ACC 432B - Tax Research Memorandum
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TAX RESEARCH MEMORANDUM
Date:
June 21
st
, 2023
Preparer:
Crystal Estridge
Reviewer:
John Conshafter
Subject:
Analysis of Tax Treatment for LLC Losses and Material Participation
Facts:
Sam Davis is a member in a limited liability company that has historically been profitable but is expecting to generate losses in the near future because of a weak local economy. In addition to the hours, she works as an employee of a local business, she currently spends approximately 120 hours per year helping to manage the LLC. Other LLC members each work approximately 140 hours per year in the LLC, and the time Sam and other members spend managing the LLC has remained constant since she joined the company three years ago. Sam’s tax basis and amount at-risk are large compared to her share of projected losses; however, she is concerned that her ability to deduct her share of the projected losses will be limited by the passive activity loss rules.
Issues:
A. As an LLC member, will Sam’s share of losses be presumed to be passive as they are for limited partners?
B. Assuming Sam’s losses are not presumed to be passive, is she devoting sufficient time to the LLC to be considered a material participant?
C. What would you recommend to Sam to help her achieve a more favorable tax outcome?
Authorities:
§469(h)(2) Garnett v. Commissioner, 132 T.C. 368 (2009)
Prop. Reg. § 1.469- 5(e)(3)(i)
Conclusion:
A. Sam’s share of the loss in the LLC will be considered or presumed as passive activity. Sam is a limited member of the LLC, and all the analysis regulations show she is not considered a Limited partner since she did not pass any of the seven material participation tests.
B. Based on the information listed, Sam would not be considered a material participant. She does not exceed the hours to satisfy the test along with not meeting any other of the seven requirements to be considered as a material participant.
C. Sam will need to increase her hours to match the other LLC members’ activity in the business, currently at 140 hours, within the year to satisfy the 3
rd
test. Analysis:
A. In section §469(h)(2) it says that limited partners are to be considered as passive within the LLC. In the case, Garnett v. Commissioner, 132 T.C. 368 (2009), the Court determined that §469(h)(2) is not always applied to all the LLC
TAX RESEARCH MEMORANDUM
members considering them as limited partner. In November 2011, the Internal Revenue Service updated the tax regulations to better define Prop. Reg. § 1.469- 5(e)(3)(i) that LLC members will not be considered or treated as limited partners if they have management rights at any time through the year. B. “In order to determine the material participation a member will have to satisfy at least one of the seven tests in Reg. § 1.469- 5T(a). They are:
1.
The individual participates in the activity for more than 500 hours during such
year.
2.
The individual's participation in the activity for the taxable year constitutes substantially all of the participation in such activity of all individuals (including individuals who are not owners of interests in the activity) for such year.
3.
The individual participates in the activity for more than 100 hours during the taxable year, and such individual's participation in the activity for the taxable year is not less than the participation in the activity of any other individual (including individuals who are not owners of interests in the activity) for such year;
4.
The activity is a significant participation activity (within the meaning of §
1.469-5T(c)) for the taxable year, and the individual's aggregate participation in all significant participation activities during such year exceeds 500 hours;
5.
The individual materially participated in the activity (determined without regard to § 1.469-5T(a)(5)) for any five taxable years (whether or not consecutive) during the ten taxable years that immediately precede the taxable
year;
6.
The activity is a personal service activity (within the meaning of § 1.469-
5T(d)), and the individual materially participated in the activity for any three taxable years (whether or not consecutive) preceding the taxable year; or
7.
Based on all of the facts and circumstances (taking into account the rules in §
1.469-5T(b)), the individual participates in the activity on a regular, continuous, and substantial basis during such year. (
Code of Federal Regulations, National Archives § 1.469-5T
)”
C. As listed above, to qualify as a material participate, the member must meet at least one of the seven tests in Reg. § 1.469- 5T(a). For a more favorable tax outcome, it is recommended to increase their business work hours to match the others LLC members hours. This in turn would satisfy the 3
rd
test and allow this member to be considered active.
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