Partnership and LLC accruals to related entities: a trap for the unwary.

Sec. 267 generally provides that when related parties are involved, there must be a matching of the payor's deduction with the recognition of income by the payee. While conceptually simple, this can get complicated in the partnership context.

Under Sec. 267, Temp. Regs. Sec. 1.267(a)-2T(c) and Regs. Sec. 1.267(b)-1(b), a partnership will not be allowed to deduct accrued business expenses or interest owed to a cash basis partner until the amounts accrued are includible in that partner's income. This rule applies to any payment made to a partner holding (actually or constructively) any capital or profits interest in the partnership or to any person (entity) related to a partner. Thus, the rule applies in the following situations:

1. Payments from an accrual-basis partnership to a cash-basis partnership when the same person is a partner in both entities.

2. Payments from an accrual-basis partnership to a cash-basis S corporation when the same person is both a partner in the partnership and a shareholder in the S corporation.

3. Payments from an accrual-basis partnership to a C corporation when the same person is both a partner in the partnership and a more-than-50% shareholder in the C corporation.

In these situations, the transaction is viewed as occurring between the related entity and the members of the partnership separately. The amount deferred is the greater of (1) the amount that would be deferred had the transaction occurred between the payor entity and the separate owners of the payee entity in proportion to their respective interests in the payee entity, or (2) the amount that would be deferred had payment occurred-between the separate, owners of the payor entity in proportion to their respective interests in the payor entity and the payee entity. If the amount computed is less than 5 of the otherwise allocable deduction, the rule does not apply.

Example 1: BA, an accrual-basis partnership, accrues an otherwise deductible expense to partnership CA, which is on the cash basis. A holds a 5% interest in BA and a 49 interest in CA. B, C and A are unrelated individuals. Here, BA must defer 49% of the deduction. The result would be the same if A held 49% of BA and 5% of CA.

Example 2: XYZ, an accrual-basis partnership, accrues an otherwise deductible expense to A Corporation, a cash-basis C corporation. Individual Z owns 35% of XYZ and 100% of A. XYZ must defer 35% of the deduction. if Z owned less than 51% of A, XYZ would be able to deduct 100% of its expense. The amount deferred must be allocated solely to Z under this regulation.

The examples make it clear that the aggregate theory of partnership taxation applies. Thus, if a partnership wishes to accrue an expense to a related flow-through entity, it must defer a portion of the deduction equal to the maximum ownership percentage in either entity of those partners that are also owners of the related entity. If the accrual is to a related C corporation, the deduction deferred is equal to the common owners' percentage interest in the partnership.

With the advent of limited liability companies (LLCs), it is anticipated that such situations will arise more frequently, since LLCs are generally treated as partnerships for Federal income tax purposes. Therefore, it is important to keep these rules in mind before making accruals to relate cash-basis entities.

From Bruce J. Belman, CPA, J.D., Cohen & Company, Cleveland, Ohio