Under Sec. 704(d), a member's allocable share of loss from a limited liability company (LLC) taxed as a partnership is deductible only to the extent of the member's outside basis in his or her LLC interest at the end of the LLC year. In determining a member's outside basis at year end, adjustments for increases and decreases are made in a specific order according to Regs. Sec. 1.704-1(d)(2).Specific Ordering of Basis Adjustments
First, basis is increased by all positive basis adjustments, including current-year cash and property contributions, income from operations, and nontaxable income (Sec. 705(a)(1)). Next, basis is decreased (but not below zero) to account for current-year distributions. Nonliquidating distributions of cash or property are deemed to have been made on the last day of the LLC year if such distributions are advances or draws against a member's share of LLC income. If both cash and property are distributed in the same transaction, the cash is considered to be distributed first (Sec. 732(a)(2)). Finally, basis is decreased (not below zero) by the member's share of LLC losses for the year, including any carryovers from prior years.
Adjustments to the basis of a member's interest in an LLC must be made in the order outlined above because the order in which adjustments are made can affect the deductibility of LLC losses by the member. For example, assume an LLC makes a distribution of cash to a member and allocates loss to that member in the same tax year, and the net effect is to reduce the member's tax basis below zero. The order in which the member's basis is adjusted for those items determines the tax treatment of the distribution and loss allocation. The proper ordering of the transactions is to reduce basis first for the distribution. Assuming the amount of the distribution does not exceed the member's tax basis, the distribution has no tax consequences. Basis is then reduced by the allocated loss. To the extent the loss exceeds the basis of the member's interest, it is not deductible and must be suspended until such time as the member has sufficient basis to deduct the loss (the "zero basis" rule).
Had the adjustments been made in the incorrect order, basis would have first been reduced by the member's allocable share of the LLC's loss. Assuming the amount of the loss does not exceed the member's basis, the loss is fully deductible. If basis is then reduced by the amount of the cash distribution, the member will recognize gain to the extent the cash received exceeds the basis of his or her LLC interest.
Example 1: D and K form DKLA LLC to market women's fashions. DKLA is classified as a partnership for federal tax purposes. D and K both have a 50% interest in LLC capital and profits. D contributes $250,000, and K contributes a small office building with a $250,000 fair market value and a $150,000 tax basis. During the LLC's first year of operations, it incurs a $300,000 operating loss and distributes $25,000 each to D and K as an advance. At the end of the first tax year, the LLC has no outstanding debts, and D and K calculate their tax basis capital accounts as shown in Exhibit 1.
K's share of the LLC's loss is limited because it exceeds the outside basis of his LLC interest. K can carry the $25,000 of suspended loss forward indefinitely until he has additional basis to deduct it against.Treatment of Suspended Losses
Typically a member's distributive share of LLC items in a loss year is made up of several separately stated components. The components may include long-term capital loss, short-term capital loss, ordinary loss from operations, and investment-interest expense, and may also include items of income. In a year in which the various separately stated LLC items combine to produce an overall loss exceeding the member's outside basis, it becomes necessary to determine which loss items are reported currently and which are deferred.
Generally, if a member's deduction of LLC losses is limited by outside basis, he or she is allowed to deduct a pro rata portion of each separately stated item that makes up the net loss, including amounts carried over because of prior years' basis limitations (Regs. Sec. 1.704-1(d)(2)). The balance of the loss is carried forward and can be deducted in future years when the member's basis increases.
If a member is allocated both income and deductions for a tax year in which he or she has a net LLC loss in excess of his or her outside basis, the member can deduct LLC losses up to the amount of allocated LLC income. Presumably, the member deducts a pro rata portion of each separately stated loss item up to the amount of allocated income. He or she then can deduct a pro rata portion of the remaining loss items up to the amount of his or her outside basis.
Example 2: P, Q, and M form D Enterprises LLC, which is classified as a partnership for federal tax purposes. Each member has a 33.33% interest in LLC capital and profits. The LLC has no outstanding debts. At the beginning of the current year, P has a tax basis and tax basis capital account of $10,000. For the LLC's calendar tax year, P is allocated the items shown in Exhibit 2.
On his individual income tax return, P reports the $5,000 of portfolio income and can deduct $15,000 of the allocated LLC losses—his $10,000 basis increased by the $5,000 of reported income. Losses of $11,000 are suspended and carried forward to subsequent years. The deductible loss is made up of a proportional share of each LLC loss item as shown in Exhibit 3.Interaction With Other Loss Limitations
If a loss allocation to an LLC member is valid under the Sec. 704 rules and the member has sufficient basis to deduct the loss, the loss may still be limited under either the at-risk or the passive loss limitations. Note that the basis limitation applies first, then the at-risk limitations, and finally the passive loss limitations (Temp. Regs. Sec. 1.469-2T(d)(6)).
It is important to realize that a loss reduces a member's basis even though it may subsequently be limited under the at-risk or passive loss rules and a member's basis will not automatically equal the at-risk amount that he or she has invested in the LLC.
Example 3: W invested $10,000 in exchange for a 15% interest in a calendar-year, accrual-basis LLC that will operate a retail store. (The $10,000 is made up of $6,000 from personal savings and $4,000 borrowed from R, who owns a 25% interest in the LLC.) W, who does not materially participate in the entity's operations, is allocated an $11,000 passthrough loss at the end of the first year. He does not receive passive income from another source.
W's basis limitation restricts his deductible loss to $10,000. The at-risk rules then limit his deductible loss to $6,000 (the amount not borrowed from a person who has an interest in the partnership). Finally, the passive activity loss rules reduce his deductible loss to zero. Thus, his entire $11,000 first-year loss will be suspended and carried over in the following order: $1,000 under the basis-limitation rules; $4,000 under the at-risk rules; and $6,000 under the passive activity loss rules.
Gain from the disposition of assets involved in an activity, or from the disposition of a partnership interest, increase a member's amount at-risk, while suspended passive activity losses are available upon the complete disposition of an LLC interest to an unrelated party in a fully taxable transaction. Conversely, gain on the sale of an LLC interest does not allow the deduction of losses suspended because of lack of basis.
Example 4: Continuing with the same facts as in Example 3, assume that W sells his LLC interest to an unrelated person for $20,000 on Jan. 1 of the following year. The first-year passthrough loss reduced W's basis to zero, so he will recognize a $20,000 gain from the sale.
The gain does not increase W's basis, so he cannot deduct the $1,000 loss suspended under the basis limitation rules. Gain on the sale of the LLC interest does, however, increase at-risk basis and allows W to deduct the $4,000 loss suspended under the at-risk rules. Furthermore, the $6,000 loss suspended under the passive activity loss rules can be deducted because W sold his entire interest in the passive activity to an unrelated party.
Observation: While the at-risk and passive activity rules are generally applied on an activity-by-activity basis, activities for purposes of applying the at-risk rules may not be the same as activities defined by the passive activity loss regulations. For example, certain activities must be segregated for at-risk purposes, and amounts at risk in these separate activities are not available to support loss deductions from other activities (Sec. 465(c)(2)).
This case study has been adapted from PPC's Guide to Limited Liability Companies, 19th Edition, by Michael E. Mares, Sara S. McMurrian, Stephen E. Pascarella II, and Gregory A. Porcaro, published by Thomson Reuters/Tax & Accounting, Carrollton, Texas, 2014 (800-431-9025; tax.thomsonreuters.com).
Ellentuck is of counsel with King &
Nordlinger LLP in Arlington, Va.