Sussex LLC operates an active business (a chain of music stores) and also owns commercial real estate. The average annual income from its music business is $950,000, and the average annual rent income from its real estate is $50,000. Ms. Reynolds, who actively participates in the music business, owns a 10 percent interest in Sussex. This January, she invested in a limited partnership in Chicago. She recently learned that her loss from this passive activity will be $25,000 annually for four years (years 0, 1, 2, and 3). Her only passive activity income is her 10 percent share of Sussex's annual rent income. The excess of the Chicago loss over the rent income will be a nondeductible passive activity loss.
Ms. Reynolds has requested that Sussex amend its operating agreement to allocate 50 percent of its rent income to her for four years (years 0, 1, 2, and 3). The other members will agree to this amendment only if her allocation of business income is decreased to 7 percent over the four-year period. Determine whether Ms. Reynolds should accept this offer by comparing the NPV of her cash flows with and without the change in her allocation percentages. When making your computations, assume the following.
? Sussex members receive annual cash distributions equal to their shares of LLC income.
? Ms. Reynolds has a 35 percent marginal tax rate and uses an 8 percent discount rate to compute NPV.
? Ms. Reynolds will dispose of her entire Chicago partnership interest (and deduct
any suspended passive activity loss) in year 4. The gain or loss recognized and any
cash flows from the sale are neutral factors in her decision.
First, we need to find the annual cash distributions before and after the change in her allocation percentages. For taxable income tax expense (cash outflow), as the excess of the Chicago loss over the rent income will be a nondeductible passive activity loss, therefore, the cash distribution from music business will be taxed according to the amount received.
Before the change
Cash distribution from music business ($950,000 x 0.10) $95,000
Cash distribution from rent income ($50,000 x 0.10) $5,000
Total cash inflow ...
This solution is comprised of a detailed explanation to determine whether Ms. Reynolds should accept this offer by comparing the NPV of her cash flows with and without the change in her allocation percentages.