DATE: TAX FILE MEMORANDUM December 01, 2021 FROM: Jane Student SUBJECT: PA LLC debt allocation Facts: The PA LLC will be formed before the end of the current year to manufacture specialty athletic apparel. The LLC will be equally owned by Paul and Anna, and both parties will be managing members. It will purchase equipment and pay other expenses for $600,000, with $160,000 paid in cash. The remaining $440,000 will be borrowed from First State Bank. The loan will be personally guaranteed by Anna. By the end of the tax year, the LLC will also have $40,000 of accounts payable (not guaranteed by either LLC member). The operating agreement provides that all LLC items will be allocated equally. Capital accounts will be appropriately maintained under the 704(b) Regulations. Any member with a deficit capital account balance upon liquidation of the LLC will be required to contribute cash in the amount of the deficit at that time. (See Instructor Note below.) The LLC expects to produce a loss of about $580,000 for its first taxable year (allocated $290,000 each to Paul and Anna), and the LLC members would both like to be able to deduct their share of the loss. At issue: Paul and Anna would like to know whether the loss limitation rules will affect their ability to deduct the $580,000 loss (allocated $290,000 to each LLC member). If limitations arise, can any adjustments be made to ensure the losses can be deducted? Conclusion and recommendations: Under the existing scenario, Paul's 704(d) loss limitation will be $100,000 and Anna's will be $340,000. Both amounts are reduced by an additional $20,000 under the at-risk limitations to $80,000 and $320,000, respectively. Paul's basis and at-risk amounts will only allow him to deduct $80,000 of his expected $290,000 share of LLC losses. Both Paul and Anna are active LLC members, so the passive activity loss limitations will not apply. The excess business loss limitation would apply to Anna and limit her allowable loss to $250,000 instead of $290,000. Instead, if both Paul and Anna were to guarantee one-half of the recourse debt, each member would have an amount at risk of $300,000. However, both Paul and Anna are single taxpayers, so, under the excess business loss rules, their loss would be limited to $250,000 each, with the additional $40,000 loss carried forward as part of each taxpayer's net operating loss. However, this is a better result than the original allocation.