| TAX FILE MEMORANDUM | | | DATE December 11, 2020 | | | FROM Jane Diaz | | | 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. | | 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. | | Issues: 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). | | Conclusion and recommendations: Under the existing scenario, because Anna will personally guarantee the loan, the entire amount will be allocated to her for basis purposes. Therefore, Paul's 704(d) loss limitation will be $ and Anna's will be $. Both amounts are reduced by an additional $20,000 under the at-risk limitations to $ and $, respectively. Paul's basis and at-risk amounts will only allow him to deduct $ of his expected $ 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 $ instead of $. 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; under the excess business loss rules, their loss would be limited to $ 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. | | Law and analysis: Losses only can be deducted under 704(d), to the extent of the LLC member's basis in the LLC interest. Paul and Anna each contributed $ of cash. In addition, their basis includes their share of the LLC's liabilities. Recourse debt is allocated to the partners/members who have an economic risk of loss with respect to the debt. Anna has guaranteed the $ equipment loan, so she bears the entire economic risk of loss with respect to that debt. The entire amount is allocated to her. The accounts payable are recourse to the LLC, but neither LLC member has guaranteed the debt, so it is nonrecourse with respect to the two LLC members. It is allocated according to the profit sharing ratios, $20,000 to each LLC member. Losses also must be evaluated under the at-risk limitations. Because PA is an LLC, neither partner is liable for the accounts payable, so those liabilities cannot be included in their amounts at risk. Absent other arrangements, Paul and Anna's losses for the year are limited as follows. | | | Paul | | Anna | | Cash contribution | $ | $ | | Recourse debt share | | | | Nonrecourse debt share | | | | 704(d) loss limitation | $ | $ | | Less: Nonrecourse debt | () | () | | 465 limitation | $ | $ | | | | As mentioned, the passive activity loss limitation would not arise because both LLC members are active in the business. However, the members must also consider whether the excess business loss limitation would apply. Under this rule, a single individual taxpayer's business losses are limited to $ in a given tax year. Neither Paul nor Anna has business income (or losses) from other sources, so the $ and $ amounts calculated above are the amounts considered under this limitation. Unfortunately, Anna's allocated loss would exceed the threshold amount, so she could only deduct $ and the remaining $ loss would be carried forward as part of her net operating loss carryover. If, instead, Paul and Anna each agreed to guarantee one-half of the recourse debt, the $ would be allocated $ to each person. Paul and Anna's bases [ 704(d) loss limitation] would be $ each, and their amounts at risk would be $ each. The passive activity loss limitation would not apply, but the excess business loss limitation would. As single taxpayers, both Paul and Anna would be limited to a $ loss. Therefore, of the total $ loss allocated to each partner, a $ deduction would be permitted. The excess $ loss would be carried over as part of each LLC member's net operating loss. | |
