Tax Lawyer Blog

A Blog written by the Tax Attorneys for Individuals and Businesses


Article by Stephen Moskowitz, J.D., LLM., Senior Partner and co-author Anthony Diosdi, J.D., LLM. Senior Associate
Date Published: Feb 09 San Francisco Business Times

A limited liability company (LLC) combines certain advantages of corporations and partnerships. Like a corporation, a LLC and its members may enjoy asset protection benefits and personal liability protection from its creditors. For taxation purposes, the IRS classifies an LLC like a partnership and the income/losses realized by a partnership are distributed to the partners. It is important to understand the potential tax benefits of utilizing an LLC to real estate investors and individuals involved in real estate ventures.

LLCs benefit from the greater flexibility of the Subchapter K provisions of the Internal Revenue Code. Under Subchapter K, losses are deductible only to the extent of a partner’s basis of his partnership interest. A partner’s basis may be increased through his share of recourse liability or the economic risk of loss of an LLC liability to the extent he would bear the loss out of his non-partnership assets. The Internal Revenue Code uses the concept of “economic risk of loss” to classify a liability of an LLC.

An “economic risk of loss” could result in the allocation of a loss that can be used to offset ordinary income. The Income Tax Regulations employ a “doomsday” liquidation analysis to determine the allocation of such a loss. Basically, the Income Tax Regulations assume that all LLC assets are worthless. They also assume all the LLC liabilities are due and payable in full for no consideration. Finally, the Treasury Regulations question whether partners would be obligated to make a payment to a creditor or contribution to the LLC. In determining a partner’s payment obligations, the regulations take into account all statutory and contractual obligations related to the partnership liability, such as guarantees or obligations imposed by state law. For this purpose, guarantees, indemnifications, and other reimbursement arrangements are taken into account.

Applying the aforementioned rules to a typical venture, if the contractual obligations of the LLC could expose any of the partners to liability, (i.e. recourse liability such as a mortgage, contract with a developer, etc.), the LLC could make an allocation of a loss equal to amount of the potential exposure. This is the case even if the contractual agreement has not been satisfied or even if the partner is not individually liable for the agreement. This potentially is a significant tax benefit because it could result in the allocation of losses that could be utilized to offset the ordinary income of each partner such as wages, interest income, or dividends. It should be noted that the partner must recognize income tax liability in the amount of the losses allocated from the LLC when it dissolves or when the partner leaves the entity.

In order for you to be able claim any of the losses allocated to you from the LLC, a partner must satisfy the passive loss rules of the Internal Revenue Code. These rules were enacted to restrict taxpayers from using deductions and other losses generated from certain passive investment activities. The rule is applied on a partner-by-partner basis, not at the LLC level. Under the passive loss rules, a partner must “materially participate” in an LLC. These rules are beyond the scope of this article. However, under the passive loss rules, the partner must participates in the LLC more than 500 hours during the year of the loss allocation. It should be noted that further restrictions might apply to real estate professionals. The Internal Revenue Code does not impose any particular recordkeeping requirements to substantiate the passive loss rules. However, the Treasury Regulations do suggest that appointment books, calendars, and narrative statements may be used to establish the approximate hours devoted to an activity. As such, anyone considering utilizing the above-mentioned strategy should keep a detailed log of the hours they participate in the LLC. This may assist you to establish that you satisfy the passive loss rules in the event of an IRS audit. Given the complexities of Section K of the Internal Revenue Code, anyone considering utilizing an LLC for tax purposes should consult with a qualified tax attorney.

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Do I Need to Worry About Gift Taxes?

Date Published Feb 2009 San Francisco Business Times

In the countdown to April 15, many people rushing to prepare their individual income tax returns will overlook another important tax return that is due the same day. They will overlook the filing of a Form 709 which must be filed with the IRS reporting taxable gifts made during the prior year. Filing to file a gift tax return can result in an expensive oversight.

For example, suppose a generous woman decides to make considerable gifts to her children and grandchildren during her lifetime. However, she fails to file gift tax returns with the IRS reporting the gifts made to children and grandchildren. Now, suppose she dies with an estate worth approximately $5 million. If the IRS were to audit her estate and discovers that the generous women failed to file gift tax returns during her lifetime, the IRS may assess significant back taxes, penalties, and interest against the estate of the generous women. The back taxes, penalties, and interest may eat up most of her family’s inheritance. To avoid a similar nightmare, we hope this article will provide our readers with a basic understanding of gift taxes.

Contrary to common misconceptions, the donor of a gift is responsible for paying any gift tax due on the transfer, not the recipient of the gift. Gift taxes are cumulative and based on how much you give away during your lifetime. The top rate for gift tax is approximately 35 percent. You can give up to $13,000 worth of gifts every year to as many people as you like, gift-tax free and without reporting the gift. Anything above this “annual exclusion” must be reported. Whether you will owe a gift tax depends on whether you have used up your lifetime gift exemption. Currently, taxpayers are allowed to gift $1 million during their lifetime. The IRS requires taxpayers to file gift tax returns to determine how much of the exemption has been used up. Spouses can pool their annual exclusions for a gift up to $26,000. This practice is known as “gift splitting.” However, each spouse is still required to file a gift tax return. In order to avoid the filing requirement, each spouse can make out a separate check for $13,000, rather than writing one check for the entire $26,000 amount. However, payments to service providers such as a doctor, school, and insurance companies are exempt from the above mentioned rules.

Filing gift tax returns is the only way to start the clock ticking on the three year statute of limitations on audits for gift taxes with the IRS. (The statute of limitations is six years if the gift’s value is understated by twenty-five percent of more). However, you should keep the gift tax returns indefinitely for your own protection. Because the gift tax rules are complex and intertwined with the estate tax rules careful consideration must be given to a wide variety of factors, as well as, personal preferences in making good decisions.

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