Problem 21-42 (LO. 3, 9, 10) Paul and Anna plan to form the PA LLC by the end of the current year to produce and sell specialty athletic apparel. Paul and Anna will both serve as member-managers of the LLC and will be active in its operations. The members will each contribute $80,000 of cash, and in addition, the LLC will borrow $440,000 from First State Bank. The $600,000 will be used to buy equipment and to lease a property they can use as a small manufacturing facility and a storefront. The bank has stated that the debt must be guaranteed, and Anna has agreed to guarantee the entire amount. At the end of the year, the LLC also expects to have accounts payable of $40,000 for inventory and supplies. The LLC's operating agreement provides that all LLC items will be allocated equally. The agreement also provides that capital accounts will be properly maintained and that each member must restore any deficit in the capital account upon the LLC's liquidation. If the LLC claims 100% bonus depreciation, it will report a loss of about $580,000 in its first year, which the LLC members would like to deduct. Paul and Anna would like to know how the debt ($440,000 loan and $40,000 of accounts payable) will be allocated, and how that allocation affects their ability to deduct the losses. Assume both Paul and Anna are single individual taxpayers. Consider all potential loss limitations and assume that neither Paul nor Anna will have business income or losses from other sources. Complete the memo for the PA LLC tax planning file for your manager's review that describes how the debt will be shared between Paul and Anna for purposes of computing the adjusted basis of each LLC interest. If an amount is zero, enter "0". 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. 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). 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 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. Problem 21-42 (LO. 3, 9, 10) Paul and Anna plan to form the PA LLC by the end of the current year to produce and sell specialty athletic apparel. Paul and Anna will both serve as member-managers of the LLC and will be active in its operations. The members will each contribute $80,000 of cash, and in addition, the LLC will borrow $440,000 from First State Bank. The $600,000 will be used to buy equipment and to lease a property they can use as a small manufacturing facility and a storefront. The bank has stated that the debt must be guaranteed, and Anna has agreed to guarantee the entire amount. At the end of the year, the LLC also expects to have accounts payable of $40,000 for inventory and supplies. The LLC's operating agreement provides that all LLC items will be allocated equally. The agreement also provides that capital accounts will be properly maintained and that each member must restore any deficit in the capital account upon the LLC's liquidation. If the LLC claims 100% bonus depreciation, it will report a loss of about $580,000 in its first year, which the LLC members would like to deduct. Paul and Anna would like to know how the debt ($440,000 loan and $40,000 of accounts payable) will be allocated, and how that allocation affects their ability to deduct the losses. Assume both Paul and Anna are single individual taxpayers. Consider all potential loss limitations and assume that neither Paul nor Anna will have business income or losses from other sources. Complete the memo for the PA LLC tax planning file for your manager's review that describes how the debt will be shared between Paul and Anna for purposes of computing the adjusted basis of each LLC interest. If an amount is zero, enter "0". 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. 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). 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 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