| TAX FILE MEMORANDUM | | | DATE September 5, 2021 | | | 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 Pedro 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 Pedro and Anna), and the LLC members would both like to be able to deduct their share of the loss. | | Issues: Pedro 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, Pedro's 704(d) loss limitation will be $fill in the blank 1 and Anna's will be $fill in the blank 2. Both amounts are reduced by an additional $20,000 under the at-risk limitations to $fill in the blank 3 and $fill in the blank 4, respectively. Pedro's basis and at-risk amounts will only allow him to deduct $fill in the blank 5 of his expected $fill in the blank 6 share of LLC losses. Both Pedro 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 $fill in the blank 7 instead of $fill in the blank 8. Instead, if both Pedro and Anna were to guarantee one-half of the recourse debt, each member would have an amount at risk of $300,000. However, both Pedro and Anna are single taxpayers; under the excess business loss rules, their loss would be limited to $fill in the blank 9 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: Each LLC member will be allocated a loss of $290,000. Losses can be deducted under 704(d), only to the extent of the LLC member's basis in the LLC interest. Pedro and Anna each contributed $fill in the blank 10 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 $fill in the blank 11 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, Pedro and Anna's losses for the year are limited as follows. | | | Pedro | | Anna | | Cash contribution | $fill in the blank 12 | $fill in the blank 13 | | Recourse debt share | fill in the blank 14 | fill in the blank 15 | | Nonrecourse debt share | fill in the blank 16 | fill in the blank 17 | | 704(d) loss limitation | $fill in the blank 18 | $fill in the blank 19 | | Less: Nonrecourse debt | (fill in the blank 20) | (fill in the blank 21) | | 465 limitation | $fill in the blank 22 | $fill in the blank 23 | | | | 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 $fill in the blank 24 in 2021. Neither Pedro nor Anna has business income (or losses) from other sources, so the $fill in the blank 25 and $fill in the blank 26 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 $fill in the blank 27 and the remaining $fill in the blank 28 loss would be carried forward as part of her net operating loss carryover. If, instead, Pedro and Anna each agreed to guarantee one-half of the recourse debt, the $fill in the blank 29 would be allocated $fill in the blank 30 to each person. Pedro and Anna's bases [ 704(d) loss limitation] would be $fill in the blank 31 each, and their amounts at risk would be $fill in the blank 32 each. The passive activity loss limitation would not apply, but the excess business loss limitation would. As single taxpayers, both Pedro and Anna would be limited to a $fill in the blank 33 loss. Therefore, of the total $fill in the blank 34 loss allocated to each partner, a $fill in the blank 35 deduction would be permitted. The excess $fill in the blank 36 loss would be carried over as part of each LLC member's net operating loss. PLEASE PROVIDE A DIFFERENT ANSWER. ALL OTHER ANSWERS FOUND TO THIS QUESTION AREN'T CORRECT. THANK YOU! | |
