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Tax Accounting Method for LLCs

An LLC that is taxed as a partnership may not be able to use the cash method if it has losses. Under Section 448(a)(3), an LLC must use the accrual method of accounting if it is a "tax shelter." (Note that the exceptions relating to farming (Section 448(b)(1)), personal services (Section 448(b)(2)) and entities with less than $5.0 million in gross receipts (Section 448(b)(3)) do not apply to a "tax shelter.") The definition of "tax shelter" is one of those grand tours of the Code. Basically you end up at Section 1256(e)(3)(B), the definition of a "syndicate." (You get there via Sections 448(d)(3) and 461(i)(3)(B).) A "syndicate" is a partnership if more than 35% of the losses are "allocable" to limited partners or limited entrepreneurs.

Section 1256(e)(3)(B). A limited entrepreneur is a person (other than a limited partner) who has an interest in an enterprise but who does not actively participate in the management of the enterprise. Section 464(e)(2). Under the regulations of Section 448, the term "allocable" becomes "allocated" thereby avoiding the problem if there are no losses to allocate. Temp. Reg. 1.448-1T(b)(3). This has allowed at least one limited partnership engaged in providing medical services to avoid the accrual requirement by not having losses to allocate. PLR 8753032. If you have net losses, you still may use the cash method if only 35% or less of those losses are allocated to people who do not actively participate in management of the enterprises. The LLC is a "syndicate" only if the 35% limitation is exceeded. The determination of whether a person actively participates in management is based on the facts and circumstances. Prop. Reg. 1.464-2(a)(3). See PLR 8346004; PLR 8503007.

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