How to report this LLC?

[JoshinNC]

TP organizes LLC as SMLLC. TP's dad "invests" funds in LLC and I instruct TP that dad won't get any tax benefit from this "investment" because dad doesn't own an interest in the LLC. TP tells dad and dad goes to his lawyer (without consulting me) and explains to lawyer that he wants a tax deduction for his investment but doesn't want ownership rights in the LLC. Lawyer drafts an Operating Agreement (OA) which previously did not exist. In the OA TP is listed in the Member section as the ONLY Member and then in a separate section dad is listed as an owner of an "economic ownership interest" with losses allocated to dad (but not profits). This is allowed under NC law.

Here's my question. This still appears to be a SMLLC because the TP is the only Member. As such, absent an entity election, the LLC reports on Sch C of the TP. How do you allocate losses to dad if it is on the TP's Sch C? I don't see how reporting on a 1065 is correct because this is not by definition a Partnership because dad is not a partner.

Anyone have suggestions or experience with this type of situation? I do dozens of LLC Partnership returns but I've never seen this structure.

[ATSMAN]

I am not sure about NC law but from an IRS filing perspective I don't think you can do a SMLLC and allocate losses to a 2nd member and issue a K1 for that.

What is their objection to a partnership of two members with one member getting a certain percentage of losses but no share of profits?

[AZ-Tax]

I have a similar situation like this in AZ

I have a situation like this in AZ except that no OA was drafted. Dad who invested in LLC is not a member but his son is along with a non-related person so its a 2 member LLC. Dad continues to ask me if there is a way for him to deduct something on his tax return. The only thing that comes to mind is if the son defaults on the loan but then again I am not sure it was a loan to begin with.

[ATSMAN]

I have a situation like this in AZ except that no OA was drafted. Dad who invested in LLC is not a member but his son is along with a non-related person so its a 2 member LLC. Dad continues to ask me if there is a way for him to deduct something on his tax return. The only thing that comes to mind is if the son defaults on the loan but then again I am not sure it was a loan to begin with.

Speaking generally these situations involve a family member funding a startup business without the obligation to run or manage the business. In other words they are simply investors.

In my opinion in those situations where they don't want to be partner or shareholder they should execute a properly drafted loan agreement in order to report any interest income or loss. I don't see a way how K1's showing losses can be issued to a non partner or shareholder.

[JoshinNC]

What is their objection to a partnership of two members with one member getting a certain percentage of losses but no share of profits?

This is the way I've always done it and I recommended this. That is when this OA showed up on my desk. 😡

[TaxGuyBill]

"economic ownership interest"

My interpretation is that although the son by be the only "member" of the LLC, the business now has TWO "owners". Therefore a Partnership return.

[JoshinNC]

Except

My interpretation is that although the son by be the only "member" of the LLC, the business now has TWO "owners". Therefore a Partnership return.

IRS Pub 541 states "an organization is treated as a partnership if it has two or more members". Dad is not a Member of the LLC. The TP is the only Member. Dad's interest does not constitute a membership in the LLC.

[TaxGuyBill]

IRS Pub 541 states "an organization is treated as a partnership if it has two or more members". Dad is not a Member of the LLC. The TP is the only Member. Dad's interest does not constitute a membership in the LLC.

The State may only recognize one member of the LLC, but in my opinion, there are still two "members" of the BUSINESS. Again, that's just how I view it.

[Snaggletooth]

Partnership Agreement

In order to make this acceptable, there should be a partnership agreement. This is always the case, but particularly in this case.

Reason being, there is nothing stopping partners from splitting profits one way and losses another. But this won't happen (or shouldn't happen) unless it is set forth in the agreement. If no agreement, no one could legitimately validate the father's wishes for tax purposes.

The existence of a partnership agreement would also put an end to the LLC (in my opinion) and create the need for a fully defined partnership. Either way, a 1065 will be required, even in years where there is no allocation to all parties.

I might add that the parties consider what will happen down the road to the capital balances if partners split profits and losses unevenly. This could end up being a Trojan Horse. I get the idea from the above conversation that Daddy is not necessarily interested in listening to all the possibilities.

[JoshinNC]

Snag

In order to make this acceptable, there should be a partnership agreement. This is always the case, but particularly in this case.

Reason being, there is nothing stopping partners from splitting profits one way and losses another. But this won't happen (or shouldn't happen) unless it is set forth in the agreement. If no agreement, no one could legitimately validate the father's wishes for tax purposes.

The existence of a partnership agreement would also put an end to the LLC (in my opinion) and create the need for a fully defined partnership. Either way, a 1065 will be required, even in years where there is no allocation to all parties.

I might add that the parties consider what will happen down the road to the capital balances if partners split profits and losses unevenly. This could end up being a Trojan Horse. I get the idea from the above conversation that Daddy is not necessarily interested in listening to all the possibilities.

The OA is the Partnership Agreement. When I recommended a Partnership Agreement that is when the dad's attorney emailed me the previously executed OA (which neither the TP nor dad nor mom could explain to me, eye roll).

An OA does not end an LLC. An OA is simply an written agreement between the Partner's (if there are any) as to how the LLC will be operated, funded and distributed in dissolution.

I fully agree that they could have easily achieved the desired income/loss splitting without this cumbersome "economic ownership unit" thingy. What I'm honestly trying to figure out is does the "economic ownership unit" owned by dad create a "Partner" by definition as a "Partner" within the perspective of the Tax Code. If dad is a "Partner" within the Code then I know precisely how to report (1065 with K1 to dad in loss years and to TP in profit years). If dad is not a "Partner" then I'm back to square one.

[Gretel]

I fully agree that they could have easily achieved the desired income/loss splitting without this cumbersome "economic ownership unit" thingy. What I'm honestly trying to figure out is does the "economic ownership unit" owned by dad create a "Partner" by definition as a "Partner" within the perspective of the Tax Code. If dad is a "Partner" within the Code then I know precisely how to report (1065 with K1 to dad in loss years and to TP in profit years). If dad is not a "Partner" then I'm back to square one.

My 2 cents: Just because you give it a different name and not calling a member a member doesn't mean he isn't a member. What else would an economic ownership mean? While you certainly can just allocate losses to one member, it will create complications to the 1065 since you now have unequal distributions. I do not have experience is this but a seminar speaker once said that in a case like this you need to keep to sets of books, one being at FMV.

To avoid this certain language needs to be in the OA that would make it mandatory to the capital accounts equal at the time of dissolution. I am certain that this topic is covered in TTB.

[JoshinNC]

No distribution issues

My 2 cents: Just because you give it a different name and not calling a member a member doesn't mean he isn't a member. What else would an economic ownership mean? While you certainly can just allocate losses to one member, it will create complications to the 1065 since you now have unequal distributions. I do not have experience is this but a seminar speaker once said that in a case like this you need to keep to sets of books, one being at FMV.

To avoid this certain language needs to be in the OA that would make it mandatory to the capital accounts equal at the time of dissolution. I am certain that this topic is covered in TTB.

because the economic owner interest is a not a capital interest (it's stated in the OA and in the NC General Statute). It's simply a profit interest. Which is another reason that I don't think it carries the weight of a Partner because the owner is not entitled to LLC assets at dissolution.

[kathyc2]

This is going outside of your question, but I wonder if the transaction you described would stand as a tax deduction. Father "invests" in sons business, but does so without any expectations of return on investment other than tax deduction for loss? Would non-related parties enter into such a transaction?

[Burke]

Here's my question. ......, absent an entity election, the LLC reports on Sch C of the TP. How do you allocate losses to dad if it is on the TP's Sch C?

Answer is: you can't. Regardless of how they have filed with the State of NC (SMLLC), the fact is -- if there is an "economic ownership interest" per the OA and it is allowable under NC law, then fine. But you have no choice when it comes to the tax return other than to file a 1065 and split the profits/losses accordingly.

[JON]

Parntership

splits of income and loss can vary(flexible), but have to be backed by economic substance (reason). That is a difficult topic if examined, but in the real estate world the attorneys used to use what I would call legalize jargon, but never saw one examined. Usually it was basically one partner (member) putting in more money for ownership units than the other and would get any loses assigned to him until partner accounts were evened out.