Using an LLC to Maximize Losses (Part I)

Many small businesses are organized as corporations or limited liability companies (LLCs) to provide personal liability protection. Owners may seek to use the first few years’ passthrough losses on their personal returns, for both income and self-employment (SE) tax purposes. Part I of this two-part article explores the benefits of using an LLC to maintain personal liability protection for business owners, while maximizing the income and SE tax benefits of business losses.

Garo Kalfayan, J.D., LL.M., CPA
Professor of Accountancy
Craig School of Business
California State University
Fresno, CA

For more information about this article, contact Prof. Kalfayan at garok@csufresno.edu .

Executive Summary

• A An LLC has a legal advantage over a general partnership or sole proprietorship—personal liability protection.

• A 1997 proposed regulation appears to be the clearest indication of the IRS’s position on LLC members and SE tax.

• LLC members seek treatment as GPs to use passthrough losses against SE tax.

Small businesses are often organized as corporations to provide personal liability protection. If losses are expected in the business's growth years, the shareholders can elect S corporation status to pass through the losses for use on their personal returns. If a shareholder (1) has sufficient basis under Sec. 1366(d), (2) has sufficient Sec. 465 amount at risk and (3) meets the Sec. 469 passive activity loss (PAL) requirements, the S election will allow the shareholder to deduct currently his pro-rata share of the S loss on his or her personal return.

However, this plan ignores self-employment (SE) tax. An S shareholder's pro-rata share of S income or loss has no effect on SE tax.¹ This outcome is favorable if the S corporation allocates income, because it does not increase a shareholder's SE tax liability. However, if the S corporation allocates a loss, the S shareholder cannot use the loss to reduce potential SE tax liability from another business he or she owns.

Example 1: Individuals X and Y each own 50% of the stock of T, a newly formed S corporation. At the end of its first year, T has a $40,000 loss; each shareholder's pro-rata share is $20,000. For income tax purposes, X and Y can deduct the $20,000 loss if each has sufficient basis, amount at risk and meets the PAL rules. However, for SE tax purposes, the $20,000 of allocated loss does not reduce either X's or Y's SE tax liability (if any).

Of course, if an S shareholder has no SE tax liability, the inability to offset it with S losses is not a concern. The S corporation business form may work well in this case, because it does not deprive a shareholder of a usable SE tax loss.² However, an S shareholder with SE tax liability from another business would want an allocated loss to be deductible for both income and SE tax purposes.

Example 2: The facts are the same as in Example 1. In addition, X has net income from a sole proprietorship and a distributive share of net ordinary income from a general partnership interest.³ X's net income from the sole proprietorship and general partnership interest creates an SE tax liability. Thus, X would want the $20,000 S loss allocation to reduce both his income tax and his SE tax liability. Even if X has sufficient basis, amount at risk and materially participates, the S loss allocation will only reduce X's income tax liability, not his SE tax liability.

When business start-up losses are expected, and SE tax is a concern to at least one of the owners, the desired result is that the entity's passthrough loss will reduce both the shareholder's income tax liability and his or her SE tax liability. This article explores the benefits of using an LLC to maintain personal liability protection for owners, while maximizing the income and SE tax benefits of losses.

Choosing an LLC

When a business owner wants to use losses to reduce both income and SE tax, an S corporation will not accomplish this result. General partnerships and sole proprietorships allow for the potential use of losses against income tax and SE tax. However, these business forms do not provide an LLC's personal liability protection.⁴ Generally, under state law, an LLC member's personal assets are not subject to the business's debts,⁵ even if the member is the LLC's managing member.⁶ A limited partnership can provide personal liability protection to limited partners (LPs), but an LP's distributive share of loss does not affect SE tax.⁷

In summary, an LLC has a legal advantage over the general partnership and sole proprietorship forms, because it provides personal liability protection to its owners.⁸ An LLC can have a tax advantage over a limited partnership and an S corporation; with planning, it can allow an allocated ordinary loss to be deductible for SE tax purposes.

Using SE Tax Losses

Absent an election, a domestic LLC with more than one member is taxed as a partnership for Federal tax purposes, under Sec. 7701(a)(2) and (3) and Regs. Sec. 301.7701-3(a) and (b)(1).⁹ For income tax and SE tax purposes, "members" of an LLC taxed as a partnership are equivalent to "partners" of a partnership, under Sec. 7701(a)(2). If an LLC member is treated like a GP, the LLC's distributive share of net ordinary loss can reduce the member's SE income from another source. However, if an LLC member is treated like an LP, the LLC's ordinary loss allocation does not have SE tax consequences.¹⁰ Thus, an LLC member must plan his or her affiliation with the LLC so as to be treated as a GP, to be able to deduct LLC ordinary business losses against other SE income.

Prop. Regs: In 1997, Prop. Regs. Sec. 1.1402(a)-2¹¹ was issued to address when a partner (including an LLC member) would be treated as a GP or an LP for SE tax purposes. Section 935 of the Taxpayer Relief Act of 1997 imposed a moratorium (until July 1, 1998) on the implementation of the proposed regulation and any other regulation relating to the definition of an LP partner for SE tax purposes. Apparently, this action was in response to criticism that the proposed regulation was overreaching.¹²

In July 1999, the American Bar Association Tax Section–in conjunction with the AICPA Tax Division–proposed an alternative to the proposed regulation.¹³ It also suggested use of the 1997 proposed regulation, if a legislative solution was not forthcoming.

Congress still has not formally addressed the issue. The 1997 proposed regulation has not been finalized, modified or withdrawn. Proposed regulations are not given the judicial deference accorded final regulations, but they do represent a position advanced by Treasury. The 1997 proposed regulation appears to be the clearest indication of the IRS's position on LLC members and the SE tax.¹⁴

Under Prop. Regs. Sec. 1.1402(a)-2(h)(5), a "service partner" of a "service partnership"¹⁵ is a GP for SE tax purposes.

Under Prop. Regs. Sec. 1.1402(a)-2(h)(2), in a nonservice partnership (and for a nonservice partner of a service partnership), a partner is treated as an LP for SE tax purposes, unless he or she:

1. Has personal liability (as defined in Regs. Sec. 301.7701-3(b)(2)(ii)) for debts or claims against the partnership by reason of being a partner;¹⁶

2. Has authority (under state law) to contract on the LLC's behalf; or

3. Participates in the LLC's trade or business for more than 500 hours during the entity's tax year.

This proposed regulation provides a fairly easy way for an LLC member to be treated as a GP, allowing the member to use LLC losses against SE tax. If the LLC operating agreement authorizes a member to be a managing member or to contract on the LLC's behalf (#2 listed above), he or she will not be deemed an LP. Thus, the member will be treated as a GP and can deduct for SE tax purposes his or her share of ordinary loss.

Example 3: A and B are the sole members of nonservice LLC AB. According to the operating agreement, they have a 50% profit and loss sharing ratio and each has the authority to contract on AB's behalf. B has $20,000 of SE income from another business. At the end of its first year, AB suffers a $40,000 ordinary loss; B's distributive share is $20,000. Under Prop. Regs. Sec. 1.1402(a)-2(i), Example (iv), B is treated as a general partner, because he has the authority to contract on AB's behalf; thus, B can offset the $20,000 distributive share of AB's loss against his $20,000 of SE income from the other business.¹⁷

Prop. Regs. Sec. 1.1402(a)-2(h)(2)(iii) allows a member another way to be treated as a GP. A member who participates in the LLC's trade or business for more than 500 hours during the tax year will be treated as a GP. However, there are some obstacles to using this rule.

When a member participates in the LLC's business, he or she is usually compensated for the services. The compensation is generally treated as a guaranteed payment, which is both income and SE taxable to the member.

Example 4: C and D are the members of nonservice LLC CD. Under the operating agreement, they have a 50% profit and loss sharing ratio, and C can contract on CD's behalf. D participates in CD's business for 600 hours during the tax year. D is paid a $6,000 guaranteed payment for his work. At the end of CD's first year, it suffers a $46,000 ordinary loss ($40,000 operating loss + $6,000 deduction for D's guaranteed payment). At year-end, D will include a $6,000 guaranteed payment in income and a $23,000 distributive share as loss. The $6,000 guaranteed payment is subject to SE tax. The $23,000 loss allocation is deductible for SE tax purposes, because D (who worked over 500 hours) is treated as a GP for SE tax purposes. The net effect on D's SE tax is a $17,000 deduction ($23,000 – $6,000).¹⁸

As illustrated in Example 4, a member who qualifies as a GP under the 500-hour rule (like any other member who receives a guaranteed payment) will trigger income and SE tax liability in the amount of the guaranteed payment received.

Another problem with the 500-hour rule occurs when multiple members have no authority to contract on the LLC's behalf. A member trying to qualify as a GP under the 500-hour rule will be treated as an LP if he or she holds only one class of interest¹⁹ and another member treated as an LP (i.e., no contract authority and does not participate more than 500 hours) owns a substantially identical interest.²⁰

Example 5: F, G and H are the only members of nonservice LLC FGH. According to the operating agreement, each has a 33 ¹/3% profit and loss sharing ratio. The operating agreement provides that F can contract on FGH's behalf, but G and H cannot. G and H own the same class of interest. G participates in FGH's business for 600 hours during the tax year, but H does not. G is paid a $6,000 guaranteed payment for his work. At the end of its first year, FGH has a $46,000 ordinary loss ($40,000 operating loss + $6,000 deduction for G's guaranteed payment). At year-end, G will have $6,000 in guaranteed payment income and will be allocated a $15,333 loss from FGH (33 ¹/3% of $46,000). G's $6,000 guaranteed payment is subject to SE tax. The $15,333 loss allocated to G cannot be deducted for SE tax purposes, because G (who worked over 500 hours) is treated as an LP under Prop. Regs. Sec. 1.1402(a)-2(i), Example (iii). G is still treated as an LP, because H is treated as an LP (no contract authority and participates less than 500 hours) and owns a substantial interest identical to G's class of interest. G's SE tax increases by $6,000 for the guaranteed payment. G's SE tax is unaffected by the $15,333 ordinary loss allocation.

As illustrated in Example 5, an LLC member may find it difficult to qualify as a GP under the 500-hour rule if he or she owns one class of interest and another nonmanaging member owns a substantially identical interest and does not work more than 500 hours in a tax year.

Conclusion

The first part of this two-part article has examined how classification of an LLC member determines SE taxability. Part II, in the next issue, will discuss meeting the basis, at-risk and PAL rules with an LLC.