An LLC may be classified for federal income tax purposes as either a partnership, a corporation, or an entity disregarded as an entity separate from its owner by applying the rules in Regulations section 301.7701-3.
See Form 8832 and section 301.7701-3 of the regulations for more details. An organization formed before 1997 and classified as a partnership under the old rules will generally continue to be classified as a partnership as long as the organization has at least two members and doesn't elect to be classified as a corporation by filing Form 8832. Spouses who own a qualified entity (defined below) can choose to classify the entity as a partnership for federal tax purposes by filing the appropriate partnership tax returns.
The partner’s basis in his partnership interest in increased by: These basis adjustments depend in large part on the allocation of partnership income, gains, losses, deductions, and credit among the partners.
The partnership agreement determines the allocation of these items. If the partnership agreement is silent, these items are allocated in accordance with the partnership interests. If the partnership agreement allocates partnership items among the partners, the allocation is respected as long as one of the following is true: If an allocation does not meet one of these requirements, the allocation of income, gain, loss, deduction, or credit is reallocated in accordance with the partner’s interest in the partnership. Special rules apply to allocations of property with built-in gain and loss. Important Note: The rules governing substantial economic effect are complex and must be given special consideration if the partnership agreement or operating agreement provides for allocations other than in accordance with each partner’s interest in the partnership.
These rules (a) allocate the partnership’s income, losses, deductions, and credit among the partners and (b) adjust basis to reflect each partner’s allocation of those items.
As stated in Taxation of Limited Liability Companies and Partnerships, limited liability companies are taxed as partnerships by default.
If the partner acquired the interest in exchange for a contribution to the partnership, his basis generally equals the amount of money and the partner’s adjusted basis in any property contributed to the partnership. If the property is subject to indebtedness at the time of the contribution, the partner’s basis is reduced by the portion of the debt that is assumed by the other partners. If the partner acquired his interest in exchange for services, his basis equals the value of services provided. If the partner purchased his partnership interest, his basis equals his cost. The partner’s initial basis is adjusted to give effect to transactions affecting the partnership.Liquidating a partnership results in a gain or loss depending on how each partner’s distribution compares to his basis.If the distribution exceeds his basis, he recognizes a gain.Unlike the rules that apply to C corporations, which tax income both at the entity and at the owner level, the partnership rules are designed to only tax income once, at the owner level.A partnership’s income, losses, deductions, and credit are passed through to the partners for Federal tax purposes and taxed directly to them, regardless of when income is distributed. Since the partners have already paid tax on the income when it is earned, a complex system of rules applies to prevent double taxation when the income is later distributed to the partners.