The advent of the Limited Liability Company, or LLC, is relatively new to the United States. Wyoming was the first state to offer an LLC business entity classification in 1977, and within 20 years, nearly every other state had followed suit. LLCs are a great option for businesses looking to obtain the liability protection of a corporation while maintaining the flexibility of a closely held business.
The IRS struggled mightily with how this new-fangled business entity should be taxed, with the ultimate decision being two-fold:
- If the LLC has only one owner, it will be disregarded for tax purposes (that is, placed on the owner’s individual return), and
- If it has multiple owners, it will default to a partnership (though an S-corporation or C-corporation can be elected, that’s a different article).
When setting up your LLC taxed as a partnership, there are a few considerations to keep in mind:
- An LLC should always have an operating agreement that outlines some key points. Without getting too technical, if this agreement does not contain certain provisions, special allocations mentioned in point 2 below may not be allowed. That being said, it almost always makes sense to go to a well-respected attorney when drafting your operating agreement to make sure it contains these key provisions. Note that an operating agreement and Articles of Organization are two different documents.
- Partnerships can allow for flexible allocations of income and losses, granted that the reason for the allocations is not simply tax avoidance. For example, if two partners form a partnership, one contributing cash and the other bringing nothing but business know-how, the agreement could state that the partner contributing cash receives his investment back first as the business generates income, before the other partner gets any allocated profits. Because the second partner is not trying principally to avoid taxes by not receiving income, the allocation is allowed. This flexibility is simply not an option with other entity types.
- When initially funding the partnership, contributing anything but cash can create an issue, as the partnership rules look at fair market values more closely than other business entities. The issue arises if the asset you are contributing has a higher or lower fair market value than what you paid for it.
A perfect example is a building. LLCs taxed as partnerships are a great vehicle for investment property as the rules allow for easy distributions of the property whenever needed. However, complex rules in the code dictate that if the market value is higher than your “tax basis”, there will be special allocations made to certain partners that are required and could leave one partner with much more income than he may have anticipated.
As a rule of thumb, if the property that will ultimately end up in the partnership has not been purchased, it is almost always advisable to contribute only cash to the partnership and have the entity buy the asset. Because cash has a market value that is always equal to tax basis, the above mentioned consequences will never happen.
The above points are only a fraction of the total consideration when starting or operating an LLC taxed as a partnership. Talk to a CPA who has experience with partnerships, as these rules are complex and can trip up even the most seasoned practitioner.
By Brock Yates, CPA