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At-Risk Rules §465
At-risk rules apply to most trade or business activities, including activities conducted through a partnership, or activities for the production of income. The at-risk rules limit the amount of loss a partner can deduct to the amounts for which that partner is considered at risk in the activity (§465(a); §465(c)).
A partner is considered at risk for the amount of money and the adjusted basis of any property he or she contributed to the activity, income retained by the partnership, and certain amounts borrowed by the partnership for use in the activity. However, a partner generally is not considered at risk for amounts borrowed unless that partner is personally liable for the repayment or the amounts borrowed are secured by the partner’s property other than property used in the activity (§465(b); §752).
Note: If real estate financing is provided by someone who is regularly and actively engaged in the business of lending money (provided that such person is neither the seller nor promoter of the property), or by a federal, state or local government, the investment is considered to be at risk, and the losses are permitted.
A partner is not considered at risk for amounts that are protected against loss through guarantees, stop loss agreements or other similar arrangements. The partner is also not at risk for amounts borrowed if the lender has an interest in the activity (other than as a creditor) or if the lender is related to a person (other than the partner) having an interest (§465(b)(3)(A); §465(b)(4)).
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Passive Loss Limitations – §469
A partner’s loss deduction from a limited partnership interest may also be disallowed under §469 (passive loss limitation rules). The IRS is now using the old “divide and conquers” theory, and it would appear that they have been rather successful at it. Section 469 now requires taxpayers to divide their activities into three “buckets:”
Passive: Income or loss from a trade or business in which the taxpayer does not materially participate (including non-business activities under §212), are
Portfolio: Annuity income, interest, dividends, guaranteed payments for return on capital, royalties not derived in the ordinary course of a trade or business, gains and losses from the disposal of related assets, etc., are portfolio items; and,
Material Participation: All earned income such as salaries, wages, self-employment income or loss from a business or trade in which the taxpayer materially participates, guaranteed payments for services rendered, etc., are all active items.
Participation in an activity is determined annually, and limited partnership income is conclusively presumed to be passive income to the recipient limited partner. As a general rule, passive activity losses may only offset passive activity income. In determining net passive activity income for a given year, all items of income and loss from passive sources are aggregated. All suspended deductions are carried forward indefinitely.
Triggering Suspended Losses
Only one reasonably high quality “out” was left for us. That is, upon final disposition (disposition must be total) of a passive activity interest, all suspended loss deductions are triggered and become available in that year. These suspended loss deductions must be applied against income or gain in the following order (§469(g)(1)):
(1) First, gain from the disposition of the passive activity interest that was
(2) Second, net income or gain from all other passive activities; and
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(3) Third, any other income items, from whatever source.
The above rules apply only when the passive activity interest is disposed of in a taxable transaction (i.e. an outright sale). If the interest is disposed of in a non-taxable manner (such as a §1031 exchange), the suspended losses are deductible only to the extent of recognized gains. The remaining suspended loss deductions will be recognized upon the sale of the asset acquired in the
Limited Liability Companies
All states now permit the formation of limited liability companies. In a limited liability company, the members or designated managers are not personally liable for any of the debts of the company. The IRS has classified limited liability companies as partnerships for federal tax purposes (R.R. 88-76).
Estates & Trusts
The federal income taxation of estates and trusts is sort of a hybrid between partnership taxation and traditional corporate taxation. As far as the similarity to partnerships is concerned, there is no double taxation of income. However, like corporations, income may be taxed to the entity rather than to the underlying individuals. Whether the income is taxed to the entity or the beneficiaries of the entity generally depends upon whether the income is retained by the entity or distributed to the beneficiaries. If the income is retained by the estate or trust,
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The income tax rates are very high. In 2017, the income tax rates for estates and trusts are:
In the event that the entity chooses to distribute its income to the beneficiaries, a modified version of the conduit principle is applied which works to pass on to the recipients the basic character of the income so distributed (i.e., tax-exempt life insurance proceeds received by a trust and passed on to the beneficiaries remains tax-exempt in their possession).
The income taxation of trust rules apply only to the ordinary trust, whether living or testamentary, sometimes also called a “true,” “conventional,” or “traditional type” trust. They do not apply to entities that are “trusts” in name only, but in reality in the nature of an association (e.g., a “business” trust, “Massachusetts” trust, “common law” trust) and therefore taxable as a corporation (§7701(a)(3);Hecht, Simon v. Malley, (1924) 265 US 144).
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Such a “trust” is taxed as a corporation, if:
(1) It has been initially created, or utilized in the tax period involved, as a vehicle for carrying on a business enterprise, and
(2) Has characteristics, under its written structure or in its adopted mode of operation, of a corporate organization, such as, centralized management, transferability of beneficial interests, continuity of existence despite death of beneficial owners, limited liability, etc. (Morrissey, T. v. Commissioner, (1935)296 US 344; Nee v. Main Street Bank, (1949, CA-8) 174 F2d 425).
In many recent cases, such business trusts have been held to be shams without any economic substance sufficient to cause them to be treated as even a separate taxable entity from the taxpayer (Paulson, TC Memo 1991-508; Aagaard, TC Memo, 1985-194; Whitehead, TC Memo 1991-455).erd
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