Tax Implications of Partnership Losses: A Case Study of Brownie and Chloe”

QUESTION

Brownie and Chloe have decided to form an LLC classified as a Partnership for federal income tax purposes. Brownie, a CPA, will contribute all of his individually owned stock in his C Corporation, Trouble, Inc., to the Partnership. Trouble Inc. is a health care management business providing management and billing services to various doctors and other health care professionals. Brownie is an employee shareholder. Brownie’s stock is worth $800,000 per a recent appraisal and has a basis to Brownie of $1 million. Brownie has owned the corporation for five years. Chloe, a lawyer, will contribute residential rental property, the Purdy Lane Apartments, which she owns and operates in her individual name. Purdy Lane has a fair market value of $1 million subject to a $200,000 liability which the Partnership will assume. Chloe purchased the property five years ago for $500,000 and that is her current basis in the property. Brownie and Chloe will be equal partners. However, Brownie will manage all partnership business and operations and Chloe wishes to have no management responsibilities and will be an investor only. Brownie and Chloe are each Florida residents, single, and each have adjusted gross income from salary compensation of $200,000, as employees of a CPA and law firm, respectively (before any partnership income or loss). Neither itemize deductions. In the Partnership’s second year of operations, the Partnership has a $1,000,000 loss. Explain how much, if any, of the Partnership loss Brownie and Albert will be able to deduct against their ordinary salary income. Explain and analyze the following limitations and if they apply. Limitations on Partnership Losses/Basis 704(d) Limitations on Partnership losses/ 465 at Risk Limitation Passive activity losses Section 469 Excess Business Loss Limitation 461(I)

ANSWER

Tax Implications of Partnership Losses: A Case Study of Brownie and Chloe”

In the given scenario, Brownie and Chloe have decided to form an LLC classified as a Partnership for federal income tax purposes. They have different types of contributions and roles in the partnership. In the partnership’s second year of operations, it incurs a $1,000,000 loss. Let’s break down how much, if any, of this loss Brownie and Chloe will be able to deduct against their ordinary salary income, taking into consideration the various limitations that may apply.

Basis Limitation (704(d))

Brownie contributed his C Corporation stock to the partnership. The fair market value of his stock is $800,000, and his basis in the stock is $1 million. Since his basis is greater than the partnership’s loss, he can deduct the full $1,000,000 loss against his ordinary salary income.

Chloe contributed residential rental property to the partnership with a fair market value of $1 million and a basis of $500,000. Her basis is greater than the partnership’s loss, so she can also deduct the full $1,000,000 loss against her ordinary salary income.

At-Risk Limitation (465)

The partnership assumes a $200,000 liability from Chloe’s property. Both partners are at risk for this amount, as they are personally responsible for the partnership’s debts. Therefore, they meet the at-risk requirements for the entire $1,000,000 loss.

Passive Activity Losses (Section 469)

Brownie is actively involved in managing the partnership, so he is not subject to the passive activity loss rules. He can use the full $1,000,000 loss against his ordinary salary income.

Chloe, on the other hand, wishes to have no management responsibilities and will be an investor only. This suggests that her involvement may be passive, and she might be subject to the passive activity loss rules. However, if she qualifies as a real estate professional and materially participates in the rental property, she can use the full $1,000,000 loss against her ordinary salary income. If not, the loss may be subject to passive activity loss limitations.

Excess Business Loss Limitation (461(l))

The excess business loss limitation under Section 461(l) limits the amount of business losses that can be deducted against non-business income. For single taxpayers in 2023, the threshold for this limitation is $518,000.

Each partner has an adjusted gross income from salary compensation of $200,000. When combined, their total income is $400,000. Since this amount is less than the threshold, they do not exceed the excess business loss limitation, and they can deduct the full $1,000,000 loss against their ordinary salary income.

In conclusion, both Brownie and Chloe can deduct the full $1,000,000 partnership loss against their ordinary salary income. The basis and at-risk limitations do not pose any obstacles in this scenario, and neither partner exceeds the excess business loss limitation threshold. However, Chloe should consider her passive activity status, as it may impact her ability to deduct losses in future years if she does not meet the criteria for real estate professional status or material participation. Consulting with a tax professional to ensure compliance with these rules is advisable.