Partnership and LLC accruals to related entities: a trap for the unwary.

• Author: Belman, Bruce J.
• Position: Limited liability companies

Sec. 267 generally provides that when related parties are involved, there must be a matching of the payor's deduction with the recognition of income by the payee. While conceptually simple, this can get complicated in the partnership context.

Under Sec. 267, Temp. Regs. Sec. 1.267(a)-2T(c) and Regs. Sec. 1.267(b)-1(b), a partnership will not be allowed to deduct accrued business expenses or interest owed to a cash basis partner until the amounts accrued are includible in that partner's income. This rule applies to any payment made to a partner holding (actually or constructively) any capital or profits interest in the partnership or to any person (entity) related to a partner. Thus, the rule applies in the following situations:

1. Payments from an accrual-basis partnership to a cash-basis partnership when the same person is a partner in both entities.

2. Payments from an accrual-basis partnership to a cash-basis S corporation when the same person is both a partner in the partnership and a shareholder in the S corporation.

3. Payments from an accrual-basis partnership to a C corporation when the same person is both a partner in the partnership and a more-than-50% shareholder in the C corporation.

In these situations, the transaction is viewed as occurring between the related entity and the members of the partnership separately. The amount deferred is the greater of (1) the amount that would be deferred had the transaction occurred between the payor entity and the separate owners of the payee entity in proportion to their respective interests in the payee entity, or (2) the amount that would be deferred had payment occurred-between the separate, owners of the payor entity in proportion to their respective interests in the payor entity and the payee entity. If the amount computed is less than 5 of the otherwise allocable deduction, the rule does not apply.

Example 1: BA, an accrual-basis partnership, accrues an...