect

a.General Test

Pursuant to Treas. Reg. § 1.704-1(b)(2)(ii)(b), allocations under a Partnership LLC

operating agreement are considered to have economic effect if the operating agreement
requires the following: (i) the maintenance of capital accounts in accordance with the
requirements of Treas. Reg. § 1.704-1(b)(2)(iv), (ii) the requirement of liquidating
distributions in accordance with positive capital account balances of the members, and
(iii) the requirement for each member to restore the amount of any negative capital
account balance to the Partnership LLC upon the liquidation of the Partnership LLC or
the member’s interest therein.

b.Alternate Test

Where the operating agreement fails to provide for a requirement of the members to
restore any negative capital account balance to the Partnership LLC upon liquidation of
the Partnership LLC or such member’s interest therein, Treas. Reg. § 1.704-1(b)(2)(ii)(d)
allows for an alternate test.

The alternate test provides that if the first two factors are satisfied and the operating
agreement contains a “qualified income offset”, an allocation to a member will be
deemed to have economic effect to the extent it does not create or increase a capital

73
Treas. Reg. § 1.704-1(b)(2)(i).
account deficit beyond the amount which the member is obligated, or deemed to be
obligated, to restore upon liquidation. For purposes of this alternative test, a member is
treated as being obligated to restore an amount equal to (i) its allocable share of the
Partnership LLC’s minimum gain plus (ii) any limited deficit restoration obligation of the
member. A qualified income offset “cures” an unexpected deficit capital account balance
of a member who is not required to restore such deficit. Pursuant to the regulations, the
operating agreement requires Partnership LLC to provide for an allocation of gross
income items in “an amount and manner sufficient to eliminate the deficit balance as
quickly as possible.”74

c.Capital Maintenance Rules

In general, the capital maintenance rules require a member’s capital account to be

increased by: (i) the amount of cash contributed to the Partnership LLC; (ii) the fair
market value of property contributed by a member to the Partnership LLC (less any
liabilities secured by the property or assumed by the Partnership LLC); and (iii)
allocations to the member of Partnership LLC income and gain.75

In contrast, the capital maintenance rules require a member’s capital account to be

decreased by: (i) the amount of cash distributed by the Partnership LLC to the member;
(2) the fair market value of property distributed by the Partnership LLC to the member,
less any liabilities securing the property or assumed by the member; (3) allocations to the
member of Partnership LLC expenditures that may not be deducted or capitalized; and
(4) allocations of the Partnership LLC’s losses and deductions.

(ii)Substantiality

As mentioned, having economic effect is solely the first part of the analysis. Such
economic effect must also be substantial to be respected for federal income tax purposes.
An allocation with economic effect is substantial provided there is a reasonable
possibility that such allocation will substantially affect the dollar amounts to be received
74
Treas. Reg. § 1.704-1(b)(2)(ii)(d).
75
Treas. Reg. § 1.704-1(b)(2)(iv)(b).
by the member from the Partnership LLC, independent of tax consequences,76 and neither
(i) shifts tax consequences among members within a single year,77 nor (ii) is transitory.78
Where there is a strong likelihood that no member of the Partnership LLC will suffer a
substantial after-tax economic detriment on a present-value basis from the allocation
compared to what that member’s economic consequences would be if the allocation were
not contained in the operating agreement, substantiality is lacking.79

Section I.15Allocations of Liabilities

How liabilities of a Partnership LLC are allocated is important, as the member’s basis in
the Partnership LLC is affected by such debt. Since Code § 704(d) permits the allocation
of losses to a member solely to the extent of such member’s basis in the Partnership LLC,
determining the allocation of this debt can be critical, and of course such allocations must
have substantial economic effect.

For allocations of deductions associated with liabilities of the Partnership LLC to have
substantial economic effect, one must determine whether the liabilities are recourse or
nonrecourse liabilities, which is addressed by Code § 752 and the regulations
promulgated thereunder. A recourse liability is defined as a liability for which a member
or a person related to a member bears the economic risk of loss for the liability.80 A
nonrecourse liability is that for which no member or person related to a member bears the
economic risk of loss.81 Thus, the principal difference between recourse and nonrecourse
liabilities is whether any member of the Partnership LLC bears the economic risk of loss
for any given Partnership LLC liability by being personally liable for such.

(iii)Recourse Liabilities

A member bears the economic risk of loss for a liability to the extent that such member
would be obligated to repay such liability (or make a contribution to the Partnership
76
Treas. Reg. § 1.704-1(b)(2)(iii)(a).
77
Treas. Reg. § 1.704-1(b)(2)(iii)(b).
78
Treas. Reg. § 1.704-1(b)(2)(iii)(c).
79
Treas. Reg. § 1.704-1(b)(2)(iii)(a).
80
Treas. Reg. § 1.752-1(a)(1).
81
Treas. Reg. § 1.752-1(a)(2).
LLC) and he would be unable to require any other member of the Partnership LLC to
reimburse him for such payment were the Partnership LLC to be constructively
liquidated. In making this analysis, we include any related parties to the members of the
Partnership LLC.82 Further, the mere fact that a liability is recourse on its face is not
determinative.83

Upon the constructive liquidation of the Partnership LLC, the following are deemed to
occur: (i) all of the Partnership LLC’s liabilities become due and payable; (ii) all of the
Partnership LLC’s assets have a fair market value of zero (with exception of property
contributed to the Partnership LLC to secure a Partnership LLC liability); (iii) the
Partnership LLC disposes of all of its assets in a fully taxable transaction for no
consideration; (iv) all items of income, gain, loss or deduction are allocated among the
members; and (v) the Partnership LLC liquidates.84

In addition, a member bears the economic risk of loss with respect to a liability of a
Partnership LLC that is otherwise nonrecourse to the Partnership LLC to the extent that a
member, or a person related to such member, either makes or acquires an interest in a
nonrecourse loan to the Partnership LLC and no other member bears the economic risk of
loss for such indebtedness.85

Since generally the members of a Partnership LLC are not personally liable for
Partnership LLC debt, Partnership LLC liabilities are usually nonrecourse. An obvious
exception to this general rule is where a member of the Partnership LLC makes a
personal guarantee on repayment of the debt. Another exception to this general rule is
where a Partnership LLC is the result of a conversion from a former legal entity type,
such as a limited partnership, creditors of the former legal entity retain all rights against
members of the converted Partnership LLC.86 Thus, where a limited partnership converts

82
Treas. Reg. § 1.752-2(b)(1).
83
See Roe v. Commissioner, T.C. Memo. 1986-510, affd. per order (8th Cir., Apr. 1, 1988).
84
Id.
85
Treas. Reg. § 1.752-2(c).
86
V.T.C.A. Business Organizations Code § 10.106(4) provides that “the rights of creditors or other parties
with respect to or against the previous owners or members of the converting entity in their capacities as
to a Partnership LLC, the general partners of the former entity remain liable to creditors
of the Partnership LLC who existed at the time of conversion, with such liabilities being
treated as recourse allocable to such general partners.

a.Effect of Recourse Liabilities on Member Basis

For purposes of determining the member’s basis in his Partnership LLC interest, such
basis includes valid liabilities incurred in acquiring the interest.87 This includes the
member’s share of Partnership LLC recourse liabilities, because the member has a “fixed,
unconditional obligation to pay, with interest, a specified sum of money.”88

(iv)Nonrecourse Liabilities

As previously mentioned, generally all liabilities of a Partnership LLC are nonrecourse.

Pursuant to Treas. Reg. § 1.752-3(a), a member’s share of Partnership LLC nonrecourse
liabilities equals the sum of three amounts: (i) the member’s share of the Partnership LLC
minimum gain,89 (ii) the amount of any taxable gain that would be allocated to the
member under Code § 704(c) if the Partnership LLC disposed of all its property subject
to one or more nonrecourse liabilities of the partnership in full satisfaction of the
liabilities for no other consideration in a taxable transaction (i.e., precontribution gain), 90
and (iii) the member’s share of the excess nonrecourse liabilities of the Partnership LLC
determined in accordance with his interest in the profits of the Partnership LLC.91

a.Minimum Gain

In short, Partnership LLC minimum gain is the amount of the nonrecourse debt which
exceeds the book basis of the property, if any such excess exists. Generally, the book
basis of Partnership LLC property is the tax basis of such property. However, this is not
always the case, as where a member contributes property to the Partnership LLC which
owners or members in existence when the conversion takes effect continue to exist as to those liabilities
and obligations and may be enforced by the creditors and obligees as if a conversion had not occurred.”
87
Crane v. Commissioner, 331 U.S. 1 (1947).
88
Corbin West LP v. Commissioner, TC Memo 1999-7 (Jan. 15, 1999).
89
Treas. Reg. § 1.752-3(a)(1).
90
Treas. Reg. § 1.752-3(a)(2).
91
Treas. Reg. § 1.752-3(a)(3).
has a fair value which differs from the member’s book basis in such property. In such
case, the Partnership LLC’s tax basis carries over from the member, but the book basis of
this property is its fair value at the time of contribution.

b.Precontribution Gain

Precontribution gain is that amount of gain which existed inherent in the property at the
time a member contributes such property to the Partnership LLC. In making this
calculation, the debt is first reduced for any minimum gain allocations to the members
previously discussed.

c.Remaining Unallocated Nonrecourse Debt

Finally, any remaining unallocated nonrecourse debt is allocated to the members in

accordance with the operating agreement of the Partnership LLC.

As an example of how these rules work, assume Arnold and Wally form A&W LLC.
Arnold and Wally each receives 50% of the membership interests in the LLC, sharing the
profits and losses equally. Arnold contributes $20,000 and a soft drink formula with a fair
market value of $50,000 and an adjusted tax basis of $10,000. The formula is subject to
nonrecourse debt of $65,000. Wally contributes $5,000 cash for his interest. In allocating
the nonrecourse debt to Arnold and Wally, the first-tier allocation for “minimum gain” on
the property equals $15,000 (the excess of the nonrecourse debt over the fair market
value of the property), with $7,500 allocated equally to each member. Next, the
nonrecourse debt is reduced by $15,000, such that A&W LLC sells the formula for
$50,000, realizing gain of $40,000. This gain is allocated solely to Arnold, the
contributing partner. Finally, the final allocation of the nonrecourse debt allocates the
remaining $10,000 of debt among Arnold and Wally equally, such that $5,000 is allocated
to each member. Thus, Arnold increases his basis as a result of the nonrecourse debt in
the amount of $52,500, while Wally increases his basis by $12,500.

Section I.16Allocations of Nonrecourse Deductions

While there are two main categories of Partnership LLC debt (recourse and nonrecourse),
Treas. Reg. § 1.704-2 introduces a third category for the purpose of allocating items of
Partnership LLC income, gain, deduction, and loss attributable to LLC indebtedness
among the members of an LLC. This third category is debt that is nonrecourse on its face,
but for which a member bears the economic risk of loss.

(v)Partnership LLC Nonrecourse Debt

Allocations of deductions attributable to Partnership LLC nonrecourse debt

(“nonrecourse deductions”) cannot have substantial economic effect because the creditor
alone bears any economic loss attributable to those deductions. Therefore, nonrecourse
deductions are allocated in accordance with the members’ interests in the Partnership
LLC.92

Treasury Reg. § 1.704-1(b) provides for a “safe harbor” in the allocation of nonrecourse
deductions. In short, an allocation of losses and deductions attributable to nonrecourse
debt will be deemed to be in accordance with the members’ interests in the Partnership
LLC if (i) capital accounts are properly maintained in accordance with Treas. Reg. §
1.704-1(b),93 (ii) liquidating distributions are required to be made in accordance with
positive capital account balances,94 (iii) either members with deficit capital account
balances have a deficit restoration obligation or the operating agreement contains a
qualified income offset,95 (iv) the operating agreement provides for the allocation of
nonrecourse deductions in a manner that is reasonably consistent with allocations that
have substantial economic effect of some other significant Partnership LLC item
attributable to the property securing the nonrecourse debt,96 (v) the operating agreement
contains a “minimum gain chargeback”,97 and (vi) all other material allocations and
capital account adjustments under the operating agreement are recognized under the

92
Treas. Reg. § 1.704-2(b)(1).
93
Treas. Reg. § 1.704-2(e)(1).
94
Treas. Reg. § 1.704-2(e)(1).
95
Id.
96
Treas. Reg. § 1.704-2(e)(2).
97
Treas. Reg. § 1.704-2(e)(3).
Treas. Reg. § 1.704-1(b).98 Nonrecourse deduction allocations which fail to qualify for
this safe harbor must be made in accordance with the members’ overall economic
interests in the Partnership LLC.

(vi)Member Nonrecourse Debt

Partnership LLC losses and deductions that are attributable to a particular member
nonrecourse debt must be allocated to such member, as he bears the economic risk of loss
for the liability.99 If more than one member bears the economic risk of loss for any
member nonrecourse liability, the member nonrecourse debt deductions attributable to
that debt must be allocated among the such members according to the ratio in which they
bear the economic risk of loss.100 If members bear the economic risk of loss for different
portions of a member nonrecourse debt, each portion is treated as a separate debt.101

Section I.17Tax Credits and Credit Recapture

Similarly, tax credits and tax credit recapture lack economic effect because they do not
have economic equivalents, and do not give rise to capital account adjustments.
Therefore, they lack substantial economic effect. As a result, tax credits and credit
recapture must be allocated in accordance with the members’ interests in the Partnership
LLC at the time the credit or recapture arises.102 In the case of the investment tax credit, if
it is allocated in the same manner as the Partnership LLC's allocation of qualified
investment property among the members, then such allocation is deemed to have
substantial economic effect.103

Chapter V
Passive Activity Loss Rules

Prior to 1986, a taxpayer could generally deduct losses in full from rental activities and
trades or businesses regardless of his or her participation. This gave rise to significant
98
Treas. Reg. § 1.704-2(e)(4).
99
Treas. Reg. § 1.704-2(i)(1).
100
Id.
101
Id.
102
Treas. Reg. §1.704-1(b)(4)(ii).
103
Treas. Reg. §1.704-1(b)(4)(ii).
numbers of tax shelters, many of them abusive, which allowed taxpayers to deduct non-
economic losses against wages and investment income, thereby reducing or eliminating
any income tax. In response, Congress implemented Code § 469, which restricts the
ability of taxpayers104 to use losses derived from passive activities to offset income from
other activities. Code § 469(c)(1) defines a passive activity as an activity that involves the
conduct of a trade or business “in which the taxpayer does not materially participate.”
Rental activities are generally deemed to be passive activities.105

Section V.1General Rule

Generally, a taxpayer may not deduct passive activity losses in excess of passive activity
income for any given tax year.106 Once a taxpayer disposes of his interest in a passive
activity, such losses can be utilized.107 In a closely-held C corporation108 (other than a
personal service corporation), the excess passive activity losses may be used to offset
income from all other activities of the taxpayer other than portfolio income, with any
excess losses being deferred until the taxpayer disposes of its interest in the activity.109

Section V.2Material Participation

Treasury Reg. § 1.469-5T(a) sets forth seven tests for determining whether a taxpayer
materially participates in an activity during a taxable year. Where a taxpayer meets any of
these seven tests, he is deemed to materially participating in an activity for the purpose of
the passive activity loss rules for any given taxable year:

1. the taxpayer participates in the activity for more than 500 hours;

104
Generally, the rules do not apply to traditional C corporations.
105
Code § 469(c)(2).
106
Code § 469(a).
107
Code § 469(g).
108
Code § 542(a)(2) defines a closely held corporation as that which has five or fewer shareholders owning
more than 50 percent in value of the outstanding stock.
109
Code § 469(e)(2).
2. the taxpayer’s participation in the activity during the taxable year constitutes
substantially all of the participation in the activity of all individuals (including
individuals who are not owners of interests in the activity);

3. the taxpayer participates in the activity for more than 100 hours, and such
taxpayer’s participation in the activity is not less than the participation in the
activity of any other individual (including individuals who lack an ownership
interest in the activity);

4. the activity is a “significant participation activity” of the taxpayer (being defined

as an activity in which the taxpayer participates for more than 100 hours during
the taxable year), and the taxpayer’s participation in all “significant participation
activities” exceeds 500 hours;

5. the taxpayer materially participated in the activity (determined without regard to

this test) for any five taxable years during the immediately preceding ten taxable
years;

6. the activity is a personal service activity110 and the taxpayer materially

participated in such activity for any three taxable years preceding the taxable year;
and

7. based on all of the facts and circumstances, the taxpayer participates in the
activity on a regular, continuous, and substantial basis during the taxable year.

However, in the case of a limited partner he can only materially participate in an activity
if (i) he participates in the activity for more than 500 hours during the taxable year; (ii) he
materially participated in the activity (determined without regard to this test) for any five
taxable years during the immediately preceding ten taxable years; or (iii) the activity is a

110
Treas. Reg. § 1.469-5T(d)) defines personal service activities as the “fields of health, law, engineering,
architecture, accounting, actuarial science, performing arts, or consulting” or any “other trade or business in
which capital is not a material income-producing factor.”
personal service activity111 and the taxpayer materially participated in the activity for any
three taxable years preceding the taxable year.112

Section V.3Tax Treatment of Partnership LLC Members

Unsurprisingly, neither the Code nor the regulations promulgated thereunder addresses
the tax treatment of Partnership LLC members. The practitioner finds himself faced with
determining whether a particular member is a limited partner, due to the restrictions
imposed on limited partners for purposes of the passive activity loss rules. The
regulations define a “limited partner” as either (i) a designation of such interest as a
limited partnership interest exists in the limited partnership agreement or in the certificate
of limited partnership, without regard to whether the liability of the holder of such
interest for obligations of the partnership is limited under the applicable state law, or (ii)
an interest where the partner’s liability for obligations of the partnership is limited under
the law of the state in which the partnership is organized to a determinable fixed amount
113
Under this definition, any member of a Partnership LLC would be designated as a
limited partner for purposes of the passive activity loss rules. However, in a case which
the court viewed as first impression, the court specifically rejected this definition,
pointing out that even a limited partnership has at least one general partner.114 The court
found that the limited partnership test for the passive activity loss rules did not apply to
all Partnership LLC members because such entities are specifically organized to permit
member participation. Therefore, the court found that a Partnership LLC member
materially participates in an activity of the Partnership LLC if he satisfies one of any of
the seven tests previously set forth herein.

Additionally, one could exclude a Partnership LLC member from being defined as a
limited partner by showing such member resembles a general partner. Revenue Proc. 89-
12115 concluded that for those “organizations not formed as a partnership,” for the purpose
111
Id.
112
Treas. Reg. § 1.469-5T(e)(2).
113
Treas. Reg. § 1.469-5T(e)(3)(B).
114
Gregg v. United States, 2001-1 USTC ¶50,169 (D. Or. Dec. 4, 2000).
115
1989-1 CB 798.
of requesting a ruling pursuant to Rev. Proc. 89-12 general partners of such an
organization “will ordinarily be those with significant management authority relative to
the other members.” Thus, an argument may be made that a member-manager of an LLC
should be entitled to be treated as a general partner, for which any of the seven test
previously set forth herein apply.

However, until either the Service issues further guidance or a court with sufficient
authority rules, practitioners must tread with care over whether or not all seven tests
apply, or whether a member of a Partnership LLC should be treated as a limited partner
and thus subject to the more restrictive definition for purposes of the passive activity loss
rules.

Section V.4Rental Real Estate Activities

Code § 469(c)(7) provides special rules for those in the “real property business”. A
taxpayer is in the “real property business” if (i) half of the personal services he performs
in a trade or business are performed in real property trades or businesses in which he
materially participates, and (ii) the taxpayer performs more than 750 hours of services
during the taxable year in real property trades or businesses in which he materially
participates.116 Real property trades or businesses mean “any real property development,
redevelopment, construction, reconstruction, acquisition, conversion, rental, operation,
management, leasing, or brokerage trade or business.”117

Chapter VI
Self-Employment Tax

The self employment tax is a Social Security and Medicare tax on the net earnings of
individuals who work for themselves. It is comparable to the Social Security and
Medicare taxes withheld from the pay of employees from wages and amounts paid by
employers on their employees, and thus has two components: (i) a 12.4 percent Social
Security portion that for 2005 income applies to the first $90,000 of net earnings from

116
Code § 469(c)(7)(B).
117
Code § 469(c)(7)(C).
self-employment and (ii) a 2.9 percent Medicare portion that applies to all net earnings
from self-employment.118

Net earnings from self-employment include income or loss from any trade or business
carried on by an individual and the individual’s distributive share of the income or loss
from any trade or business carried on by a partnership of which the individual is a
member,119 while excluding certain items such as rentals from real estate,120 dividends on
any share of stock, and interest on any bond, debenture, note, or certificate, or other
evidence of indebtedness,121 gain or loss from the sale or exchange of a capital asset, 122
and the distributive share of any item of income or loss of a limited partner (other than
guaranteed payments to a limited partner). 123 The Code defines guaranteed payments as
payments made “for services actually rendered to or on behalf of the partnership to the
extent that those payments are established to be in the nature of remuneration for those
services.”124

Section VI.1Partnership LLC Members – General or Limited Partners?

The conundrum facing the tax practitioner in determining whether distributions to a

member of a Partnership LLC are includible as self-employment income is whether the
member should be treated as a limited partner, with such distributions excluded from self-
employment income, or as a general partner, with such distributions included in self-
employment income. Unfortunately, the very complexity that the check-the-box
regulations sought to expunge have crept back with the advent of the LLC, requiring the
tax practitioner to determine the amount of involvement which a member in deciding
whether the member is a general or limited partner.

118
Code § 1401(a), (b); Rev. Rul. 2004-104, 2004-46 I.R.B. 837.
119
Code § 1402(a).
120
Code § 1402(a)(1).
121
Code § 1402(a)(2).
122
Code § 1402(a)(3).
123
Code § 1402(a)(13).
124
Id.
If a member of a Partnership LLC is actively involved in the management of the business,
it would seem appropriate to treat such member as a general partner, with the distributive
share of such member includible as self-employment income. In fact, in a private letter
ruling, the Service has ruled just that.125 Alternatively, if the member’s involvement in the
Partnership LLC is limited to passive activities, it would seem equally appropriate to
exclude such member’s distributive share from self-employment income.

Section I.18The 1994 SE Regulations

On December 29, 1994, the Service issued proposed regulations (the “1994 SE
Regulations”) which addressed the treatment of income derived by members of a
Partnership LLC for self-employment tax purposes.126 Pursuant to the 1994 proposed
regulations, a member of an LLC was to be treated as a limited partner, and thus not
subject to the self-employment tax with exception of guaranteed payments, if:

1. the member could not be a manager, whether a designated manager or a member

manager; and

2. the Partnership LLC entity could have been formed as a limited partnership rather
than an LLC in the same jurisdiction, and the member could have qualified as a
limited partner in such limited partnership under applicable state law.127

While some were pleased with the 1994 SE Regulations for attempting to conform the
treatment of Partnership LLCs with partnerships, others criticized the regulations due to
administrative and compliance problems, as well as “disparate treatment between
members of different LLCs with identical rights based solely on differences in the limited
partnership statutes of the states in which the members form their LLC”.128

125
See P.L.R. 9432018 (ruling that members of an LLC who actively engage in the performance of
professional services on behalf of the LLC must include their distributive share of the LLC’s income and
loss as self-employment income).
126
Prop. Treas. Reg. § 1.1402(a)-18, 59 Fed. Reg. 67253 (1994).
127
Prop. Treas. Reg. § 1.1402(a)-18(b).
128
See Notice of Proposed Rulemaking, Definition of Limited Partner for Self-Employment Tax Purposes,
61 Fed. Reg. 1702 (Jan. 13, 1997).
Section I.19The 1997 SE Regulations (the “Proposed Regulations”)

In response, the Service in 1997 issued the Proposed Regulations to address the issue.
The Proposed Regulations proposed a simplified approach to determining who would be
a “limited partner” for purposes of the self-employment tax. Pursuant to these
regulations, a member in a Partnership LLC would be treated as a limited partner unless
the member:

1. had personal liability for the debts of, or claims against, the partnership by reason
of being a partner;

2. had authority to contract on behalf of the partnership under the statute or law
pursuant to which the partnership is organized; or

3. participated in the partnership’s trade or business for more than 500 hours during
the taxable year.129

The Proposed Regulations further provided for exceptions in the case of a member who
(i) held more than one class of interest in the Partnership LLC or (ii) received guaranteed
payments for his services to the partnership.130 In response, a firestorm erupted and
Congress took the unusual step of prohibiting the Service from enacting the Proposed
Regulations, as well as any further proposed or temporary regulations on the matter prior
to July 1, 1998, via Section 935 of the Taxpayer Relief Act of 1997.

Section I.20Status Unclear

While the Service is able to promulgate regulations to address this sensitive subject as the
moratorium has long since expired, the Service has understandably remained mute. As of
September 2005, the Service has failed to issue any further guidance on the classification
of a member of a partnership or LLC as a “limited partner” for self-employment income
tax purposes. This requires that the tax practitioner take extra care in making the

129
Prop. Treas. Reg. § 1.1402(a)-2(h)(2), 62 Fed. Reg. 1702 (1997).
130
Prop. Treas. Reg. § 1.1402(a)-2(h)(3).
determination, always aware that the Service may take the position that all income to a
member of a Partnership LLC is includible in self-employment income.

Nevertheless, the Proposed Regulations do provide a framework with which one can
work. If one can obtain the desired result by working within the Proposed Regulations, it
is highly unlikely that the Service would take a position contrary to its own regulations
and thus presumably such position would be safe from challenge. On the other hand, if
the Proposed Regulations do not provide the desired results, either the taxpayer may
choose (i) to ignore the Proposed Regulations, and instead rely upon a position similar to
that of the bifurcated S corporation interest or (ii) to adopt an alternative structure that
complies with the current regulations yet accomplishing a favorable result.

(i)Applying the Proposed Regulations

In short, a partner is automatically classified as a limited partner, unless the individual (i)
has personal liability for the Partnership LLC debts by reason of being a partner; (ii) has
authority to contract on behalf of the Partnership LLC; or (3) participates in the
Partnership LLC’s trade or business for more than 500 hours during the taxable year.
Since the Texas statute provides protection to the members of an LLC from personal
liability for the Partnership LLC debts by reason of being a partner, the first should never
apply. Thus, members must take care in connection with being a manager of a Partnership
LLC or by participating in the business for more than 500 hours per year.

For members who work more than 500 hours per taxable year, so long as another member
of the Partnership LLC holds an identical interest and such other member is treated as a
limited partner, than the Proposed Regulations provide an exception and the active
member regains status as a limited partner whose distributions are excluded from the self-
employment tax.131 Thus, a taxpayer could easily include a non-participatory spouse as a
member and retain the ability for distributions to be exempt from the self-employment
tax.

131
Prop. Treas. Reg. § 1.1402(a)-2(h)(4).
In the case of a member who is also a manager and able to contract on behalf of the
Partnership LLC, the Proposed Regulations permit distributions to such managing
member to be exempt from self-employment tax so long as there are two classes of
membership interests, and the managing member has a class of membership interest with
identical rights and obligations to that interest held by other limited partners.132 Thus, the
use of a non-participatory spouse would easily provide a means for a managing member
to exempt distributions from the self-employment tax.

(ii)An Alternative Structure

However, the case may arise where the Partnership LLC lacks any qualifying limited
partners, e.g., all members will either be participating for more than 500 hours per tax
year in the business of the Partnership LLC or act as managers for such entity. In such
case, an alternative structure is available. The members form an alternate entity for the
purpose of acting as a manager of the Partnership LLC, e.g., a C corporation. The C
corporation lacks any membership interest in the Partnership LLC and the members are
employed by the C corporation to provide services to the Partnership LLC. Therefore,
distributions to the members qualify as distributions to limited partners, thus exempt from
self-employment tax. The C corporation would also provide benefits to the employee-
members, such as a fully-deductible health insurance plan and a medical reimbursement
plan.

Chapter VII
State Income Taxation

The Federal check-the-box rules do not apply for purposes of the Texas franchise tax. The
Texas franchise tax is imposed on limited liability companies at a rate of 0.25 percent
(0.25%) on net taxable capital and 4.5 percent (4.5%) on net taxable earned surplus. 133
Because the earned surplus component of the Texas franchise tax is the larger portion of

132
Prop. Treas. Reg. § 1.1402(a)-2(h)(3).
133
Tex. Tax Code Ann. §171.002(a).
the tax and is like an income tax,134 the discussion below will refer to the Texas franchise
tax as being imposed on income.

An LLC that is formed in Texas is required to pay Texas franchise tax on its distributive
share of partnership income earned in Texas, regardless of whether the LLC owns a
limited partnership interest or a general partnership interest in the partnership. 135 An LLC
organized in a state other than Texas (a “Foreign LLC”) must pay Texas franchise tax if it
conducts a business in Texas directly136 or as a general partner.137 However, a Foreign
LLC is not liable for Texas franchise tax on its distributive share of partnership income if
the Foreign LLC owns a limited partnership interest in a limited partnership transacting
business in Texas.138

The LLC can be used to avoid the Texas franchise tax via the formation of a limited
partnership where the LLC owns the minority general partner interest (e.g., 1%), with
individuals or partnerships owning the vast majority of the limited partnership (e.g.,
99%). Where the LLC is a foreign LLC in a low tax jurisdiction such as Delaware or
Nevada, the use of management agreements and other services agreements between the
Texas limited partnership and the foreign limited liability companies further reduce the
base on which the Texas franchise tax is calculated.

134
See Tex. Tax Code Ann. §171.110(a) (computing net taxable earned surplus by reference to the entity’s
reportable federal taxable income).
135
See 34 Tex. Admin. Code §§3.549(e)(29) (for purposes of calculating taxable capital, receipts reflecting
a corporation’s share of the net profit of a joint venture or partnership apportioned to the principal place of
business of the joint venture or partnership for Texas franchise tax purposes), 3.546(c)(12)(B) (for Texas
franchise tax purposes, a foreign corporation (but not a Texas corporation) is not doing business in Texas if
the foreign corporation is a limited partner in a limited partnership) and 3.557(e)(24) (for purposes of
calculating earned surplus, a corporation’s gross receipts includes its share of gross receipts of a joint
venture or partnership).
136
34 Tex. Admin. Code §3.546(a).
137
34 Tex. Admin. Code §3.546(c)(12).
138
Id.
APPENDIX A
APPENDIX A
APPENDIX A
APPENDIX A
APPENDIX A
APPENDIX B
APPENDIX B