| || The IRS recently reminded taxpayers of a new election that can prevent a business from meeting the definition of a "tax shelter." |
Being deemed a "tax shelter" has never been a good thing, but after passage of the Tax Cuts and Jobs Act, you really don't want to fall victim to that designation. A tax shelter can't use the cash method. A tax shelter can't ignore Section 263A or treat inventory as non-incidental materials and supplies under Section 471. And a tax shelter can't use the small-taxpayer exception to bail out of the interest limitation rules of Section 163(j)(3). That's a lot of inconvenience stemming from two small words.
So who is a "tax shelter?" There's a wide range of different definitions that originate in the Code in Section 448(a)(3), but the most expansive definition is that of a "syndicate" under the meaning of Section 1256. Section 1256(e)(3)(B) defines a syndicate as “any partnership or other entity (other than a corporation which is not an S corporation) if more than 35 percent of the losses of such entity during the taxable year are allocable to limited partners or limited entrepreneurs (within the meaning of Section 461(k)(4))." Recently issued regulations under Section 448 replace the word “allocable” with “allocated,” making it clear that a business must have a loss for a tax year before it can possibly meet the definition of a syndicate.
That's a lot to unpack, so it's prudent to take the syndicate designation in two steps. First, as we just established, the business must have a taxable loss in order to be a syndicate. For these purposes, gains or losses from the sale of capital assets or Section 1231 assets are not taken into account.
Next, more than 35% of the losses must be "allocated" to a limited partner or limited entrepreneur. It is important to understand that a “limited partner” is a true limited partner under the partnership law and the meaning of Section 1402(a)(13); i.e., a partner who is barred under state law from participating in the management of the partnership. This distinction is critical because you could make the mistake of believing that a member in an LLC defaults to being a “limited partner.” The courts have concluded, however, that because an LLC member can – and often does – participate in the management of the LLC under state law, an LLC member is not the same as a limited partner. (See Garnett and Thompson)
While an LLC member is not a limited partner, it may fall victim to the "limited entrepreneur" designation, which Section 461(k)(4) defines as “a person who both 1) has an interest in an enterprise other than as a limited partner, and 2) does not actively participate in the management of such enterprise.”
Unfortunately, the Code does not provide a definition of "actively participating" in the management or operations of an enterprise; rather, it deems it to depend on the specific facts and circumstances. Section 1256(e)(3)(C) does, however, provide for attribution of a taxpayer’s active participation to a spouse or relative, or if the individual had actively participated in the management for at least five years in the past.
So how do we know if our owner "actively participated" in a potential syndicate? The best we have to go on are withdrawn regulations under Reg. Section 1.464-2(a)(3), which give insight into how the Service originally envisioned “active participation” in the farming context when it applied the "limited entrepreneur" designation to certain farming syndicates:
“Factors which tend to indicate active participation include participating in the decisions involving the operation or management of the farm, actually working on the farm, living on the farm, or hiring and discharging employees (as compared to only the farm manager). Factors which tend to indicate a lack of active participation include lack of control of the management and operation of the farm, having authority only to discharge the farm manager, having a farm manager who is an independent contractor rather than an employee, and having limited liability for farm losses”
Most of these aspects can be applied to a non-farm business. Clearly, working in the business and being involved in decisions of the operations or management of the business would qualify, but having authority only over a manager, especially one that is an independent contract, would not. The withdrawn regulations, of course, are not authoritative, and do us little favors by not clearly defining “participating in the decisions involving the operation or management of (a business)”.
This syndicate issue is particularly problematic in 2020, a year in which even historically profitable businesses may produce a one-off loss owing to the impacts of COVID-19. Many of those same businesses will allocate more than 35% of the losses to partners who don't lift a finger. Does that mean they are required to switch to the accrual method, apply Section 163(j), and do all the other bad things that come with being a syndicate?"
That's exactly what it means, but don't panic, because at the end of 2020, the IRS granted relief that will prevent "one off" loss years from creating a syndicate and requiring a bunch of accounting method changes. But only if it truly was a "one-off" year, and the business will produce taxable income again in 2021.
Reg. 1.448-2(b)(2)(iii)(B) permits a business to make an ANNUAL election to determine syndicate status by looking at whether it allocated more than 35% of its losses to limited partners or entrepreneurs in the prior year. Because this is an annual election; in the event of a single, anomalous loss year, a business could elect in the lone year of loss to base the syndicate determination on the prior year – and thus avoid syndicate status – and then refrain from making the look-back election in the following year, avoiding syndicate status for both years.
Example. In 2019, LLC had $100 of taxable income. In 2020, LLC had a $100 loss; 50% of which was allocated to a limited entrepreneur. To avoid syndicate status, LLC may elect in 2020 to determine its status based on its 2019 income/loss, and because there was income in 2019, LLC is not a syndicate in 2020. In 2021, LLC again produces taxable income. In that year, LLC simply refrains from making the election, and is not a syndicate in 2021.
As you can see, this election can be incredibly valuable. Of course, if the business will have a tax loss for both 2020 AND 2021 -- and if more than 35% of that loss is allocated to a limited partner or entrepreneur in both years -- the election serves only to delay the inevitable, because by 2021, regardless of upon which year you base the syndicate determination, you're going to be deemed to be a tax shelter. In which case, you'd better start brushing up on your Forms 3115 and Section 163(j). Maybe start here.