Considerations for Formation of Multiple Member Limited Liability Companies (“MMLLCs”) and Family Limited Partnerships (“FLPs”)

In general, no gain or loss is recognized to a partnership or to a partner who contributes property to the partnership if one or more partners contribute property to the partnership in exchange for a partnership interest. This provision of “non-recognition” applies to partner contributions of property both at the time of formation of the partnership and after the partnership is formed and operating. From a tax perspective, this “gain non-recognition rule makes it relatively easy to add new partners who are contributing appreciated property to an existing partnership or LLC treated as a partnership.

Conversely, the contribution of services in return for a partnership interest is eligible for income non-recognition treatment, only if the service contributor receives the right to participate in future profits, which would be a profits interest. Receipt of a profits interest does not result in current income taxation to the service contributing partner, because no income has actually been realized at the time of receipt.

Receipt of a capital interest in a partnership in return for contribution of services requires the contributor to recognize ordinary income equal to the fair market value of the partnership interest received. Ownership of a capital interest allows the partner to receive not only income from the partnership but also a share of the proceeds, if the partnership is liquidated.Part

Part ||

Those who receive a partnership capital interest for the performance of services generally include the fair market value of the partnership interest in income. If, however, conditions are attached to receipt of the partnership interest, the partnership interest is not immediately includable in income by the recipient. For example, the partner may be required to forfeit the partnership interest if he or she leaves the partnership within 5 years. The partner is not required to include the value of the partnership interest in his or her income until his or her ownership of the partnership interest is no longer subject to a risk of forfeit. 

Section 83(b) provides that a service-contributing partner whose receipt of property is subject to a risk of forfeiture may elect to include the value of that property in his or her income immediately and value the propcrty without regard to the risk of forfeiturc, if he or she chooses to do so.

Loss Deductions

A partner’s deductible share of net losses from a partnership cannot exceed his or her basis in the partnership. Any losses exceeding the partner’s basis may be carried forward indefinitely to be used when the partner’s basis is increased.

When basis is insufficient and more than one item reduces basis, such as when a partnership allocates both ordinary and capital losses, the flow-through of each item is determined in a pro rata manner. Any items increasing basis are assumed to flow through to the owner before any items that reduce basis, including distributions, regardless of the actual timeline of these adjustments. 

Adjustments for cash distributions made by a partnership during a tax year are taken into account before applying the loss limitation for the year. As a result, cash distributions during a year reduce the adjusted basis for purposes of determining the allowable loss for the year. Consequently, the loss for a year does not reduce the adjusted basis for purposes of determining the tax status of cash distributions made during the year.

Passive Activity Loss Limitations

The passive activity loss rules of Section 469 limit the amount of loss a partner can deduct for a partnership loss to the amount of passive income the taxpayer has. Excess passive losses for the year are suspended and carried forward; they can be used in a later year if the taxpayer generates passive income for the year, or if the taxpayer makes a full and complete disposition of the activity generating the passive loss.

Limited partners are generally unable to materially participate in trade or business activities conducted through partnerships.

Generally, passive activities include any trade or business activity in which the partner does not materially participate, as well as all rental activities, regardless of the partner’s participation, with the following exception for real estate professionals.

Real Estate Professionals

Taxpayers who own real estate should consider whether they qualify as real estate professionals. By qualifying as real estate professionals, they may be able to fully utilize their rental losses for the year.

Rental real estate activity in which a partner materially participates is not considered a passive activity if both of the following conditions apply:

1. More than half of the personal services the partner performs in any trade or business involve material participation in real property trade orbusiness activities; and
2. The partner materíally participates in more than 750 hours of services in real property trade or business activitics.

Qualifying taxpayers may elect to aggregate all their rental real estate activities and treat them as a single activity in order to pass the material participation test. Generally, this means the taxpayer must spend more than 500 hours on the activity. If a taxpayer makes this election, material participation is determined for the combined activity. Taxpayers then must determine if they satisfy one of the seven tests for material participation for rental real estate activity,

Contributed Property

Generally, property contributed to a partnership or an LLC by a partner or member takes the contributor’s basis in the hands of the partnership or LLC. The business allocates depreciation deductions, including the Section 179 deduction, to partners or members.

A partnership must allocate income, gain, loss and deduction with respect to property contributed by a partner to the partnership to take into account any variation between the adjusted tax basis of the property and its fair market value at the time of contribution (this difference is referred to as either the “built-in gain” or “built-in loss”). If the partnership sells such property and recognizes gain or loss, built-in gain or loss is allocated to the contributing partner.

If contributed property is subject to depreciation, the allocation of depreciation must take into account built-in gain or loss on the property. However, the total depreciation, depletion, gain or loss allocated to partners cannot be more than the depreciation or depletion allowable to the partnership or the gain or loss realized by the partnership.

A built-in loss may be taken into account only by the contributing partner and not by other partners. In determining the amount of items allocated to partners other than the contributing partner, the basis of the contributed property is treated as the fair market value at the time of contribution. Thus, if the contributing partner’s partnership interest is transferred or liquidated, the partnership’s adjusted basis in the property is based upon its fair market value at the time of contribution, and the built-in loss is eliminated.