Q&A Corner

There is a misconception that the answer is no in all circumstances, because of the classification of most personal service businesses as specified service trades or businesses (“SSTBs”). However, if the partner’s taxable income is below certain specified amounts, the SSTB restriction does not apply (for 2024, $191,950, or $383,900 in the case of a joint return, subject to phase-in of the SSTB limitation between those amounts and $241,950, or $483,900 in the case of a joint return, respectively).

If an individual holder of the partnership interest sells the interest there is no PTE deduction, because the partnership interest has not been sold by a flow-through entity. However, if the individual contributes the interest to a newly formed partnership (e.g., with a spouse or other family member), and the recognized partnership sells the partnership interest, a PTE deduction may be available. Care has to be taken to make sure the newly formed partnership has the appropriate “belts and suspenders.”

Yes, an S corporation can hold §1202 stock; however, if converting an S corporation to a C corporation in order to start the clock running on the required five-year holding period, one has to be careful of the manner of conversion. Revoking an S election or contributing the S corporation stock to a newly formed C corporation does not do the trick. For instance, the S corporation can contribute its assets to a newly formed C corporation (or engage in a “corporate inversion” transaction) in exchange for newly issued qualifying C corporation stock and receive §1202-eligible stock. However, §1202 exclusion eligibility is limited to a shareholder’s ownership interest in the S corporation at the time the S corporate acquires the §1202 stock and cannot be increased.

Potentially yes, under the §465(c)(3)(B) aggregation rules. The two activities must constitute a “trade or business” and at least 65% of the losses must be allocated to “active” participants. Note that box 22 of the K-1 must be checked when there is “more than one activity for at-risk purposes,” and the LLC is required to attach a separate statement to the K-1 containing information as to the income, expenses, and other items for each activity.

In many circumstances, the entire gain on sale is reported in the subsequent taxable year when the exchange period lapses. However, it is the IRS position that the partner has a negative tax capital account, the partner will recognize gain in the year of sale to the extent of the negative tax capital account, although some professionals believe this is an erroneous position.

Clearly, the first losses must be allocated to the partner who, under §704(b) principles, will be deemed to bear the loss, which in the facts above is the partner who contributed the intangible property, even though that partner might have no basis or amount at risk to deduct the loss. The §704(c) implications are too complicated to be addressed in a paragraph, but involve a consideration of the §704(c) method (traditional or remedial) elected by the partnership (LLC) – issues discussed at our programs.

None, if §751 hot assets are not present. But if they are, there is a new Form 8308 that has been revised for 2023 tax years. In the past, the form reported only the fact of the existence of §751 hot assets, but not the amount. The revised form now requires the reporting the amount of the hot asset responsibility. Moreover, if the form is required to be filed, a selling partner’s share of any collectibles gain and unrecaptured section 1250 gain must be reported. Note that the form is not filed in connection with a redemption transaction.

No, only a recognized partnership (i.e., two or more members) or an S corporation is eligible to make a deductible state income tax payment and pass through the payment to its owners as a tax credit for state income tax reporting purposes. (See Notice 2020-75.) In fact, we commonly explore with clients whether it makes sense to convert a single-member LLC to a multi-member LLC (e.g., via a small gift to a spouse or other family member) to obtain the PTE benefits.

In the appropriate circumstances, a sale of a shareholder’s personal goodwill may be in order, which generally results in long-term capital gain for the shareholder and only one level of tax. Commonly, this opportunity exists when the shareholder controls customer relationships (and there is no non-compete or non-solicitation agreement in place) or has key supplier relationships. However, structuring the sale requires care, such as (1) making sure that the sale is contemplated at the letter of intent stage, (2) obtaining an appraisal for the value of the goodwill (not required but strongly recommended), and (3) ensuring appropriate transition to the purchaser of the personal goodwill.

It’s easy to forget about the §465 at-risk rules that can come into play. Very generally, a taxpayer can receive a distribution where the at-risk rules are irrelevant; however, if the taxpayer has previously deducted losses that were supported by a capital contribution and later receives a distribution funded by nonrecourse debt, the previously deducted losses can be subject to ordinary income recapture under the rules of §465(e).

No. However, in many circumstances it may be possible to convert the guaranteed payment to a priority distribution of profits subject to a cap. For example, assume a partner is entitled to receive a guaranteed payment of $200,000. Alternatively, for instance, the partnership agreement could provide that the partner be allocated annually the first $200,000 of partnership income and receive a corresponding draw against such income, subject to a repayment obligation if the partnership’s profits for that year are less than $200,000 (with a possible “make-up” in subsequent years). While such an arrangement is not free from the risk of the IRS asserting that the arrangement is a disguised fee, many tax professional are comfortable that the amount received may be considered an allocation of partnership income eligible for a §199A deduction.

No. If the limited partner is a material participant in the business under §469 standards, the income can avoid both the SE tax and the NII tax. In fact, if the partner provides the services through a management company, the result does not change. (See Reg. §1.469-5(f) and Reg. §1.469-5T(k) Ex. 2, both of which provide that services provided for a partnership in any capacity count for §469 material participation purposes.)

Yes, if the S corporation can obtain enough “good” gross receipts, such that the S corporation passive investment income does not exceed 25% of its total gross receipts. Good gross receipts generally come from a trade or business (which includes a trade of business of renting property, if sufficient services are being provided by the landlord); however, many sellers in these circumstances do not want to acquire an active trade or business. The solution often can be for the S corporation to invest in a publicly traded oil & gas partnership, which is considered to generate good gross receipts for purposes of the S corporation passive investment income limitations and often generates a lot of gross receipts per dollar invested.