Passive Activity Loss ATG - Exhibit 6.3: LLCs: Passive Activity Issues
Publication Date - December 2004
NOTE: This guide is current through the publication date. Since changes may have occurred after the publication date that would affect the accuracy of this document, no guarantees are made concerning the technical accuracy after the publication date.
Exhibit 6.3: LLCs: Passive Activity Issues
_____ If a rental has been transferred into an LLC, verify that losses on disposition have not been deducted on Form 1040 Schedule E or D. In particular, look for losses erroneously entered in the non-passive column of Schedule E – or losses in excess of $25,000 on the face of Schedule E due to a “disposition”. The transfer is NOT a qualifying disposition under IRC § 469(g) as it is not fully taxable nor is it to an unrelated party. A mere change in form is not a qualifying disposition. Losses stay with the individual and remain on Form 8582.
_____ For businesses conducted via an LLC, scrutinize LLC member Schedule K-1s and consider raising a passive loss issue if: Low ownership percentage, out-of-state address or name/address suggesting a minor.
REMINDER: The Reg. 1.469-5T(e)(3)(i)(B) holds that a partnership interest is a limited partnership interest if the liability of the holder of the interest for obligations of the partnership is limited under the law of the State in which the partnership is organized. This generally does not apply to LLC members. The LLC members will generally NOT be treated as limited partners under Reg. 1.469-5T(e)(4)(v)(3) and may use any of the seven material participation tests. However, limited partners (LP) are subject to more restrictive tests for material participation. Tests 1 (500hour), 5 (material participant 5 of prior 10 years) and 6 (material participant in personal service activity any 3 prior years) in Reg. 1.469-5T(a) are the exceptions to the limited partner taint. If a limited partner fails these three tests and has no passive income on his Form 1040, business losses are generally not deductible. They go on Form 8582 line 3b.
_____ At the initial interview, ask what each LLC member does. Determine the time and activities of each LLC member. Also request LLC agreement (and management agreements, or contracts, if any) with duties highlighted. See log in Chapter 4.
_____ If the LLC is involved in long-term leasing of equipment, review all LLC member returns. Losses are generally not deductible unless the individual taxpayer has other passive income. See IRC § 469(c) and Chapter 2.
_____ If the LLC rents its building or equipment from an LLC member individually, determine whether the LLC member works on a regular basis in the business. If the member materially participates, the income is recharacterized as non-passive. While it still is reportable on Schedule E of Form 1040, it cannot be used to offset other passive losses and should not be reflected on Form 8582 line 1a.
Exception: If there is a written, currently binding lease signed before 2/19/88, the LLC member may characterize net income as passive. See Reg. § 1-469-2T(f)(6) and § 1.469-11(c)(ii). This exception is rarely seen as the lease period would have to be more than fifteen years to bind the current year.
_____ When perusing the LLC members' individual returns, verify Schedule K-1 portfolio income (line 4) have not been entered on Form 8582 line 1a or 3a. This type of income is reportable on Schedule B, D and E, but should not be on Form 8582 as it is non-passive income under IRC § 469(e). If portfolio income is on F 8582, it should be removed. Result: there is generally a passive loss adjustment up to the amount of income removed from Form 8582.
_____ Verify that guaranteed payments or other types of personal service income has not been entered on members' Form 8582 line 1a or 3a as passive income. Passive income can only be generated by a rental activity OR a business in which the member does not materially participate. See IRC § 469(e)(3) and Reg. §1.469-2T(c)(4).
_____ When making flow through adjustments to the individual LLC member returns, consider automatic adjustments due to MAGI. If MAGI (AGI per return plus an add back for any passive activity losses and several other minor modifiers) exceeds $100,000 AND the taxpayer has rental real estate, his $25,000 offset is reduced 50 cents for every $1.00 over $100,000. See MAGI exhibit at the end of Chapter 1 and IRC § 469(i)(3)(Form) .
_____ If the LLC falls under TEFRA, prepare an affected item report for passive issues.
ACTIVITY RULES: Under the activity grouping rules in Reg. § 1.469-4, a taxpayer may group his activities, including LLC businesses, into ONE single activity IF they form an appropriate economic unit. Often it is easier for the taxpayer to meet the 500-hour test material participation if businesses are grouped. Factors considered are: similarities, common control, common ownership, geographical location, and reliance between or among activities. To be grouped, the business must form an integrated and interrelated economic unit. See Chapter 8.
RENTAL REAL ESTATE LLCs filed as PARTNERSHIPS: For 1994 and subsequent years, a taxpayer who spends more than half his personal services in real property trades or businesses AND works more than 750 hours in real property trades or businesses AND materially participates in each rental real estate activity may deduct losses in full. See IRC § 469(c)(7), Reg. § 1.469-9, and Chapter 2.
BASIS AND AT-RISK: Basis and at-risk rules override IRC § 469. If taxpayer has no basis or is not at-risk under IRC § 465, LLC losses are not allowable - even if the loss would have been allowed under IRC § 469. See Reg. § 1.469-2(a)(2)(ii) and Reg. § 1.469-2(d)(2)(x).