254 Planning and Forecasting
that these profits and losses are passed through to all partners, including lim-
ited partners, even though one could argue that those profits and losses are de-
rived entirely from the efforts of the general partners. It is this aspect of the
limited partnership which made it the form of choice for tax-sheltered invest-
ments. The loss incurred by the business (much of which was created on paper
through depreciation and the like) could be passed through to the limited part-
ners, who typically had a considerable amount of other investment and com-
pensation income to be sheltered.
Although the tax treatments of limited partnerships and subchapter S
corporations are similar, there are some differences that drove the operators of
tax shelters to use partnerships over the corporate form even at the risk of
some unlimited liability. For one, although profits and losses must be allocated
according to stock ownership in the subchapter S corporation, they are allo-
cated by agreement in the limited partnership. Thus, in order to give the in-
vestors the high proportion of losses they demand, promoters did not
necessarily have to give them an identically high proportion of the equity. The
IRS will attack economically unrealistic allocations, but reasonable allocations
will be respected. In addition, whereas the amount of loss the investor can use
to shelter other income is limited to the tax basis in both types of entities, the
tax basis in subchapter S stock is essentially limited to direct investment in
the corporation, while in a limited partnership it is augmented by certain types
of debt incurred by the entity itself.
Both types of entities are aff licted by the operation of the passive loss
rules, added by the Tax Reform Act of 1986 in an attempt to eliminate the tax
shelter. Thus, unless one materially participates in the operations of the entity
(virtually impossible, by definition, for a limited partner), losses generated by
those operations can normally be applied only against so-called passive income
and not against active (salar ies and bonuses) or portfolio (interest and div i-
dend) income. Furthermore, owners of most tax pass-through real estate ven-
tures are treated as subject to the passive loss rules, regardless of material
participation.
Limited Liability Companies
LLCs are taxed in a manner substantially identical to limited partnerships. This
combination of limited liability for all members (without the need to construct
the unwieldy, double-entity, limited partnership with a corporate general part-
ner) and a pass-through of all tax effects to the members’ personal returns,
makes the LLC the ideal vehicle for whatever tax shelter activity remains after
the imposition of the passive-activity rules.
Technically, under recently adopted “check the box” regulations, LLCs,
limited partnerships, and all other unincorporated business entities may
choose to be taxed either as partnerships or as taxable corporations. Recogniz-
ing that the vast majority of these entities are formed to take advantage of the
opportunity to have taxable income or loss pass through to the owners, these