What happens to partnership losses allocated to partners in excess of the tax basis in their partnership interests?

A partnership interest can be broken down into two distinct rights: (1) capital interest and (2) profits interest. To become a partner in a partnership, you will receive at least one of these rights. A capital interest is the right to receive a share of the partnership assets at liquidation. A profits interest is the right to share in the future earnings and losses of the partnership. While these rights are given to most partners that contribute cash or property, special rules exist when these rights are given to partners in exchange for services.

When a partner receives a capital interest in exchange for services rendered to the partnership, the partner must treat the liquidation value of the capital interest as ordinary income. Further, the tax basis for the partner will be equivalent to the amount of ordinary income recognized. The holding period for this tax basis will begin on the date the capital interest is received. From the partnership's perspective, the partnership can deduct or capitalize the value of the capital interest depending upon the type of services rendered. This is determined on a fact and circumstance basis. Additionally, the amount deducted by the partnership is allocated to the non-service partners as consideration for effectively transferring a portion of their capital interest to the service partner.

When a partner receives a profits interest in exchange for services rendered to the partnership, the partner has no immediate tax impact because the profits interest has no liquidation value at the time the interest is received. Thus, the non-service partners will not receive any deductions for adding the additional partner to the partnership. As the partnership makes future profits and losses, the service partner will be allocated her/his portion of these losses according to the profit sharing ratios. The debt allocated to non-service partners must also be redistributed with the additional service partner receiving her/his portion of debt. Therefore, the initial tax basis of a service partner with only a profits interest will either be zero or the portion of debt the partner is allocated (if any).

Before a string of relatively recent Tax Court decisions, only Proposed Reg. §1402(a)-2 provided guidance on this matter; however, the regulation was never finalized leaving LLCs without any authoritative guidance to help resolve this issue. The proposed regulation provided that if an LLC member is involved in the operations of the LLC, the member should treat the ordinary business income as self-employment income. The regulation listed the following three criteria that would demonstrate active involvement in the LLC: (1) personal liability for the debt of the LLC as an LLC member, (2) authority to contract on behalf of the LLC, or (3) more than 500 hours participating in the LLC's trade or business during the taxable year. If any one of these requirements were met, then the LLC member would be more associated as a general partner and should account for their share ordinary business income as self-employment income.

The recent Tax Court decisions providing authoritative guidance in this area are consistent with the spirit of the Proposed Regulation issued years earlier by the IRS. These decisions provide that LLC members with either management control or that provide significant services to the LLC should treat their share of ordinary business income as self-employment income (see Renkemeyer, Campbell & Weaver, LLP, et al. v. Commissioner, 136 TC 137 (2011), Riether, 919 F.Supp.2d 1140 (D. N.M. 2012), and Castigliola T.C. Memo. 2017-62.) With these decisions to consult, LLCs and their advisors should face less uncertainty than in the past when deciding how to treat an LLC member's share of ordinary business income for self-employment tax purposes.

While a partnership can create an ordinary business loss, the individual partners potentially will not be able to deduct the entire amount in the year of the loss. The partner must potentially overcome four loss limitation rules before the deduction is available. If the loss does not pass any of the limitations, then the loss is suspended indefinitely under that specific hurdle. The four loss limitations are (1) the tax basis limitation, (2) the at-risk loss limitation, (3) the passive activity loss limitation, and (4) the excess business loss limitation.

First, a partner is not able to take any losses that exceed the tax basis of the partner, the partner's outside basis. This limitation prevents partners from taking losses beyond their investment or basis in their partnership interests. Second, a partner cannot take any losses that exceed the at-risk amount for the partner. The at-risk amount is generally the same as the partner's tax basis, except that it excludes the partner's share of nonrecourse debt. This limit still includes recourse debt and qualified nonrecourse debt. In the case of a passive participant in a partnership, losses cannot be taken if the loss exceeds the amount of passive income reported by the partner. Passive losses such as losses from rental activities or losses allocated to a limited partner can only be offset with passive income and gains. Finally, losses remaining after overcoming the prior three hurdles are limited to the sum of the partner's aggregate business gross income or gain of the taxpayer plus a threshold amount. The threshold amount for a tax year is $500,000 for married taxpayers filing jointly and $250,000 for other taxpayers.

According to the Code, a partner is considered to be a passive participant if the activity conducted is a trade or business and the partner does not materially participate in the activity. The IRS has made it clear that those participants in rental activities and limited partners within a partnership are automatically considered to be passive participants.

Further, regulations help clarify whether a partner would be considered a material participant. If the partner meets any of the conditions below, then the partner would be a material participant and the activity would not be considered a passive activity to the partner.

1. The individual participates in the activity more than 500 hours during the year.
2. The individual's activity constitutes substantially all of the participation in such activity by individuals.
3. The individual participates more than 100 hours during the year and the individual's participation is not less than any other individual's participation in the activity.
4. The activity qualifies as a "significant participation activity" (individual participates for more than 100 hours during the year) and the aggregate of all other "significant participation activities" is greater than 500 hours for the year.
5. The individual materially participated in the activity for any 5 of the preceding 10 taxable years.
6. The activity involves personal services in health, law, accounting, architecture, and so on, and the individual materially participated for any three preceding years.
7. Taking into account all the facts and circumstances, the individual participates on a regular, continuous, and substantial basis during the year.

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