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Top Ten Partnership and LLC Mistakes to Avoid
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Top Ten Partnership and LLC Mistakes to Avoid

In this article we turn to the partnership and the new kid on the block, the limited liability company (LLC). While the relative newness of the limited liability company may account for some of these mistakes, the owner continue to confuse certain matters even in the case of the long-standing partnership vehicle.

  1. Failure to recognize taxation on service partners. Many deals wed the "money" interest with the "expertise" interest, but §721 only provides nonrecognition to persons contributing property in exchange for stock. Practitioners had to distinguish between the granting of a profits interest and a capital interest to avoid instant taxation, a distinction that often was not made. Within the past month, the Service has issued new proposed regulations that in effect remove this distinction, but provide a safe harbor that can be used in structuring new arrangements.
  2. Failure to use member-managed LLCs. The continuing controversy concerning the imposition of self-employment taxes on passive members of an LLC is not advanced when the entity is organized as member-managed. As one of the three requirements in the now-withdrawn (but still practically used) regulations on limited owners focused on the lack of authority to contract on behalf of the entity, only the use of a manager-managed LLC with the group of passive investors not included in the management group will enable such members to avoid self-employment tax.
  3. Failure to allocate debt correctly. Partnerships and LLCs typically use debt a lot, but the rules for allocating the debt among the investors have several layers, in part depending on the kind of partnership and the type of debt. In a general partnership, all partners are jointly and severally liable on the partnership's recourse debt. In a limited partnership, the limited partners are not liable on the partnership's debt; the same is true of members of an LLC, although there tend to be few recourse debts in the latter organization. Nonrecourse debt follows a complicated three-tier regime that requires making side calculations each year. Throw in a guarantee by some or all of the investors, and the allocation can shift.
  4. Failure to distinguish between a draw and a guaranteed payment. A draw is essentially an advance against the partner/member's share of profits from the business, while a guaranteed payment is an amount paid specifically to the owner for services or the use of the owner's property. For tax purposes, a distribution or draw is generally not taxed; what is taxed is the distributive share of entity income whether or not distributed, based on the character of items composing the investor's share, some of which may be subject to self-employment tax. In contrast, a guaranteed payment is always taxed to the recipient as ordinary income - and is generally deductible by the business - that is subject to self-employment tax.
  5. Failure to take into account limitations at the entity level. Tax items such as the §179 expense are applied at both the entity and investor levels. This has two related implications. First, as the partnership cannot elect to expense above the annual limitation ($105,000 in 2005), the partner cannot maximize his own limitation from that corporation. Conversely, the member may have a portion of §179 expense allocated from several entities, each less than the annual limitation but in the aggregate in excess of the limitation, an excess that cannot be used in any taxable year. This is not a mere loss of a deduction, but a cause of additional future tax. The member's basis in the stock will be reduced dollar-for-dollar of allocated §179 expense even if the member cannot use some of it. Short of relief by the basis step-up at death, the member has created phantom future gain by a basis reduction without corresponding tax benefit.
  6. Failure to recognize that owners cannot be paid W-2 wages. Owners of these entities are not employees, but self-employed persons. Whether paid as a distribution or as a guaranteed payment, amounts received by an owner are self-employment income, not W-2 wages, and this fact can adversely affect businesses with domestic-production gross receipts, as W-2 wages act as a limitation on the extent to which the new manufacturers' deduction may be available.
  7. Failure to recognize the loss of fringe benefits. Related to the W-2 issue are the many consequences that flow to the owners by reason of not being an employee. Many fringe benefits predicate the exclusion from income and exception from employment taxes on the status of the beneficiary as an employee (or as a relative of an employee). In the case of medical coverage, a partner/member may not exclude the coverage from gross income or self-employment income. While the Code has provided some relief by permitting a deduction for this benefit, self-employment taxes continue to apply to medical insurance covering an owner. In other cases, such as statutory fringe benefits, there is neither income exclusion nor deduction nor employment-tax exemption.
  8. Failure to recognize the partner/member as an employee for pension purposes. A partner cannot set up a retirement plan on his own outside of the business. He will be covered, if at all, by a Keogh plan covering owners and common-law employees of the business. An owner is an employee for qualified-plan purposes.
  9. Failure to provide for guarantees. Guarantees do not provide tax basis in a partnership or LLC unless and until paid, but the Service has indicated that they do provide at-risk basis in a limited liability company. Guarantees can also convert a seemingly nonrecourse debt to a recourse debt, so allocation of entity debt can shift from some members to others by reason of this action.
  10. Failure to provide for varying interests throughout the year. When a new investor comes into the organization, some practitioners report distributive shares as if the new member had been so during the entire year. Doing so has the effect of shifting certain deductions and income away from the other members. The entity can close the books and allocate between the two parts of the taxable year defined by that closing, but recognize that a new member is not entitled to any of the tax items properly allocable to the period up to the closing.

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