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LLCs & LLPs

the passive-activity-loss limitations,
An LLC’s election to be classified as an and the excess-business-loss limita-
tion of Sec. 461(l)). It also allows a
S corporation results in a hybrid entity with partner to receive nontaxable cash
state law characteristics that align in many distributions, provided the cash distri-
respects with a partnership while being butions do not exceed the partner’s tax
basis of its interest in the partnership.
treated for tax purposes as a corporation. In contrast, a shareholder of an S
corporation cannot include entity-
level indebtedness in the shareholder’s
three safe harbors (all three must be partner may, in present value terms, tax basis of his or her stock. Subchap-
met) to satisfy the economic-effect be enhanced compared to such ter S of the Code does not have a
analysis and require that these be in- consequences if the allocation (or counterpart to Sec. 752. Further, it is
cluded in the partnership agreement or allocations) were not contained in relatively settled law that a sharehold-
LLC operating agreement: the partnership agreement, and (2) er guaranty of corporate debt does
1. Partner capital accounts must be there is a strong likelihood that the not increase the shareholder’s stock
maintained in accordance with the after-tax economic consequences basis until, and unless, the shareholder
rules prescribed by the regulations; of no partner will, in present value is required to personally pay on the
2. Liquidating distributions are re- terms, be substantially diminished guaranty.32
quired to be made in accordance compared to such consequences if
with the partners’ positive capital the allocation (or allocations) were Reason 6: Gain recognition
account balances; and not contained in the partnership for distributions of
3. There exists either a deficit resto- agreement …30 appreciated property
ration obligation or, in the alterna- Distributions of appreciated property
tive, a qualified income offset.29 Reason 5: S corporation by an S corporation to a shareholder
The second part of the analysis member/shareholder tax can result in gain recognition. In
requires that the allocation be “sub- basis excludes entity-level general, Subchapter C of the Code
stantial.” Substantiality essentially indebtedness applies to S corporations and its
looks to the ultimate tax consequences A significant advantage of partnership shareholders. Accordingly, both cur-
of the allocation and whether there taxation versus S corporation taxation rent and liquidating distributions of
is an after-tax benefit to the alloca- is the ability to include entity-level appreciated property by the S cor-
tion or allocations. The regulations indebtedness in the partner’s tax basis poration to its shareholders result in
provide that: of his or her interest in the partner- gain recognition at the S corporation
ship.31 Most real estate investments level that passes through to its share-
the economic effect of an alloca- are held in entities that are classified holders.33 The distribution of property
tion (or allocations) is not substan- as partnerships principally for this is treated as if the property were sold
tial if, at the time the allocation reason. This leverage allows a partner to the distributee shareholder at its
becomes part of the partnership to deduct losses in excess of contribut- fair market value.34 In addition, a
agreement, (1) the after-tax eco- ed capital (subject, of course, to other corporate-level tax could result for
nomic consequences of at least one limitations, such as tax basis, at-risk, recognized built-in gains for an S

29. Regs. Secs. 1.704-1(b)(2)(ii)(b) and (d) (dealing with the qualified income such partner of partnership liabilities, shall be considered as a contribution of
offset). money by such partner to the partnership” (Sec. 752(a)). Conversely, “[a]ny
30. Regs. Sec. 1.704-1(b)(2)(iii)(a). See Regs. Sec. 1.704-1(b)(2)(iii)(b) for alloca- decrease in a partner’s share of the liabilities of a partnership, or any de-
tions that have “shifting tax consequences” and Regs. Sec. 1.704-1(b)(2)(iii) crease in a partner’s individual liabilities by reason of the assumption by the
(c) dealing with “transitory allocations.” partnership of such individual liabilities, shall be considered as a distribution
31. Partnership-level debt is accorded treatment under the aggregate theory (as of money to the partner by the partnership” (Sec. 752(b)).
opposed to the entity theory) of partnership taxation whereby a partner is 32. See, e.g., Brown, T.C. Memo. 1979-220; Albert, T.C. Memo. 1980-567;
deemed to “own” a pro rata share of assets and liabilities of the partnership. Estate of Leavitt, 875 F.2d 420 (4th Cir. 1989).
“Any increase in a partner’s share of the liabilities of a partnership, or any 33. Secs. 311(b) and 336(a).
increase in a partner’s individual liabilities by reason of the assumption by 34. Id.

30 October 2022 The Tax Adviser