When not to use an LLC to own real estate.

Over the last several years, many tax practitioners have concluded that limited liability companies (LLCs) are the entity of choice for clients desiring passthrough treatment for new business activities. This is because they can be treated as partnerships for U.S. income tax purposes, while generally being treated as corporations for purposes of providing the owners with protection from business liabilities.

The perceived advantage of an LLC over a limited partnership is that, in a limited partnership, the general partner does not receive protection from liabilities. Accordingly, S corporations are often established to act as general partners of limited partnerships, adding complexity and cost to the structure. However, in certain circumstances involving real estate, the additional tax benefits of using a limited partnership may be worth the cost.

A limited partnership is more advantageous than an LLC for real estate professionals expected to devote between 100 and 500 hours a year to a rental real estate activity. Under Sec. 469(c)(7), special rules apply to taxpayers who qualify as real estate professionals. These rules modify the general definition of passive activities and provide that rental activities are not treated as passive for a real estate professional if he materially participates in the activity. Thus, a professional can use a rental activity's losses to offset nonpassive as well as passive income, without applying the passive loss limits.

The determination of whether an individual materially participates in an activity may be different for an LLC member and a partner. An individual generally is treated as materially participating in an activity in which he has a limited partnership interest only if one of the following tests is met:

1. The individual participates in the activity for more than 500 hours during the tax year (Temp. Regs. Sec. 1.469-5T(a)(1));

2. The individual materially participated in the activity for any five tax years during the 10 tax years preceding the tax year in issue (Temp. Regs. Sec. 1.469-5T(a)(5)); or

3. The activity is it personal service activity and the individual materially participated for any three tax years preceding the tax year in issue (Temp. Regs. Sec. 1.469-5T(a)(6)). Under Temp. Regs. Sec. 1.469-5T(e)(3)(i)(B), an individual is treated as a limited partner if his liability is limited to a determinable amount by state law. In Gregg, DC OR (11/29/00), the IRS argued that, under this regulation, an LLC member was a limited partner. However, the court agreed with the taxpayer that this regulation was obsolete "when applied to LLCs and their members," and further stated, "[t]he limited partnership test is not applicable to all LLC members, because LLCs are designed to permit active involvement by LLC members in the management of the business." Under Regs. Sec. 1.469-4(a), a taxpayer's activities include those conducted through S corporations and partnerships. In addition, Regs. Sec. 1.469-4(d)(5)(i) states, in general:

A C corporation subject to section 469, an S corporation, or a partnership (a section 469 entity) must group its activities under the rules of this section. Once the section 469 entity groups its activities, a shareholder or partner may group those activities with each other, with activities conducted directly by the shareholder or partner, and with activities conducted through other section 469 entities.

Temp. Regs. Sec. 1.469-5T(e)(3)(ii) states:

A partnership interest of an individual shall not be treated as a limited partnership interest for the individual's taxable year if the individual is a general partner in the partnership at all times during the partnership's taxable year ending with or within the individual's taxable year (or portion of the partnership's taxable year during which the individual (directly or indirectly) owns such limited partnership interest).

Therefore, an individual who owns, in the same entity, both limited and general partnership interests (even if the latter is owned through another passthrough entity) should be able to use the following additional tests to determine whether he materially participates in the entity's activities for the tax year:

1. The individual's participation in the activity constitutes substantially all the participation of all individuals (Temp. Regs. Sec. 1.469-5T(a)(2));

2. The individual participates in the activity for more than 100 hours and no other individual has greater participation (Temp. Regs. Sec. 1.469-5T(a)(3));

3. The activity is a significant participation activity and the individual's participation in all such activities during the tax year exceeds 500 hours (Temp. Regs. Sec. 1.469-5T(a)(4)); or

4. The individual participates in the activity for more than 100 hours and all facts and circumstances indicate that he participates in the activity on a regular, continuous and substantial basis (Temp. Regs. Sec. 1.469-5T(a)(7)).

Regs. Sec. 1.469-9(g) allows real estate professionals to elect to treat all interests in real estate as a single rental real estate activity. The entire activity generally is treated as a limited partnership interest if this election is made and at least one interest in rental real estate is held as a limited partner, unless the de minimis exception in Regs. Sec. 1.469-9(f)(2) is met. However, as noted under Temp. Regs. Sec. 1.469-5T(e)(3)(ii), an individual who is both a general and a limited partner in an entity is not treated as a limited partner. Accordingly, a real estate professional, who is both a general and limited partner and who makes the appropriate election, should be able to use any of the seven tests in Temp. Regs. Sec. 1.469-5T for determining whether he materially participates in all his rental real estate activities.

If the Service acquiesces to Gregg, there may be no reason not to own real estate through an LLC. However, in the meantime, the added expense of maintaining a limited partnership generally will be minimal compared to the income tax benefit currently available. Therefore, taxpayers who qualify as real estate professionals and do not expect to spend more than 500 hours a year on a particular rental real estate activity, but who are willing to serve as general partners (either individually or through a passthrough entity), may wish to consider forgoing use of an LLC in favor of a limited partnership.

FROM ISABEL H. GOLDBERG, CPA, MST, MIAMI, FL