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Using an LLC to
Maximize Losses Part I of this two-part article explored the benefits of using a limited liability company to maintain personal liability protection for business owners, while maximizing the income and self-employment (SE) tax benefits of business losses. Part II, below, discusses basis, at-risk and passive-activity loss rules, SE tax issues and planning for generating income.
Garo Kalfayan, J.D.,
LL.M., CPA
For more information about this article, contact Prof. Kalfayan at garok@csufresno.edu.
Executive Summary
In the last issue, Part I of this two-part article addressed the benefits of using a limited liability company (LLC) to maintain personal liability protection for business owners, while maximizing the income and self-employment (SE) tax benefits of business losses. Part II, below, examines deducting losses for income tax and SE purposes, and meeting the basis, at-risk and passive-activity loss (PAL) rules.
Deducting Losses Business owners may have to consider three sets of income tax rules to determine whether an allocated loss is deductible currently: the basis (e.g., Sec. 704(d) or 1366), at-risk (Sec. 465) and PAL (Sec. 469) rules, in that order.21
Basis Rules The Sec. 1366(d)(1) basis rules limit an S shareholder’s loss to stock basis plus any loans the shareholder made to the corporation. A shareholder’s stock basis includes initial contributions of money and property, but not debt that the S corporation incurred. By contrast, Secs. 752(a) and 722 increase a partner’s (or LLC member’s) basis by initial contributions of money and property and a portion of partnership debt.
As illustrated above, an owner of a business that incurs liabilities will usually prefer the entity to be taxed as a partnership (or LLC), rather than as an S corporation, in a loss year. The partner (member) will have a higher basis than an S shareholder, allowing for greater use of losses.23
At-Risk Rules Although a partner (member) of a partnership (LLC) may have sufficient basis to allow use of a loss, the loss will only be allowed to the extent of his or her at-risk amount.24 Sec. 465(b)(1) defines an at-risk amount as the amount of cash and adjusted basis of property the taxpayer contributed to an activity. Sec. 465(b)(2) states that a partner’s at-risk amount includes his or her share25 of recourse debt to the extent he or she is personally liable for repayment. Further, under Sec. 465(b)(2)(B) and (b)(6), a partner’s (LLC member’s) at-risk amount is generally not increased by nonrecourse debt unless it is (1) secured by the partner’s property (not used in the partnership) or (2) related to an activity of holding real property (and is "qualified nonrecourse financing" (QNF)). Because LLC members are not personally liable for LLC debts, LLC debts are deemed nonrecourse. Thus, absent special arrangements, LLC members are not at risk for LLC debt. If an LLC member (like a limited partner) seeks to increase an at-risk amount beyond his or her initial cash and property contributions, he or she will either have to guarantee LLC debt, formally agree to make future additional cash contributions,26 use unrelated property as security or qualify the debt as QNF.
As illustrated above, an LLC member (like a limited partner) may have to relinquish some liability protection to be able to deduct allocated losses in excess of initial cash and property contributions.
PAL Rules If an LLC member has a sufficient basis and amount at-risk, an allocated loss would be income tax deductible only if it satisfied the Sec. 469 PAL rules. Most individual LLC members would seek to treat their distributive shares of the entity’s ordinary losses as "active" rather than "passive," to not be limited by the PAL rules. An individual can use an active loss to offset active income (e.g., Sec. 469(e)(3) wages or guaranteed payments for services rendered) or Sec. 469(e)(1)(A)(i)(I) portfolio income (e.g., interest, dividends and investment gains). A PAL can offset other passive income, but not active or portfolio income.
As these examples illustrate, an LLC member with passive income from another source in excess of an LLC ordinary loss is indifferent as to whether the loss is active or passive. However, if the member desires to use the LLC loss currently to offset active income, the LLC loss must be active. Seven tests: With a few exceptions,28 an individual member’s distributive share of ordinary loss is categorized under Sec. 469(c)(1), as active or passive depending on his or her material participation in an LLC’s business activity. Temp. Regs. Sec. 1.469-5T(a)(1)–(7) provides seven tests to determine whether an individual materially participated in an activity: 1. The individual participated in the activity for more than 500 hours during the tax year. 2. The individual’s participation in the activity for the tax year constituted substantially all of the participation in the activity of all individuals, including nonowners. 3. The individual participated in the activity for more than 100 hours during the tax year, and such participation was not less than the participation of any other individual (including a nonowner). 4. The activity is a significant participation activity29 (SPA) for the tax year and the individual’s aggregate participation in all SPAs during the year exceeded 500 hours. 5. The individual materially participated in the activity for any five tax years during the 10 tax years immediately preceding the current tax year. 6. The activity is a personal service activity,30 in which the individual materially participated for any three preceding tax years. 7. The facts and circumstances indicate the individual participated in the activity on a regular, continuous and substantial basis during the tax year. An LLC member treated as a general partner can meet any of the seven tests to qualify as a material participant.31 However, under Sec. 469(h)(2), a limited partner is presumed not to participate materially, except as provided in Temp. Regs. Sec. 1.469-5T(e)(2). That rule states that a limited partner must meet test 1, 5 or 6, above, to be a material participant. Consequently, an LLC member’s classification as a "general" or "limited" partner for Sec. 469 purposes may determine whether he or she qualifies as a material participant (and has a loss treated as active). Temp. Regs. Sec. 1.469-5T(e)(3)(i)(B) provides that an interest is a limited partnership interest if "[t]he liability of the holder of such interest for obligations of the partnership is limited, under the law of the State in which the partnership is organized, to a determinable fixed amount.…" This rule would treat all LLC members (including managing members) as limited partners for Sec. 469 purposes, because state statutes grant all LLC members limited liability protection. Use any test: In Gregg,32 a district court held that the Temp. Regs. Sec. 1.469-5T(e)(3)(i)(B) limited partnership restriction does not apply to LLCs and their members. It agreed with the taxpayer that this restriction is obsolete when applied to LLCs and their members, because the limited liability statutes create a new type of business entity that is materially distinguishable from a limited partnership. The court held that, in the absence of any regulation asserting that an LLC member should be treated as a limited partner of a limited partnership, the IRS’s conclusion is inappropriate. Thus, the more restrictive standard of material participation for limited partners should not be applied to LLC members. The LLC in that case was a service business, in which capital was not an income-producing factor. According to Gregg, an LLC member (like a general partner) is treated as materially participating if he or she meets any of the seven tests. Under the temporary regulations, an LLC member, like a limited partner, can materially participate only by meeting one of three tests (test 1, 5 or 6).
To summarize, an LLC member who participates over 500 hours during the tax year (or meets test 1, 5 or 6) will be a material participant and be able to deduct an LLC loss. If the member could not meet test 1, 5 or 6, then, according to Gregg, the four other general partner tests might be available to qualify the LLC member as a material participant.
Combining SE and Sec. 469 Issues With simple planning, small business owners can use an LLC ordinary loss for both income and SE tax purposes. An owner can have a deductible loss for SE purposes if he or she is treated as a general partner. Generally, a member will be treated as a general partner for SE purposes if he or she has the authority to contract on the LLC’s behalf. This can be accomplished by designating the member as a manager of a manager-managed LLC, or by verifying that the operating agreement of a member-managed LLC does not restrict the member’s right to contract. A member without contract authority could also be treated as a general partner for SE purposes if he or she works over 500 hours in the business. If the member holds only one class of interest, there cannot be other nonworking members with 500 or fewer hours who do not have contract authority and who own 20% or more of an identical interest. A member treated as a general partner for SE purposes can also be treated as a material participant for income tax purposes under the Sec. 469 PAL rules. If the member participates at least 500 hours during the tax year, the loss will be treated as active. If Gregg applies, an LLC member will not be treated as a limited partner, but rather, as a material participant if he or she meets any of the seven material parti-cipation tests.
If M seeks to treat his $20,000 ordinary loss as active for income tax purposes, he must meet test 1, 5 or 6 under Temp. Regs. Sec. 1.469-5T(a); if Gregg applies, he could meet any of the Temp. Regs. Sec. 1.469-5T(a) tests. Because M has SE income from another source, he seeks to be treated as a general partner for SE purposes to deduct the $20,000 LLC ordinary loss. As long as M can contract on the LLC’s behalf, his loss is also deductible for SE tax purposes.34
If M has no authority to contract, his loss will still be active under the PAL rules, because he met test 1 by participating for more than 500 hours. For SE tax purposes, M will still be treated as a general partner and can deduct his loss (because he participated over 500 hours).35 (If there were another member without contract authority, who did not participate over 500 hours, and who owned 20% or more of an interest identical to M’s, M would be treated as a limited partner; his loss would have no SE tax consequences.)
Minimizing SE Tax on Making a Profit Most business owners do not plan to lose money in perpetuity. If an LLC has a profitable year, the LLC owners would not want their distributive share of profit to have SE tax consequences, because it will increase their SE tax.36 To avoid SE tax consequences, an LLC member currently treated as a general partner could change his or her managerial arrangement (to have no contract authority) and participation arrangement (to work under 500 hours) to be treated as a limited partner. As a result, the member, as a limited partner, could avoid SE tax consequences on LLC income.37 However, a better approach may be for the LLC either to legally reorganize as a corporation under state law or elect to be taxed as a corporation under the check-the-box rules.38 The shareholders could then elect S status; an S shareholder’s pro-rata share of ordinary income (regardless of contract authority or participation) is not subject to SE tax.39
Conclusion Business owners desiring liability protection can use start-up business losses for both income and SE tax purposes. With careful planning, an LLC can provide the necessary framework to accomplish this goal. |
