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  • Material participation in LLC

    Friend of mine asked me about this, I think I know the answer but couldn't exactly say why I was right?

    Friend is part of a 3 person LLC set up by his bro that invests in a single company. It's basically a vehicle for a family held partnership to own a chunk of another business which is a food service business. There is no real activity of the LLC itself (no meetings, minutes, office space etc).

    He clearly doesn't pass the material participation test and is therefor a passive partner.

    What he was wondering, and what I think I know the answer to, is there any way under the sun he could become a material participant of such an LLC? The safe harbor appears to be 500 hours which works out to 1 workday/year approximately. There is no way that the activity of this LLC could justify such an amount of work.

    This is obviously kind of a stupid question, but is it the case that within some LLC it is essentially impossible to be a material participant? I think the answer is pretty definitively "yes" but wondering if smarter people have looked at this.


    but then, shift the mindset to real estate:

    I always hear of friends w/ real estate holdings wrapping several properties into an LLC, wouldn't this material participation test effect them pretty heavily in terms of their ability to deduct business losses? If you have a big real estate portfolio held in 4 LLCs (common scenario) do you have to pass a 500 hour safe harbor for each LLC? That would seem like something that would be really hard to do for multiple LLC and also defeat the purpose of this "passive income."

    Am I missing something?

  • #2
    So really depends on how they setup the LLC and its purpose. You use two terms interchangeably but very different: LLC vs partnership. - and structure matters on this.

    So lots of ways for LLC to be determined 'material participation'. Easiest is the holding of meetings, minutes, and paper trail on who is doing what and deciding for the LLC what is going on in the course of business of the LLC. Track that a few years and that sets precedence for future material participation and holds and tracks for a decade. This matters if the LLC creates a loss or significant profit for taxes -- loss writedowns or self-employment taxes on either side of the equation.

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    • #3
      A couple of points.

      A three member LLC that has not elected to be treated as a subchapter S corporation. Is considered by the IRS to be a disregarded entity. What remains is a Partnership.

      It does not matter how this LLC is setup. It is point blank a passive investment company with a single holding. It doesn't matter how many meetings, minutes, etc... there are. There is nothing active to participate in.

      ​​​​​​​P.S. OP, I assume you meant one ten hour workday per week and not year.

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      • #4
        thank you for the replies, these make total sense.

        i was just wondering exactly how the IRS made this distinction, spiritrider's point makes sense.

        and yes i mean one day/week.

        i'm still confused about the treatment of real estate holdings within LLCs

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        • #5
          Any LLC that has not elected S-Corp status is disregard by the IRS for tax purposes.

          A default single member LLC with real estate holdings is no different for tax purposes than a sole proprietorship. A default multi-member LLC with real estate holdings is no different for tax purposes than a partnership.

          An LLC has no bearing on whether real estate holdings are a strictly passive investment, are active for a real estate professional allowing a loss claim on a personal return or the much more involved and difficult actively engaged in the business of real estate.

          The latter generally involves the buying, selling, rehab, and/or rental of multiple properties. Rental income alone does not generally meet the criteria until there are more than a handful of tenants. As is unfortunately common in tax matters, this a facts and circumstances determination.

          Material participation only matters when actively engaged in the business of real estate. Only then can this be considered self-employment income eligibile to adopt an employer retirement plan.
          Last edited by spiritrider; 06-30-2021, 05:56 AM.

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          • #6
            Correct me if I am wrong.
            In the real estate the partnership participated in the business. What is bought, operated, ran and often guarantees any financing of the real estate activities.
            Different than a passive pure investment.

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            • #7
              While you might think financing, buying and operating rental property is not a passive investment. The tax code and the IRS state otherwise. Rental income from real estate properties are presumed to be passive income. There is a separate schedule E for almost all rental income.

              To be able to claim it as active income you must qualify as a real estate professional. The two main criteria are:
              • You must perform at least 50% of your personal services in all businesses during the year in the real estate business.
              • This must be at least 750 hours/year.
              These are very high hurdles. Very few professionals can work more on their rental real estate holdings than on their primary means of income. Having an unemployed or part-time spouse do this is still very difficult. Even several low occupancy rental properties does not require 750 hours/year in personal services.

              Even if you qualify as a real estate professional, it does not qualify as self-employment income to allow adopting an employer retirement plan. The active income just allows you to claim losses on your personal tax return.

              The rules for being actively engaged in the business of real estate require substantially more than the just the purchase, financing and operation of rental income property. You must be deemed to be in the business of real estate.

              This is very difficult with just rental income. Think many properties and/or high occupancy buildings. Flipping houses is another way.

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              • #8
                Originally posted by spiritrider View Post
                Any LLC that has not elected S-Corp status is disregard by the IRS for tax purposes.

                A default single member LLC with real estate holdings is no different for tax purposes than a sole proprietorship. A default multi-member LLC with real estate holdings is no different for tax purposes than a partnership.

                An LLC has no bearing on whether real estate holdings are a strictly passive investment, are active for a real estate professional allowing a loss claim on a personal return or the much more involved and difficult actively engaged in the business of real estate.

                The latter generally involves the buying, selling, rehab, and/or rental of multiple properties. Rental income alone does not generally meet the criteria until there are more than a handful of tenants. As is unfortunately common in tax matters, this a facts and circumstances determination.

                Material participation only matters when actively engaged in the business of real estate. Only then can this be considered self-employment income eligibile to adopt an employer retirement plan.
                These are some constant questions that we had when using our LLC for both real estate and our regular side business activities. When walking through taxes on turbo tax. TT separates real estate and other activities expenses income into different K1 to each member....eg I get two K1 for business dealings and real estates dealings from our K1 as do spouse and kids. I always found that interesting but I've never questioned it.

                We went through an in depth IRS audit a few years ago --national research program and they dove into the LLC and entire family members including teenage sons material participation in the LLC vs daughter's passive participation. They really didn't question the real estate side (probably cause their were mild gains) vs the losses the regular business side incurred and son's active participation designation.

                That audit was nerve wrecking.
                ​​

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                • #9
                  Originally posted by StarTrekDoc View Post

                  These are some constant questions that we had when using our LLC for both real estate and our regular side business activities. When walking through taxes on turbo tax. TT separates real estate and other activities expenses income into different K1 to each member....eg I get two K1 for business dealings and real estates dealings from our K1 as do spouse and kids. I always found that interesting but I've never questioned it.

                  We went through an in depth IRS audit a few years ago --national research program and they dove into the LLC and entire family members including teenage sons material participation in the LLC vs daughter's passive participation. They really didn't question the real estate side (probably cause their were mild gains) vs the losses the regular business side incurred and son's active participation designation.

                  That audit was nerve wrecking.
                  ​​
                  what was the result?
                  did they ask for documentation?
                  could you expand a bit?

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                  • #10
                    The active participation in real estate activities that qualify you as REPS (real estate professional, and hence active income rather than passive) are spelled out above. We structured our real estate affairs in 2021 so my spouse meets the IRS criteria for REPS. We acquired 9 new properties so far this year. We bought a property that we rehabbed top to bottom and supervised the entire project. Yes, this is work and time, but my spouse is an interior designer who thrives on this type of project. The hours allowed qualification for REPS.

                    The result of REPS is all other W2 and active business income can be sheltered with depreciation deductions. Our 2021 taxable income will likely be zero.

                    We have been long term buy and hold real estate investors, but we decided to ramp it up to take advantage of the unmatched tax benefits.

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