Renting Property to an LLC

Editor:
Albert B. Ellentuck, Esq.
Of Counsel
King & Nordlinger, L.L.P.
Arlington, VA

Editor’s note: This case study has been adapted from PPC’s Guide to Limited Liability Companies, 11th Edition, by Michael E. Mares, Sara S. McMurrian, Stephen E. Pascarella II and Gregory A. Porcaro, published by Practitioners Publishing Company, Ft. Worth, TX, 2005 ((800) 323-8724; ppc.thomson.com).

Rather than contributing or selling property, a limited liability company (LLC) member may wish to retain property ownership, while making it available for the LLC’s use or benefit. Leases of property to LLCs and other transactions in which a member retains ownership—such as a member’s pledge of separately owned assets to obtain or secure LLC debt—are regarded as transactions between an LLC and a nonmember (subject, of course, to related-party transaction considerations); see Regs. Sec. 1.707-1(a).

Possible Disallowance of Rent Expense Deduction

A lease agreement involving related parties can be a vehicle for shifting income and deductions, as well as a disguise for other transactions between the lessee and a related lessor. For this reason, Sec. 267 provides for careful matching of income and deductions between related parties. As with other expenses paid to a cash-basis member, an accrual-basis LLC cannot deduct rent expense owed to a cash-basis member until the expenses are paid and included in the member’s income; see Sec. 267(a)(2). This rule also applies to payments from an accrual-basis LLC to any cash-basis taxpayer who indirectly holds an interest in the LLC, or to any cash-basis taxpayer related to a member.

In addition, related parties are presumed not to be dealing at arm’s length and, accordingly, are subject to additional scrutiny by the IRS. For example, in United Builders Supply, Inc., DC MS, 1/11/78, rents were found to be excessive and unreasonable in amount; consequently, a portion of the lessee’s rent deduction was disallowed. When a deduction for unreasonable rent is disallowed, the Service is not obligated to reduce the rent income of the related lessor, making this a potentially disastrous situation. If a question exists as to the reasonableness of the rent, the parties may consider adding a clause to the agreement (before entering into it) providing for repayment by the lessor of any disallowed rents. However, this may create a red flag that the parties believed the rent charged might be unreasonable.

Practice tip: The deductibility of rents between related parties is essentially determined by the facts and circumstances; thus, it is wise for the member and the LLC to build evidence at the onset of the lease to support the reasonableness of the rent called for in the lease agreement. This could include documentation of the commercial practices and the rents paid for similar properties in the area at the time the lease is entered into. Additionally, there should be a written lease with the usual and customary lease provisions. The validity of the lease may also be enhanced by evidence that both parties complied with its terms and that rents were paid on time.

Applying the Self-Charged Rent Rules

The passive activity loss rules contain special provisions that apply when a member rents property to an LLC for use in a trade or business in which the member materially participates (the self-charged rent rules). These rules generally require an amount of passive gross rental activity income equal to the net rental activity income from the property for the year to be recharacterized as nonpassive income; see Regs. Sec. 1.469-2(f)(6).

In other words, if rental of the property to the LLC generates passive income for the member, the income will be recharacterized as nonpassive (to be offset by the member’s share of the nonpassive LLC rental expense deduction). This prevents the member from manipulating the transaction to generate passive income to offset passive losses from other activities. The recharacterization rule does not apply to (1) property rented incidental to a development activity or (2) rent payments pursuant to a written binding contract entered into before Feb. 19, 1988; see Regs. Sec. 1.469-2(f)(6)(ii) and -11(c)(1)(ii).

Example

Maggie is a member in Cicely Airways, LLC, with a 50% interest in its capital and profits. Cicely is classified as a partnership for Federal tax purposes. Maggie is a pilot and materially participates in the business. She rented her airplane to the LLC (a passive activity) beginning in March 2006 and incurred expenses of $15,000 for the plane’s maintenance and upkeep for the year. Maggie’s gross rental income from the airplane is $20,000. The $15,000 of expenses reduces the rental income that must be recharacterized. Accordingly, $5,000 of Maggie’s rental income is recharacterized as nonpassive.

Application

When applying this recharacterization rule, the gross rental activity income for a tax year includes any passive activity gross income (determined without regard to the recharacterization rules) that is income for the year from the rental or disposition of the property; see Regs. Sec. 1.469-2(f)(9)(iii).