By Jason Watson, CPA

Posted Thursday, April 25, 2024

We are just coming out of tax season with a stack of notes with mostly good ideas, and likely some bad ones too. One of those pieces of paper (well, virtual paper with a fancy reMarkable tablet) had updates to our Taxpayer’s Comprehensive Guide to LLCs and S Corps. Here we go…

Being Considered a Passive Investor in a Business

This is aimed at business owners where they no longer materially participate in the business activity, and as such they are now considered passive investors. Seems easy right, but why would you care? You would like to be considered a passive business owner to either-

• have passive losses be deductible against your newfound passive income,
• to avoid having to pay yourself a reasonable salary in an S Corp environment (and only take shareholder distributions), or
• have your income avoid self-employment taxes in a sole proprietor, single-member LLC or partnership environment.

The world is always trending towards harmony, so here are the passive business owner downsides. It is difficult to claim passive business owner given the material participation tests.

Rental Property in a Partnership

WCG encourages short-term rentals to be owned by partnerships (ie, a multi-member LLC). Why? For three reasons-

First, the historical audit rate of partnerships (Form 1065) is 0.4%. Super low compared to individual tax returns (Form 1040). Why does this matter? When you have a big cost segregation depreciation plus your big startup expenses such as furniture and supplies, and you then have a big tax deduction against your big W-2 income because your passive losses are no longer limited with your big material participation, it increases your audit risk a ton. Putting all this action into a partnership tax return reduces the risk right back down to an acceptable amount.

Second, with a partnership tax return, we can mechanically show your capital contribution (at-risk money) including recourse loan debt. Why does this matter? Let’s say you invest $250,000 into a new business, and that business loses money. The IRS sees your “partner basis,” the $250,000, on Form 7203 which is filed within your 1040 tax return, and suddenly the $100,000 first-year loss doesn’t seem so out-of-whack. Conversely, rental property activities reported on Schedule E of your 1040 tax return do not present the same way.

Third, all rental activities, including short-term rental (STR) activities, within a partnership tax return are reported on Form 8825. This is another layer of cloaking within the 1065 tax return and allows your rental income and deductions to fly just a little closer to the ground as compared to Schedule E page 1 of your 1040 tax return. There are three degrees of separation… the 1040 to the K-1 to the 1065 to the 8825, all wrapped with a nice 7203.

Downsides include the additional tax return preparation fees and perhaps unnecessary state taxes such as California’s franchise tax and LLC fee which can be summarized as money-grabs or pleasure to do business in our state fees. You need to consider your exposure versus the cost of reducing your exposure and therefore subsequent risk.

LLC Holding Company

We have written about holding companies versus management companies, but this particular LLC holding company variant does not have any commercial activity. What are we talking about here? Let’s say two people want to own an airplane. They could title it in their own names such as Buzz Aldrin and Amelia Earhart JTWROS. The fancy JTWROS is joint-tenancy with rights of survivorship. This means that should Amelia die before Buzz, typically Buzz would absorb her interest in the airplane.

Time moves along, and Buzz and Amelia want to bring in Pete Mitchell as a third owner. They could add Maverick to the title because no one really knows who Pete Mitchell is, but this gets a bit cumbersome. If you add financing with personal loan guarantees to the mix, it could get messy if the bank wants to re-write the loan docs to add Pete… err… Maverick.

Rather, Buzz and Amelia would create a multi-member limited liability company (MMLLC) called The Little Red Bus LLC. This entity would hold title to the airplane, but would not have any commercial activity. The LLCs’s Operating Agreement would dictate how members could come and go, what happens if one member passes away, and other entity governance items. Therefore, when Pete Mitchell wants to be a part-owner, he would simply acquire member interest in the LLC. Title would not change since The Little Red Bus LLC owns the airplane, and Buzz, Amelia and Maverick own the LLC. Loan documents would not change, but perhaps an additional personal guarantee would be required.

LLCs are being used more and more in non-commercial or non-operating environments to make transfer of ownership super easy. We see this with boats, exotic car collections, art, among other things. Also, since there is no commercial activity, a tax return would not be required. Yes, an EIN would be necessary for a business banking account, but that in itself does not trigger a tax return filing requirement.

Jason Watson, CPA is a Senior Partner of WCG Inc., a business consultation and tax preparation CPA firm located in Colorado Springs, and is the author of Taxpayer’s Comprehensive Guide on LLC’s and S Corps which is available online and from mostly average retailers.