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When Will an LLC's Trade Or Business Be Imputed to Its Members?

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When Will an LLC's Trade Or Business Be Imputed to Its Members? When Will an LLC’s Trade or Business be Imputed to its Members? by Sheldon I. Banoff [Published in the Journal of Taxation, September 1997] The imputation of a partnership’s trade or business to all or some of its partners can be relevant whenever a taxpayer’s status as being involved in a trade or business has tax consequences. The growing popularity of LLCs provokes the question, when, if ever, on LLC’s trade or business will be attributed to its members. If imputation occurs, which of the members will be deemed engaged in the LLC’s trade or business? In making this analysis, does the sparse tax law relating to imputing a partnership’s trade or business to all or some of its partners provide meaningful guidance? It is submitted that, where a partnership’s trade or business would be imputed to all or some of its partners for certain operative purposes of federal tax law, attribution similarly should be made from an LLC to all or some of the LLC’s members, for the same purposes. Imputation in an LLC should be to those members who either have the authority to participate, or in fact actively participate, in the day-to-day management or operations of the LLC’s trade or business. Accordingly, imputation of the LLC’s trade or business should occur to the following members: 1. Where the LLC is a member-managed entity, to all members. 2. Where the LLC is manager-managed, to (a) those who have the authority to actively participate in the day-to-day management decisions of the LLC (i.e., typically those members who are the managers) and (b) those nonmanager members who in fact actively so participate. RELEVANCE If a partnership or LLC’s trade or business is attributed to all or some of its partners or members, the latter generally will be deemed to be engaged in the trade or business of the partnership or LLC when they enter into transactions in their individual capacity.1 As of 1986, the phrase “trade or business” reportedly appeared in at least 492 subsections of the Code and in over 664 regulations.2 Its relevance arises with respect to “carrying on a trade or business,” being “engaged in a trade or business,” being involved in an “active trade or business,” and “in connection with a trade or business.”3 If an LLC’s trade or business is ultimately held to be imputed to some or all of its members, various diverse tax consequences may follow under any of those provisions, including the following: 1. The dealer status of a real estate development LLC could be imputed to a member to taint real estate gains that are realizes personally, so as to preclude capital treatment.4 2. A member might incur a business bad debt for unpaid advances made to the LLC, thereby obtaining an ordinary, rather than capital, loss.5 3. A loss sustained on the worthlessness of a member’s interest in an LLC may be a business loss (and thus qualify for inclusion in the partner’s NOL deduction if the partner is considered to be engaged in a trade or business).6 4. A member’s ACRS or MACRS deductions for depreciable property purchased individually may be limited in certain situations by the short-year ACRS or MACRS rules unless the LLC’s business is attributed to the individual member.7 5. Business deductions may be granted under Section 162 for payments made by a member in connection with the trade or business of the LLC or the member.8 6. A member’s legal and accounting fees incurred in litigating and settling a lawsuit against the managers of the LLC may be deductible under Section 162.9 7. A corporate member of an LLC could be deemed to have a trade or business for purposes of the five-year active conduct of a trade or business requirement of Section 355, so as to permit a tax-free distribution by one corporation of the stock of another corporation.10 As indicated above, imputation of a partnership or LLC’s business can extend beyond tax matters relating to the partnership or LLC and affect the tax treatment of the partners or members with respect to unrelated matters. IMPUTATION OF TRADE OR BUSINESS STATUS Although to date there have been no cases, rulings or Regulations dealing with the imputation of an LLC’s trade or business to its members, authority (albeit not always consistent) exists as to the imputation of trade or business from state law limited and general partnerships to all or some of their partners. Since a domestic LLC generally will be treated as a partnership for tax purposes (either by election or default under the check-the-box Regulations11), the analysis that will be applied to LLC members by the IRS and the courts as to attribution of trade or business may be analogous to that applied to the partners (limited and general) of a partnership. The distinction between the trade or business of a partnership (or LLC) and that of its partners (or members) is fundamental to the entity theory of partnership taxation. The operation of Subchapter K does not mandate the attribution of a partnership’s trade or business to its partners — while Section 702(b) characterizes the partnership items at the entity level and then treats the partner as realizing them directly, this concept does not necessarily extend beyond distributive shares from the partnership so as to create a trade or business for other purposes.12 The anti-abuse rule as to use of partnership entities provides no guidance and should have no relevance on the question.13 The authorities are somewhat inconsistent on the subject of imputation, and this unsettled issue has long been called “one of the most illusory.”14 The requisite level of the taxpayer’s conduct will differ under the various Code provisions dealing with trade or business status. For example, a taxpayer may be “engaged in a trade or business” without being -2- “engaged in the active conduct” of such trade or business. It is unclear whether imputation of a partnership or LLC’s trade or business to a partner or member also will be determined or affected by the operative Code provision at issue.15 For purposes of this article, it will be assumed that the operative question is whether the partner or member is “engaged in” the entity’s trade or business via imputation. General Partners Although not all partnerships are engaged in a trade or business,16 where a partnership is so engaged it is clear that its business will be imputed to its active managing partner,17 and as a general rule to other general partners, as well. The Tax Court has stated that “cases too numerous to cite have held that the business of a partnership is the business of its partners”.18 It is well settled that a general partner is considered as engaged in a trade or business, at least where the partnership is so engaged.19 The Service has espoused the principle that partners are viewed as engaged in the partnership’s business20 or at least has acknowledged that a general partner “may be considered to be engaged in a trade or business” of the partnership.21 In addition, the IRS has issued two interpretive Regulations involving deductions for farm expenses that support the broad imputation of a partnership’s trade or business to all of its partners (general and limited). Section 175(a) permits a taxpayer engaged in the business of farming to deduct certain soil or water conservation expenditures. For years prior to 1986, Section 182 permitted a taxpayer engaged in the business of farming to deduct certain land clearing expenditures. Regulations under both sections state that a taxpayer is engaged in “the business of farming” if he is a member of a partnership engaged in the business of farming; the Regulations refer to Reg. 1.702-1, apparently as authority.22 It is not clear if the Regulations would permit one engaged in the business of farming solely through imputation from a partnership to deduct expenditures with respect to land unrelated to the partnership. Therefore, it is not certain that broad imputation to all partners -- general and limited -- is intended under these Regulations. In two areas, the question of imputation is resolved by the Code itself. Section 875(1) provides that a nonresident alien individual or a foreign corporation is considered as being engaged in a trade or business within the U.S. if the partnership in which the individual or corporation is a partner is so engaged. This has been interpreted to require imputation to limited as well as general partners.23 Section 1402(a) defines“net earnings from self-employment” (NEFSE) as including an individual’s distributive share of income or loss from the trade or business of a partnership of which he is a member. Although both Section 875(1) and Section 1402(a) result in a partner’s being treated the same as if the taxpayer were directly engaged in the trade or business of the partnership, the IRS Chief Counsel’s Office recognizes that neither section lends significant support to the general premise that, as a matter of law, a partner is engaged in the trade or business of his partnership.24 Limited Partners It can be argued that trade or business attribution should not extend to a limited partner (except where Congress has explicitly so provided, as in Sections 875(1) and 1402(a)).
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