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.

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.

Example 1: A and B contribute $5,000 each to buy 50% each of the stock of S corporation Q. Q uses the $10,000 and borrows $90,000 to buy a $100,000 building. Q suffers a $12,000 loss, allocated, $6,000 to each shareholder. Because A's and B's basis is only $5,000 each, only $5,000 of the loss is allowed to each; $1,000 each is disallowed (and, under Sec. 1366(d)(2), is carried forward as though incurred in the next tax year).

If, instead, Q were a partnership (or LLC), A's and B's basis would be $50,000 each ($5,000 contribution + $45,000 (50% of the $90,000 partnership debt)). (22) Because each partner's basis ($50,000) exceeds the loss allocated to each ($6,000), the basis rules do not limit use of the allocated losses.

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 share (25) 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.

Example 2: C and D contribute $5,000 each to buy a 50% interest each in LLC Z (taxed as a partnership). Z borrows another $90,000 and buys a $100,000 asset. The debt is secured by the asset; C and D are otherwise not liable on the debt and the debt is not QNF. Although C and D each have a $50,000 basis ($5,000 initial contribution + $45,000 debt), their amount at-risk is only $5,000, because as LLC members, neither C nor D would have ultimate responsibility for payment if Z defaults. However, C or D could increase the amount at-risk by properly guaranteeing the note payment. (27)

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.

Example 3: J, an LLC member, earned $70,000 in wages and $6,000 in interest in 2002.J also has a $5,000 loss from her LLC interest. J would want her LLC loss to be deemed active, to partly offset her wage and interest income (provided she has sufficient basis and amount at-risk).

Example 4: The facts are the same as in Example 3, except the $6,000 is passive income, not interest. J's $5,000 LLC ordinary loss does not have to be active to lower her 2002 taxable income. Provided J has sufficient basis and amount at-risk, the loss can partly offset J's $6,000 of passive 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 we 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 activity (29) (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, became 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).

Example 5: X, an LLC member, participated in an activity for 550 hours during the LLC's tax year. Even if X were treated as a limited partner, he will be a material participant because he met test 1. X's LLC loss is active and currently income tax deductible.

Example 6: Y, an LLC member, participated less than 500 hours during the LLC's tax year. If she is treated as a limited partner under the temporary regulations, Y probably fails all of the three limited partner material participation tests. (33) Y would not be a material participant and the LLC loss would be passive. However, if Y were treated as a general partner under Gregg, she might satisfy one of the four additional tests (2, 3, 4 or 7) to be a material participant.

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 participation tests.

Example 7: M and R form an LLC (not a service LLC). According to the operating agreement, each has a 50% profit- and loss-sharing ratio (i.e., the LLC has one class of interest). All of M's other income is active; further, M has some SE income from another business.

Both M and R anticipate that at the end of the first year, the LLC will have a $40,000 ordinary operating loss ($20,000 loss to each of M and R). Each has sufficient basis and amount at-risk. How can they structure their LLC management and participation to maximize the SE and income tax benefits of the projected loss?

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)

Example 8: The facts are the same as in Example 7, except that R has sole authority to contract for the LLC. How can M deduct the $20,000 loss for income and SE tax purposes?

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)

Example 9: T and V are the sole members of an LLC. They expect to be allocated a distributive share of ordinary income from it in the next tax year. They both work in the business and have authority to contract on its behalf. By converting the LLC for tax purposes from a partnership to a corporation and electing S status, the entity's pro-rata share of ordinary income will not increase SE tax.

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.

EXECUTIVE SUMMARY

* With simple planning, small business owners can use an LLC ordinary loss for both income and SE tax purposes.

* If an LLC member seeks to increase an at-risk amount beyond his or her initial cash and property contributions, the member will either have to guarantee LLC debt, formally agree to make additional cash contributions or use unrelated property as security or qualify the debt as QNF.

* In Gregg, a district court held that an LLC member can meet any of the seven material participation tests to qualify losses as active.

Abbreviations commonly used in The Tax Adviser

TTA             The Tax Adviser
aff'g           affirming
Ann.            IRS Announcement
CB              Cumulative Bulletin
Cir.            Court of Appeals
Cl. Ct.         Claims Court
COBRA           Consolidated Omnibus Budget
                  Reconciliation Act of 1985
Ct. Fed. Cls.   Court of Federal Claims
DC              District Court
EGTRRA          Economic Growth and Tax Relief Reconciliation Act
                  of 2001
ERISA           Employee Retirement Income Security Act of 1974
Fed. Cir.       Court of Appeals for the Federal Circuit
F2d             Federal Reports, second series
F3d             Federal Reports, third series
F Supp          Federal Supplement
F Supp2d        Federal Supplement, second series
GCM             General Counsel Memorandum
HIPAA           Health Insurance Portability and Accountability Act of
                  1996
H. Rep.         House Ways and Means Committee Report
IR              Internal Revenue News Release
IRB             Internal Revenue Bulletin
IRSRRA '98      Internal Revenue Service Restructuring and Reform Act
                  of 1998
Regs. Sec.      Treasury Regulation
Rev. Proc.      Revenue Procedure
Rev. Rul.       Revenue Ruling
rev'g           reversing
SBJPA           Small Business Job Protection Act of 1996
Sec.            Section (refers to the Internal Revenue Code of 1986,
                  unless otherwise indicated)
SOA             Sarbanes-Oxley Act
S. Rep.         Senate Finance Committee Report
Sup. Ct.        Supreme Court
TAM             Technical Advice Memorandum
TBOR2           Taxpayer Bill of Rights 2
TC              Tax Court (regular decision)
TC Memo         Tax Court (memorandum decision)
TD              Treasury Decision
TRA '86         Tax Reform Act of 1986
TRA '97         Taxpayer Relief Act of 1997

(21) See Temp. Regs. Sec. 1.469-2T(d)(6).

(22) Partners do not necessarily increase basis by an equal portion of partnership debt. Partnership debt may be allocated to one or more partners in differing amounts, depending on each partner's status (as general or limited) and the debt's nature (e.g., recourse or nonrecourse); see Regs. Sec. 1.752-1.

(23) LLC members are not liable for the entity's debts; thus, absent some exceptions, all LLC debt should be deemed nonrecourse when allocating to members' bases. See Starr, Schmalz, Baucum and Crnkovich, Limited Liability Companies, 725 T.M., pp. A31-A34.

(24) Sec. 465(a)(1) states that the at-risk rules apply to individuals (including partners, LLC members and S shareholders) and closely held C corporations. For individuals, the rules are applied on an owner-by-owner basis.

(25) According to Sec. 465 (b)(4), a partner's at-risk amount does not include recourse partnership debt to the extent the partner is protected via a stop-loss agreement or other loss-limiting arrangement. Thus, a partner's share of an amount at-risk is the amount remaining after considering his or her right of contribution from the other partners under state law; see, e.g., Marcus W. Melvin, 894 F2d 1072 (9th Cir. 1990).

(26) Even if a general partner were primarily liable for a partnership debt, the limited partners could increase their at-risk amounts for the debt if the general partner had a right to require future additional cash contributions from the limited partners if the partnership defaults. See Melvin, id. and Jerry E. Pritchett, 827 F2d 644 (9th Cir. 1987). This may be difficult to duplicate in an LLC setting, because there is no general partner who is personally liable. In an LLC, an agreement requiring future additional cash contributions might be ineffective to create at-risk amounts if the members control the right to enforce the agreement.

(27) LLC members who guarantee LLC debt should be able to increase their amount at-risk similar to that of limited partners. LLC members do not have a right of indemnification (such as from a general partner) and, thus, should be ultimately responsible for a personal guarantee of debt to a lender.

(28) Rental activities are automatically passive unless a taxpayer qualifies under Sec. 469(c)(2) and (7) to make rental real estate active. A working interest in oil and gas property is usually active (under Sec. 469(c)(4)), as is portfolio income (under Sec. 469(e)(1)).

(29) A SPA is defined by Temp. Regs. Sec. 1.469-5T(c) as a trade or business in which a member does not materially participate (under any of the other material participation tests), but participates for more than 100 hours during the tax year.

(30) Temp. Regs. Sec. 1.469-5T(d) defines a personal service activity as one that involves the performance of personal services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts or consulting, or any other trade or business in which capital is not a material income-producing factor.

(31) According to Temp. Regs. Sec. 1.469-2T(e), while passthrough entities (e.g., partnerships, LLCs and S corporations) are not subject to the PAL rules, their partners, members and shareholders who are individuals are.

(32) Stephen A. Gregg, DC OR, 12/4/00.

(33) If Y were involved in another business activity, she might be able to group the other business and the LLC as one activity. If Y's combined participation in both businesses exceeded 500 hours, she would be a material participant with an active LLC loss. Y could also be a current-year material participant based on tests 5 and 6, which require material participation in the same activity in prior years.

(34) A loss must be allowed for income tax purposes under the Sec. 469 rules for it to be allowed as a deduction for SE tax purposes; see Regs. Sec. 1.469-1T(d)(3).

(35) M (who has one class of interest) is not "switched" to limited partner status by R's 50% identical class of interest. R is treated as a general partner (due to his contract authority) and, thus, his interest cannot be used to "switch" M to a limited partner; see Prop. Regs. Sec. 1.1402(a)-2(h)(4)(i).

(36) If an individual LLC member has combined FICA and SE taxable income in excess of $84,900 (the 2002 limit), the SE tax rate on an LLC distributive share drops to 2.9%.

(37) See Sec. 1402(a)(13). A limited partner's distributive share has no SE tax consequences, but a Sec. 707(c) guaranteed payment to a limited partner is SE taxable.

(38) See Regs. Sec. 301.7701-3 et seq.; see also Form 8832, Entity Classification Election. The "switch" from a taxable partnership to an S corporation should not create income tax consequences for the owners. See Rev. Rul. 84-111, 1984-2 CB 88.

(39) See Paul B. Ding, 200 F3d 587 (9th Cir. 1999).

For more information about this article, contact Prof. Kalfayan at [e-mail].

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