As you probably know, a taxpayer realizes gain when the taxpayer transfers appreciated property in exchange for other property. There are exceptions to this general rule. One of those exceptions is defined in Internal Revenue Code Section 721. Section 721 governs when a taxpayer contributes property to a partnership in exchange for a partnership interest. As usual in tax law, this exception is defined to eliminate transactions that don’t fit the intent of the provision. As a consequence, some taxpayers will realize gain when they contribute property to a partnership in exchange for a partnership interest.
Partners in partnerships are allowed to deduct operating losses in partnerships that their shareholder counterparts in S corporations cannot deduct. The difference results from a difference between partners and shareholders as to entity-level debt. That debt increases a partner’s tax basis in her partnership interest. That debt will not increase a shareholder’s tax basis in her corporate shares (unless she is the lender).
Congress most likely believed it was doing real estate professionals and their advisors a favor when it enacted Section 469(c)(7). That section excepts real estate professionals from limits on losses (and tax credits) generated on real estate rental activity. Those limits generally apply to passive activities. Under passive activity rules, taxpayers can deduct net passive activity losses only in certain cases. One of those cases applies when a taxpayer materially participates in an activity. This material participation case generally does not apply to losses generated from rental activities, though. Rental activity is per se “passive” under passive activity rules of Section 469. In other words, generally, no matter how much time a taxpayer spends on a real estate rental activity, all losses from that activity will be passive losses.
“Choice of entity” may be the most mercilessly beaten dead horse of all. There are many varieties of the presentation. All of them have merit. Criteria used vary widely. No matter which criteria folks emphasize, all agree that there is a choice to be made. No business entity is clearly superior in all cases or circumstances.
Business and tax attorneys draft partnership agreements, including LLC agreements. These agreements often contain cash waterfall provisions that are designed to cause cash to be distributed a certain way until certain investors achieve a designated internal rate of return. For example, partnership waterfall provisions may provide that available cash is distributed as follows:
First, to A until A has achieved an 8% internal rate of return (IRR);
Second, 10% to B and 90% to A until A has achieved a 15% IRR;
The balance, 20% to B and 80% to A.
Partnerships do not pay federal income tax. Instead, the partners of the partnership pay income tax on their distributive shares of the partnership’s income. Their distributive shares of income are determined under the partnership agreement, if the partnership agreement properly allocates the partnership’s income.