Randy M. Javorski, et ux. v. Commissioner, TC Summary Opinion 2010-136
This was originally published on September 22nd, 2010.
I try to cultivate humility. I have several people who assist me in this most notably my children. And I do plenty of things to be humble about. I mention this because I reread the Javorski case after coming up with the flippant title to the post. I noticed that the company involved was a Canadian company, so there may have been practical cross-border issues that dictated the structure that they used.
Nonetheless, the tale of woe in this case is a great illustration of the benefits of an LLC structure. Randy Javorski was a manufacturer's rep for several lines of furniture and lighting. He had long wanted to own his own furniture store. In 2002 he formed Lucca Interiors, Inc with Stephan Eberle. Mr. Javorski contributed $150,000 in exchange for a 49% ownership position in Lucca. Mr. Eberle received the balance of the stock in exchange for his services. Besides its own profit potential Mr. Javorski would also benefit from having Lucca as a customer.
Lucca was not profitable. Mr. Javorski exhausted one line of credit and then another in making advances to allow Lucca to fund its operations. Design Institute of America, one of the lines that Mr. Javorski represented, held him accountable for Lucca's failure to pay its bills promptly, creating more pressure for Mr. Javorski to advance funds. In total Mr. Javorski put $382,000 into Lucca.
Lucca was unsuccessful and went into bankruptcy in 2005. Mr. Javorski did not put in a claim, but it was conceded that he would not have received anything if he did. The controversy in the case was the nature of Mr. Javorski's loss. He was arguing for bad debt treatment in 2005. The IRS said a capital loss in 2006. The advances were not well documented as loans so the Court went with the IRS on characterization.
What would have happened if this were an LLC ? The entity's operating losses would have been 100% allocated to Mr. Javorski (loss allocations to Mr. Eberle would not have had substantial economic effect). It is possible that the losses would have been suspended depending on how much time Mr. Javorski spent on the enterprise and whether it would have been permissible to group it with his manufacturer's rep activity (possibly not). Even if the losses were suspended, they would have been allowed in full since the bankruptcy would have been a total disposition.
Now we just have to hope that Mr. Javorski has some good returns in the stock market to use up that capital loss carryover. Maybe next year.
Showing posts with label LLC. Show all posts
Showing posts with label LLC. Show all posts
Friday, November 25, 2011
Thursday, November 10, 2011
LLC Member Not Presumed to be Passive
This was originally published on PAOO on August 30th, 2010.
In Action On Decision 2010-002 the IRS acquiesced in a Court of Claims decision (Thompson v. US 104 AFTR 2d 2009-5381) holding that a membership interest in a LLC was not presumptively passive. Since the LLC is really the entity of choice, if you want a flow through this can be of significance. The passive activity loss rules were probably the most novel element of the Tax Reform Act of 1986. They created a new taxonomy of business undertakings based on each individual taxpayers participation in the business.
The income or loss created by passive activities are aggregated and, in general, the losses are only allowed to the extent of the income. It is erroneous to think of the process as an offset, because the various types of income and losses retain their character. So if you have a capital gain from one passive activity and an ordinary loss from another activity, the ordinary loss will be allowed, while the capital gain will retain its character as a capital gain. Losses without accompanying gains languish suspended from year to year until they are released by the total disposition of the activity giving rise to them. It all gets tracked by Form 8582. If you have been involved in passive activities it could be a worthwhile exercise to review your 8582's from year to year. You will have two sets, one for the regular tax and another for the alternative minimum tax. If you have switched tax preparers, there is a decent chance something got lost in transition. It can happen even from preparers switching software.
The cleanest way out of the morass of passive activity concerns is "material participation". The regulations give an individual seven ways to establish material participation :
(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 paragraph (c) of this section) 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 this paragraph (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 paragraph (d) of this section), 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 paragraph (b) of this section), the individual participates in the activity on a regular, continuous, and substantial basis during such year.
The regulations go on to state that if the taxpayers interest in the activity is as a limited partner qualification for material participation can only come from items 1, 5, and 6 above. Thus a limited partner who does more than any other individual in the activity will not be considered to be materially participating if that amounts to less than 500 hours. In the Thompson case the service had argued that an LLC membership interest was the same as a limited partnership interest for purposes of this regulation. The Court of Claims did not agree and the service has thrown in the towel on this issue.
This decision should further bolster the LLC as the entity of choice where a flow though is desired. Taxpayers should bear in mind though that if they are posting negative numbers from an activity, the IRS will likely attack any reconstruction of their time as a ballpark guesstimate (This has become a term of art apparently).
In Action On Decision 2010-002 the IRS acquiesced in a Court of Claims decision (Thompson v. US 104 AFTR 2d 2009-5381) holding that a membership interest in a LLC was not presumptively passive. Since the LLC is really the entity of choice, if you want a flow through this can be of significance. The passive activity loss rules were probably the most novel element of the Tax Reform Act of 1986. They created a new taxonomy of business undertakings based on each individual taxpayers participation in the business.
The income or loss created by passive activities are aggregated and, in general, the losses are only allowed to the extent of the income. It is erroneous to think of the process as an offset, because the various types of income and losses retain their character. So if you have a capital gain from one passive activity and an ordinary loss from another activity, the ordinary loss will be allowed, while the capital gain will retain its character as a capital gain. Losses without accompanying gains languish suspended from year to year until they are released by the total disposition of the activity giving rise to them. It all gets tracked by Form 8582. If you have been involved in passive activities it could be a worthwhile exercise to review your 8582's from year to year. You will have two sets, one for the regular tax and another for the alternative minimum tax. If you have switched tax preparers, there is a decent chance something got lost in transition. It can happen even from preparers switching software.
The cleanest way out of the morass of passive activity concerns is "material participation". The regulations give an individual seven ways to establish material participation :
(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 paragraph (c) of this section) 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 this paragraph (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 paragraph (d) of this section), 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 paragraph (b) of this section), the individual participates in the activity on a regular, continuous, and substantial basis during such year.
The regulations go on to state that if the taxpayers interest in the activity is as a limited partner qualification for material participation can only come from items 1, 5, and 6 above. Thus a limited partner who does more than any other individual in the activity will not be considered to be materially participating if that amounts to less than 500 hours. In the Thompson case the service had argued that an LLC membership interest was the same as a limited partnership interest for purposes of this regulation. The Court of Claims did not agree and the service has thrown in the towel on this issue.
This decision should further bolster the LLC as the entity of choice where a flow though is desired. Taxpayers should bear in mind though that if they are posting negative numbers from an activity, the IRS will likely attack any reconstruction of their time as a ballpark guesstimate (This has become a term of art apparently).
LLC or S Corporation - Six of One A Dozen of the Other
PLR 20107019
This was originally published on PAOO on August 23rd, 2010.
I've known some people who mangle common expressions without realizing it. "He wants everything handed to him on a silver spoon." "She'll just have to fish or get off the pot." I don't think I do it myself very often. If I mangle a common expression, its on purpose. So I am well aware that the expression is "Six of one - half a dozen of the other". I owe the modification to a friend of mine, who I will gladly credit, if he should claim priority. (I checked with my friend Alan Jacobs. He doesn't remember coining the phrase, but he grants it was characteristic.) He thought "Six of one - half a dozen of the other" was a stupid expression like the oxymoronic "same difference". By using the even stupider "Six of one - a dozen of the other", he made you pay attention.
In general, a corporation is a tax paying entity. Individuals who realize income from corporations either as dividends or from gains on selling interests in corporations are taxed on that income. Profit from an activity can thus be taxed twice before it goes to the ultimate beneficiary of the profit. Used to be if you didn't like that you could just do business as an individual and have unlimited liability or in a partnership where at least one person had unlimited liability. That was a long time ago, though.
Skipping over much history there are two ways in which you can have an entity that provides a liability shield without being subject to double taxation, as some loosely term it. One is to for a corporation make an S election, which requires the consent of all the shareholders. The other is to form a Limited Liability Company (LLC). You can elect to have your LLC treated as a corporation, but absent that election the LLC will be treated as a partnership, if it has more than one owner, or it will be disregarded, for income tax purposes, if it has a single owner.
There, are, however, many difference between the taxation of S Corporations and LLC's, which are treated as partnerships. Generally speaking the partnership form is much more flexible than that of the S Corporation. There is a perception that partnerships are much more complicated than S Corporations. This is mainly due to people taking advantage of the flexibility of the partnership form to do more complicated things. An example of a significant difference is that partners (read LLC members) have basis in their share of the partnership's liabilities, where as S Corporation shareholders do not even if they have personally guaranteed them. So if you had a shopping mall owned by an S corporation that refinanced and used the proceeds to make a distribution, the shareholders might have to recognize gain on the distribution. It is unlikely that LLC members would. These differences will be a persistent theme in this blog as various developments illustrate them.
PLR 20107019 was issued on April 30, 2010 making it still reasonably fresh. It concerns one of the things that make S Corporations appear simpler than entities treated as partnerships. That is the single class of stock rule. An S Corporation can have more than one class of stock. There might be for, example, be voting and non-voting stock. The stock must, however, have identical rights with respect to current and liquidating distributions. Entities taxed as partnership can split the pie up any way that they want. The complexity comes in from the regulations that require that allocations of taxable income reasonably relate to the economic deal. The single class of stock rule makes S corporations a bad choice for deals in which money investors are to get their original investment and a preferred return.
The thing that is scary about S Corporations is that if you screw up badly enough you no longer have a flow through entity. Screw up a non-corporate entity and you are talking more about moving the income or losses around among the different parties, not creating a whole new layer of taxation. The PLR comes out of that type of concern. I had originally considered titling the article "Possible Triumph of Common Sense".
The shareholders of S corporations and partners in partnerships (which includes most LLC members) are taxed on the entity's income regardless of whether it is distributed. Other than in very closely held situations, this creates a business problem. A non-controlling owner has to be concerned that they won't have the cash to pay the taxes that the entity creates for them. This is typically dealt with by having an agreement by the entity to make tax distributions. Generally the distribution is some sort of formula. Certainly in the case of an S corporation it could not be the exact amount of each shareholders federal and state tax, since this amount is unlikely to work out exactly on a per share basis. For example, if you distributed more to a shareholder who happened to live in California, you would probably be violating the single class of stock rule.
PLR 20107019 has a unique wrinkle though. Its tax distribution plan is based on making distributions in proportion to ownership at the time that the taxable income is generated rather than based on ownership when the distribution is declared.
If X's taxable income is increased or its creditable foreign taxes are decreased after X's original return for a particular taxable year is filed, the Stockholder's Agreement allows X to make a distribution to its shareholders, in accordance with their respective interests in X's taxable income or loss for that period, with respect to the deficiency resulting from such increase or decrease within a reasonable time after the amount of the increase or decrease becomes final (the Discretionary Payment Provision). The Discretionary Payment Provision is intended to allow X to assist its shareholders in paying their additional tax liability resulting from adjustments to X's originally filed tax returns.
So imagine that in 2009 X had shown no taxable income and then you sold your stock in early 2010. Sometime in 2012 X settles an audit and you get a corrected K-1 for $20,000. X will then declare a special distribution some of which will go to you even though you have not been a shareholder for over two years.
The IRS ruled that this special plan did not violate the single class of stock rule. Advisers to substantial S Corporations may want to take a look at this ruling as might owners of minority interests in S Corporations.
This was originally published on PAOO on August 23rd, 2010.
I've known some people who mangle common expressions without realizing it. "He wants everything handed to him on a silver spoon." "She'll just have to fish or get off the pot." I don't think I do it myself very often. If I mangle a common expression, its on purpose. So I am well aware that the expression is "Six of one - half a dozen of the other". I owe the modification to a friend of mine, who I will gladly credit, if he should claim priority. (I checked with my friend Alan Jacobs. He doesn't remember coining the phrase, but he grants it was characteristic.) He thought "Six of one - half a dozen of the other" was a stupid expression like the oxymoronic "same difference". By using the even stupider "Six of one - a dozen of the other", he made you pay attention.
In general, a corporation is a tax paying entity. Individuals who realize income from corporations either as dividends or from gains on selling interests in corporations are taxed on that income. Profit from an activity can thus be taxed twice before it goes to the ultimate beneficiary of the profit. Used to be if you didn't like that you could just do business as an individual and have unlimited liability or in a partnership where at least one person had unlimited liability. That was a long time ago, though.
Skipping over much history there are two ways in which you can have an entity that provides a liability shield without being subject to double taxation, as some loosely term it. One is to for a corporation make an S election, which requires the consent of all the shareholders. The other is to form a Limited Liability Company (LLC). You can elect to have your LLC treated as a corporation, but absent that election the LLC will be treated as a partnership, if it has more than one owner, or it will be disregarded, for income tax purposes, if it has a single owner.
There, are, however, many difference between the taxation of S Corporations and LLC's, which are treated as partnerships. Generally speaking the partnership form is much more flexible than that of the S Corporation. There is a perception that partnerships are much more complicated than S Corporations. This is mainly due to people taking advantage of the flexibility of the partnership form to do more complicated things. An example of a significant difference is that partners (read LLC members) have basis in their share of the partnership's liabilities, where as S Corporation shareholders do not even if they have personally guaranteed them. So if you had a shopping mall owned by an S corporation that refinanced and used the proceeds to make a distribution, the shareholders might have to recognize gain on the distribution. It is unlikely that LLC members would. These differences will be a persistent theme in this blog as various developments illustrate them.
PLR 20107019 was issued on April 30, 2010 making it still reasonably fresh. It concerns one of the things that make S Corporations appear simpler than entities treated as partnerships. That is the single class of stock rule. An S Corporation can have more than one class of stock. There might be for, example, be voting and non-voting stock. The stock must, however, have identical rights with respect to current and liquidating distributions. Entities taxed as partnership can split the pie up any way that they want. The complexity comes in from the regulations that require that allocations of taxable income reasonably relate to the economic deal. The single class of stock rule makes S corporations a bad choice for deals in which money investors are to get their original investment and a preferred return.
The thing that is scary about S Corporations is that if you screw up badly enough you no longer have a flow through entity. Screw up a non-corporate entity and you are talking more about moving the income or losses around among the different parties, not creating a whole new layer of taxation. The PLR comes out of that type of concern. I had originally considered titling the article "Possible Triumph of Common Sense".
The shareholders of S corporations and partners in partnerships (which includes most LLC members) are taxed on the entity's income regardless of whether it is distributed. Other than in very closely held situations, this creates a business problem. A non-controlling owner has to be concerned that they won't have the cash to pay the taxes that the entity creates for them. This is typically dealt with by having an agreement by the entity to make tax distributions. Generally the distribution is some sort of formula. Certainly in the case of an S corporation it could not be the exact amount of each shareholders federal and state tax, since this amount is unlikely to work out exactly on a per share basis. For example, if you distributed more to a shareholder who happened to live in California, you would probably be violating the single class of stock rule.
PLR 20107019 has a unique wrinkle though. Its tax distribution plan is based on making distributions in proportion to ownership at the time that the taxable income is generated rather than based on ownership when the distribution is declared.
If X's taxable income is increased or its creditable foreign taxes are decreased after X's original return for a particular taxable year is filed, the Stockholder's Agreement allows X to make a distribution to its shareholders, in accordance with their respective interests in X's taxable income or loss for that period, with respect to the deficiency resulting from such increase or decrease within a reasonable time after the amount of the increase or decrease becomes final (the Discretionary Payment Provision). The Discretionary Payment Provision is intended to allow X to assist its shareholders in paying their additional tax liability resulting from adjustments to X's originally filed tax returns.
So imagine that in 2009 X had shown no taxable income and then you sold your stock in early 2010. Sometime in 2012 X settles an audit and you get a corrected K-1 for $20,000. X will then declare a special distribution some of which will go to you even though you have not been a shareholder for over two years.
The IRS ruled that this special plan did not violate the single class of stock rule. Advisers to substantial S Corporations may want to take a look at this ruling as might owners of minority interests in S Corporations.
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