Page 324 - TaxAdviser_2022

CASE STUDY

The fact that the services provided his 25% share of LLC income), the for comparable services to third parties
to the LLC are of a nature that L also value of his services is not treated as an and it is reasonably certain that the
provides to third parties and that the expense of the LLC and, consequently, payment will be made. However, if the
payment does not affect L’s income is not expensed or capitalized as part of property is a speculative project without
allocation are indications that L is act- the building’s cost. Had the LLC paid any leases when the members enter into
ing as a nonmember. Assuming that a third-party builder to construct the the operating agreement, L may be at
it is correct to treat L as a third party building, the builder would have re- enough risk with respect to receiving
with respect to the management fee it ported the fee as income, and the LLC the payment that the arrangement is re-
receives from the LLC, H deducts the would have capitalized the fee to the spected as an allocation of LLC income
management fee as a business expense cost of the building. followed by a payment of that distribu-
in the year that the expense is properly Preferential income allocations tive share. See the discussion above for
accrued. Likewise, L reports the fee as and distributions: Members who details on making this determination.
income when the income accrues. L’s perform services in their capacity as
Schedule K-1, Partner’s Share of Income, members are sometimes allocated a Disguised-payment-for-
Deductions, Credits, etc., from H does share of LLC income in addition to service rules
not reflect the management fee paid to the allocation based on their share In some cases, amounts distributed to
L (other than to the extent it reduces of capital (often called a preferential members are recharacterized as pay-
the LLC’s taxable income that is al- allocation). In some cases, it is ments to nonmembers. Sec. 707(a)
located to all members). appropriate to treat this as an allocation (2)(A) provides that if (1) a member
Caution: If L were a cash-basis of the member’s share of the LLC’s performs services for an LLC; (2) there
taxpayer, the LLC’s deduction would be income. Such a preferential allocation is a related direct or indirect income
deferred until the year that L receives of income generally has the same allocation and a distribution from
payment. effect on LLC income as a guaranteed the LLC to the member; and (3) the
When the LLC makes payments payment. The member receiving the performance of such services and the
for services to members acting as non- allocation reports it as income, and allocation and the distribution, when
members, the LLC should generally the allocation to the service-providing viewed together, are properly character-
issue that member a Form 1099-NEC, member effectively reduces the income ized as a transaction between the LLC
Nonemployee Compensation, to report to be allocated among the other and a nonmember, it is treated as such.
the amount paid. members. In other words, the distribution to the
member is treated as a payment for ser-
Services provided by a Example 2. Preferential allocation of vices made to a third party under Sec.
member acting as a member LLC income to a member providing 707(a)(1). The payment is deducted or
A member acting as a member is usu- services as a member: Assume the capitalized by the LLC according to
ally compensated for services rendered same facts as Example 1, except that the character of the services provided
to the LLC either with a guaranteed instead of paying L a set amount, by the member and recognized as
payment or simply an allocation of a H’s operating agreement provides compensation by the member acting
share of LLC income or loss. Members that L will receive a special alloca- in the capacity as a nonmember. If
who receive only their distributive share tion equal to 10% of LLC gross the service provider has a significant
of LLC income or loss do not report revenues. During the year, H’s gross entrepreneurial risk with respect to the
the value of their services as income revenues are $660,000. LLC, this rule generally does not come
(i.e., they report only their share of into play. ■
LLC income or loss). Likewise, the L’s special allocation is $66,000
LLC does not deduct (or capitalize, as ($660,000 gross revenue × 10%).
the case may be) the value of the mem- Whether the payment is a management
ber’s services. fee (that is, a payment to a member act- Contributor
For example, if a member who owns ing as a nonmember) or an allocation
Sheila Owen, CPA, is a senior specialist
a 25% interest in a real estate develop- of LLC income is a question of fact.
editor with Thomson Reuters Checkpoint.
ment LLC is a builder who supervises Generally, the allocation will be treated
For more information about this column,
the construction of a building for the as a management fee paid to a non-
contact thetaxadviser@aicpa.org.
LLC and receives no payments from member if the members expected it to
the LLC (other than distribution of approximate the fee L normally receives

44 June 2022 The Tax Adviser