Why Your LLC Losses May Not be Deductible
When an individual receives a Schedule K-1 from an LLC losses you first have to determine if it’s deductible.
When an individual receives a Schedule K-1 for LLC losses, there are several things to consider before deciding if the loss can be deducted. In order to determine deductibility, a partner’s basis and at risk limitations need to be evaluated.
First and foremost, a partner must have adequate basis in the partnership in order to consider the deductibility of the LLC losses. A taxpayer’s tax basis in a partnership interest (often called the partner’s outside basis) represents the partner’s cost for tax purposes and is used to measure the taxable gain or loss upon disposition of the partnership interest.
In addition, a partner’s tax basis can (1) limit the partner’s ability to deduct a LLC losses; (2) cause a cash distribution to be taxable instead of tax-free; and (3) affect the basis of property received as a distribution.
A partner’s initial basis equals the amount of money contributed, plus the adjusted basis of property contributed, plus the partner’s share of the partnership’s liabilities.
All liabilities of the partnership are classified into three categories. First is recourse debt, which is debt that a partner would be responsible to pay back if there is an economic risk of loss on the debt, such as security deposits and loans made by partners to the partnership.
Next is non-recourse debt, which is debt a partner is not liable to repay if the entity cannot. The last type of liability is qualified non-recourse debt, such as a mortgage held by a financial institution.
Typically, all three types of liabilities are allocated to the partners in the same proportion as the profit and loss allocation, except for recourse debt, which is allocated based on whoever bears the risk of economic loss.
Once a partner passes the basis test, the next test to be applied is that of the “at risk” rules of Section 465 of the Tax Code. The at-risk rules are applicable at the partner level, rather than the partnership level, and are designed to ensure that a taxpayer deducts losses only to the extent he or she is economically or actually at risk for the investment.
A partner is considered at risk with respect to an activity for (1) the amount of money and the adjusted basis of other property contributed to the activity; and (2) amounts borrowed for use in the activity if the partner is personally liable for repayment of the borrowed amount or has pledged property, other than property that is used in the activity, as security for the borrowed amount.
The primary distinction between basis and at risk— thereby causing LLC losses to be deductible for one while not the other—are the nonrecourse liabilities. A partner’s share of the nonrecourse liabilities can increase their basis, but not the at risk limitation. In order to deduct these LLC losses, partners may be tempted to guarantee partnership debt. Depending on the type of partnership, limited partnership (LP) or limited liability company (LLC), the impact on the at risk limitation can be different than the desired result.
In a recent IRS communication, the IRS distinguished the LLC guarantee from a debt guarantee in a limited partnership. Generally a limited partner in an LP who guarantees partnership debt is not at risk with respect to the guaranteed debt, because the limited partner has a right to seek reimbursement from the partnership and the general partner for any amounts that the limited partner is called upon to pay under the guarantee. However, in the case of an LLC, all members have limited liability with respect to LLC debt. In the absence of any co-guarantors or another similar arrangement, an LLC member who guarantees LLC debt becomes personally liable for the guaranteed debt and is therefore at risk in relation to the debt.
As you can probably tell, this is a very complex area, and navigating the rules should be done in coordinated consultations between the client’s attorney and tax advisor. We do recommend that clients consult with a tax advisor to discuss their liabilities to ensure their basis and at risk limitations are being properly reported.