Taxation issues of entities taxed like partnerships
With the "acceptance" of limited liability companies by the IRS (and, more importantly, their acceptance as an entity taxed as a partnership unless they otherwise elect), their use has greatly grown. At the same time, particularly in agriculture, the use of limited partnerships and limited liability partnerships to bring necessary capital together for large scale agricultural activities all have resulted in a large number of entities subject to partnership taxation rules (so-called Subchapter K rules). While the general concepts of partnership taxation (for a general partnership with a few partners who put cash in at the same time to acquire their interests) are relatively straightforward to begin with (at least related to their treatment during operations) as multiple partners and multiple levels of partnership interests are added to the equation and then combined with some form of limited liability, the tax rules become incredibly complex with surprising (and not always pleasantly surprising) results.
The first concept that is generally faced in entities being taxed as partnerships that combine with that a concept of limited liability for the partners (referred to herein as Ltd. Partnership Entities) is the impact of entity debt on the tax basis of the assets allocable to the Ltd. Partnership Entities (the so-called "inside basis") and the tax basis of the partner/members in their Ltd. Partnership Entities interests (the so-called "outside basis"). In theory, at least where the Ltd. Partnership Entities’ interests were acquired on the initial formation for cash (as contrasted to the contribution of property or from interests acquired from other partners/members), the outside Ltd. Partnership Entity interest must equal the inside Ltd. Partnership Entity’s tax basis in its assets.
The "outside" interest of a partner/member is the total of the tax basis in what that partner/member contributed into the Ltd. Partnership Entity plus that partner/member’s allocable share of Ltd. Partnership Entity debt (then increased or reduced based on profits, losses, contributions and distributions from the Ltd. Partnership Entity). However, the allocable share of the Ltd. Partnership Entity’s debt to the individual partners/member can be complex. Initially, if no partner/member is liable for a particular Ltd. Partnership Entity debt (trade payables for example), they are generally allocated among the partners/members based on their respective share of profit and loss (subject to any special allocations called for under the partnership/operating agreement). In contrast, Ltd. Partnership Entity debts guaranteed by partners/members are allocated only to those partners/members that have guaranteed such debt (and in proportion to that guarantee and not the profit/loss sharing ratio). Finally, as it relates to taking losses in an individual year, the debt share of non-recourse debts is not available to create outside tax basis to use current losses.
These rules then combine with the general rule that a particular partner/member may not take losses in excess of his/her outside tax basis in a particular year. However, those losses are not allocated to other partners/members but rather then become "suspended" losses available to offset future income or the sale of the interest. The rules also interact with the rule that a change in a partner/member’s interest in profits or losses (say from the admission of a new partner/member or the sale of some or all of a partner/member’s interest) that provide that to the extent the change results in a smaller "share" of Ltd. Partnership Entity debt, it is a deemed cash distribution to the partner/member whose outside "share" of Ltd. Partnership entity’s debt has been reduced. Some of these changes may not be as apparent as one would think. For example, adding personal guarantees by other partner/members can impact this percentage. In addition, guarantees by related persons (spouses and/or entities controlled by the partner/member) can qualify as debt guaranteed by the partner/member but not if that spouse and/or related party is also a partner/member of the Ltd. Partnership Entity (that change alone, the adding of a spouse and/or related entity as a partner/member can suddenly shift the allocable share of Ltd. Partnership debt). Where the outside tax basis has been reduced to near 0 by other losses, these changes in ownership percentage can result in surprise (and phantom) taxable income.
In a sale or other disposition of a partner/member’s interest in a Ltd. Partnership Entity, the initial thought is that such a sale should qualify for capital gains and the interest can be sold on the installment basis. However, there are major exceptions to this rule related primarily to what is referred to as unrealized receivables but which are, in reality the selling partner/member’s share of not only a cash basis Ltd. Partnership Entity’s share of receivables, but also depreciation recapture, and 0 basis assets (such as livestock that has been raised and/or expensed as purchased) and inventory. Generally speaking the selling partner/member’s share of these assets will not qualify for installment treatment (and thus must be reported in the year of sale) again creating taxable income that may have to be reported not only as ordinary income but also well before the receipt of payment to which they relate.
While the general goal of Subchapter K is to treat a "redemption" of a partner/member’s interest similarly to a sale of that interest to a third party, there are a number of differences in the treatment depending on the method elected and this is an area in which a person is able to structure the transaction either way as they choose but once chosen, that approach will have to be lived with for tax purposes. The contribution or withdrawal of property for or in satisfaction of partnership/membership interests, merger or joint-ventures with other Ltd. Partnership Entities can further create unanticipated tax problems and issues. These entities can be immensely useful investment vehicles but their tax complexities cannot be overlooked.