An advance of money by a member to a limited liability company (LLC) classified as a partnership may be in the form of a capital contribution or a loan. This distinction has significant tax consequences. For example, a capital contribution increases the contributing member's basis in his or her LLC interest on a dollar-for-dollar basis, but a loan increases the member's basis only by an amount equal to his or her increased share of LLC liabilities under Sec. 752. (However, a loan from a member or member affiliate generally is allocated 100% to that member for basis purposes under the Sec. 752 rules.)Bona fide debt
If an advance from a member to an LLC is bona fide debt, the transaction is treated as a loan from a third party. Under such an arrangement, payments of principal and interest are taxed as if the loan were between unrelated parties. The lender/member reports interest income according to his or her accounting method. Likewise, the LLC deducts the interest paid to the member according to the LLC's accounting method. However, the deductibility of the interest payments may be subject to related-party rules controlling the timing of the deduction.
For the loan to be respected as a third-party debt, the parties should execute a promissory note to evidence the loan in the same way a note would be executed if the loan were made to an unrelated third party. The debt instrument should have a fixed payment date and provide for adequate stated interest. Other factors that suggest an LLC loan from a member is bona fide debt are (1) the member's right to seek a security interest in LLC property (it may be a good idea to give the member a secured interest in LLC property), and (2) terms that reflect commercial reasonableness — such as waiver of demand, presentation, and notice; right to attorney's fees; and guarantee by other members. See PK Ventures, T.C. Memo. 2006-36, for a good discussion of what constitutes bona fide debt.
Members should be aware that third-party lenders may require subordination of the member debt as a condition of making a loan, particularly if the member's debt is secured by LLC property.
If a member makes loans to the LLC throughout the year and the LLC routinely repays the loans, the practitioner may want to consider setting up a master loan arrangement that permits the LLC to establish a line of credit with the member. The master loan agreement should contain the normal terms and language includible in a line-of-credit agreement. This alleviates the need to document each loan in writing and allows the practitioner to review the loan terms annually.
Example 1. Loan from a member to an LLC: D owns a 25% interest in P LLC, which is classified as a partnership. D lends the LLC $52,000 on Sept. 1 to cover unusual operating expenses for the year. Both D and P are cash-basis taxpayers. The LLC signs a demand note calling for annual payments of simple interest on Dec. 31 of each year at an adequate interest rate.
D has carefully documented this transaction. He has a signed note from the LLC calling for payment of principal plus interest at an adequate rate. The note should be treated as a loan for tax purposes and not as a capital contribution. The LLC deducts the interest expense as a trade or business expense. D's Schedule K-1, Partner's Share of Income, Deductions, Credits, etc., from the LLC does not reflect the interest payment from the LLC. D reports the interest payment on his individual return as interest income.
If the amount loaned to the LLC is actually contributed capital, the interest-like payments are taxed as guaranteed payments.
If the LLC loans money to a member, the parties must be careful to ensure the repayment is not treated as a distribution. This is especially true if the amount exceeds the member's basis in his or her LLC interest, since such distributions can produce taxable gain. As with a loan to the LLC, the transaction should be carefully documented. The member should pay interest to the LLC as in any other loan arrangement. The authors suggest that interest on such loans be paid monthly (or at least quarterly) to more closely mirror commercial loan terms. The LLC records should reflect whether collateral, spousal guarantee, and similar issues were addressed before the loan was made. An alternative to collateralizing the loan is creating a right of setoff, where the LLC can keep any cash distributions or capital allocable to the borrower if there is a default on the loan.
An LLC's advance of funds to a member is respected as a loan only if there is a legally enforceable obligation to pay a sum certain — the principal amount of the loan — at a determinable date. An advance that creates a deficit capital account is not necessarily a loan, even if the member is required by law or by the LLC operating agreement to restore the deficit (Rev. Rul. 73-301; Mangham, T.C. Memo. 1980-280; Seay, T.C. Memo. 1992-254). If loan status is desired, the parties should execute a written promissory note as if unrelated parties were involved.
If an advance to a member is treated as a loan, and the debt is later canceled, the cancellation is treated as a distribution of money at the time of the cancellation (Rev. Rul. 57-318, clarified by Rev. Rul. 73-301).Self-charged interest
The self-charged interest rules correct the unfair tax result that could otherwise occur when a passthrough entity and its owners engage in lending transactions. For example, if a member makes a loan to an LLC for use in a passive activity, the result is interest income to the lending owner and some allocation of LLC-level interest expense to the same member. Under the general passive activity loss (PAL) rules, the interest income is treated as portfolio income. This cannot be offset by any related passive interest expense passed through from the LLC (which is generally the case unless the member materially participates in the activity). Regs. Sec. 1.469-7 allows recharacterization of some or all of a member's self-charged interest income (including guaranteed payments for the use of capital) from portfolio to passive. As a result, that interest income can be offset by the member's share of the LLC's passive interest expense.
The self-charged interest rules apply to loans between a member and an LLC in which the member owns either a direct or indirect interest in capital and profits. An indirect interest is one held through one or more passthrough entities. These rules may also apply to loans between passthrough entities (including LLCs) with identical ownership. (See "Identically Owned Passthrough Entities," below.) The self-charged income recharacterization rules apply only to interest income — not to other self-charged income items such as rent, management fees, or compensation arrangements between passthrough entities and their owners. Additionally, the self-charged interest rules apply only to interest income and expense incurred in the same tax year.
Election out of the self-charged interest rules
Members can elect not to apply the self-charged interest rules (Regs. Sec. 1.469-7(g)). Electing out of the self-charged interest rules might be appropriate if the member has plenty of passive income but needs portfolio income to be able to deduct investment interest expense. Electing out might also be beneficial if the member needs portfolio (nonbusiness) income to be able to increase a net operating loss (NOL) by claiming more nonbusiness deductions (which are limited to nonbusiness income). The election out is made at the LLC level. However, the impact of the election out occurs at the member level.
To calculate a member's self-charged interest income that is recharacterized as passive income, the member's interest income from a loan to the LLC is multiplied by his or her passed-through share of the LLC's passive interest expense deductions from all member loans (including loans by other members) and divided by the greater of (1) that member's passed-through share of interest expense deductions from all member loans used for passive activities or otherwise, or (2) that member's interest income from all loans to the LLC.
If all the amounts loaned to the LLC by members are used in passive activities and the loans and allocations of the LLC's interest expense are pro rata, 100% of all members' self-charged interest income is recharacterized as passive (assuming the same interest rate applies to all member loans). If a particular member loans more than his or her share, less than 100% of his or her self-charged interest income is recharacterized as passive. If a particular member loans less than his or her share, 100% of his or her self-charged interest income is recharacterized as passive.
Example 2. Calculation of self-charged interest when member loans more than his or her share: J and G are equal members in A Productions LLC, which is classified as a partnership. The LLC borrowed $50,000 from J at the beginning of the year and used the money in its rental real estate operations. The loan bears simple interest at a rate of 10%. G did not lend any money to A. In this situation, J loaned more than his share to the LLC. J and G are each allocated $2,500 of the LLC's interest expense on the loan from J for the year.
J will treat $2,500 (50% × $5,000) of his interest income on the loan to A as passive activity income. This represents J's interest income ($5,000) multiplied by his share of the LLC's passive interest expense from all member loans ($2,500) divided by the greater of (1) J's share of A's interest expense on all member loans used for passive activities or otherwise ($2,500), or (2) J's interest income from A ($5,000).
Example 3. Calculation of self-charged interest when member loans less than his or her share: E and P are equal members in R LLC, which conducts a single passive activity. R is classified as a partnership. E lends R $10,000 on Jan. 1 and receives $1,000 of interest income during the year. P lends R $20,000 on Jan. 1 and receives $2,000 of interest income during the year. E loans less than her share. E and P are each allocated $1,500 of R's interest expense on loans from members for the year.
E will treat $1,000 (100% × $1,000) of her interest income as passive activity income. This represents E's interest income ($1,000) multiplied by her share of passive interest expense from all member loans ($1,500) divided by the greater of (1) E's share of R's interest expense from all member loans ($1,500), or (2) her interest income from R ($1,000).
P will treat $1,500 (75% × $2,000) of her interest income as passive activity income. The $1,500 represents P's interest income ($2,000) multiplied by her share of R's passive interest expense from all member loans ($1,500) divided by the greater of (1) P's share of the LLC's interest expense from all member loans used for passive activities or otherwise ($1,500), or (2) her interest income from R ($2,000).
If there is a loan from an LLC to a member, the LLC receives interest income that will, in turn, be passed through to the members. If the member uses the loan proceeds in a passive activity, the self-charged concept applies (Regs. Sec. 1.469-7(d)). The member can recharacterize some or all of his or her share of LLC interest income from all loans to members. The amount recharacterized as passive is the member's share of the LLC's interest income from all loans to members multiplied by the member's passive interest expense paid to the LLC and divided by the greater of (1) the member's interest expense (passive or otherwise) paid to the LLC or (2) the member's passthrough share of the LLC's interest income from all loans to members (used in passive activities or otherwise).
Example 4. Calculation of self-charged interest on loans from LLCs to members: J and N each own 50% interests in U LLC, which is classified as a partnership. On Jan. 1, J borrows $30,000 from U and pays $3,000 in interest for the year. J used $15,000 of the loan proceeds for personal expenses and invested the remaining $15,000 in a passive activity. J and N are each allocated $1,500 of the LLC's interest income from loans to members for the tax year.
J treats $750 (50% × $1,500) of his share of the LLC's interest income from loans to members as passive activity income. The $750 amount is J's share of interest income from loans to members ($1,500) multiplied by his passive interest deductions for interest charged by the LLC ($1,500) divided by the greater of (1) J's deduction for interest (passive or otherwise) charged by the LLC ($3,000) or (2) J's share of the LLC's self-charged interest income ($1,500).
An LLC that loans money to a member should report to the member his or her share of LLC interest income from all loans to members (used for whatever purposes by the members) so the member can determine how much of the LLC interest income can be recharacterized as passive.
A back-to-back loan arrangement occurs when a member borrows money from a third party and then lends the money to the LLC. In such situations, the member recharacterizes all or a portion of his or her interest expense (paid to the third party) as passive if the LLC uses the funds in a passive activity. Ordinarily (under the interest tracing rules of Temp. Regs. Sec. 1.163-8T), the interest on a loan whose proceeds are used to make another loan results in investment interest expense rather than passive interest expense. (Notice 89-35 covers the treatment of interest expense on owner loans used to acquire interests in or make capital contributions to passthrough entities.) The percentage used to recharacterize the member's interest expense is the same as the percentage used to recharacterize the member's self-charged interest income from a loan to the LLC. (See "Loans From Members to LLCs" on the previous page.)
Identically owned passthrough entities
The self-charged interest rules also apply to lending transactions between passthrough entities if each owner of the borrowing entity has the same proportionate ownership interest in the lending entity. To the extent an owner shares in interest income from a loan between passthrough entities (including partnerships, S corporations, and LLCs classified as partnerships), the owner is treated as having made the loan to the borrowing passthrough entity and the rules described under the heading "Loans From Members to LLCs" apply.Imputed interest
An LLC may be required to impute interest on a below-market loan to a member under the rules of Sec. 7872 when (1) the member is also an independent contractor and the loan is compensation-related; (2) a member receives a loan as consideration for services rendered; (3) the loan has a tax-avoidance purpose; or (4) a loan has a significant tax impact on the member or the LLC. The Sec. 7872 rules do not apply to any day on which the aggregate outstanding amount of such a loan does not exceed $10,000. (However, this exception does not apply if one of the principal purposes of the loan is tax avoidance.)
A below-market loan is one in which the stated interest rate is lower than the applicable federal rate (AFR). The below-market loan rules require recognition of a deemed transfer of money from the lender to the borrower equal to the amount of forgone interest and a corresponding retransfer of that interest by the borrower back to the lender. The characterization of the deemed transfer and the timing of reporting the forgone interest depend on the nature of the transaction and the type of loan. The rules generally require that a minimum rate of interest, equal to the AFR, be computed and deemed paid on any loan described in this paragraph.
Planning tip: When AFRs are low, consider (1) making additional low-interest loans to members; (2) replacing existing higher-interest loans with new ones that charge lower rates; or (3) converting demand loans to term loans to lock in the low rates since deemed transfers occur annually while demand loans are outstanding but only once for term loans — when the loan is made (Prop. Regs. Sec. 1.7872-7(a)(1)).Interest expense paid by accrual-basis LLC to cash-basis member
Bad debt deductions
An LLC generally deducts the interest payable on a member loan according to its accounting method. However, an accrual-basis LLC cannot deduct accrued expenses owed to a cash-basis member until the expenses are paid and included in the cash-basis member's income.
If an LLC is unable to repay a loan from a member, the member can claim a bad debt deduction. Unless the member is in the business of making loans, the deduction is generally a nonbusiness bad debt expense (Sec. 166). However, in certain cases, partners were successful in arguing that their loans to their partnerships were made in the course of their trade or business, when they were able to attribute the partnership's trade or business to themselves (see Lemons, T.C. Memo. 1997-404; Dagres, 136 T.C. 263 (2011); Owens, T.C. Memo. 2017-157).
Practice tip: The first hurdle to claiming a bad debt deduction for a loan from a member to an LLC is to prove that a bona fide debt existed. (See "Bona Fide Debt" above.)
Rather than loaning an LLC money, a member could guarantee the LLC's debt. In the case of guarantee agreements, a taxpayer's payment on the guarantee is treated as creating a debt, with the debt becoming worthless in the tax year in which the payment is made or, if the agreement provides for a right of subrogation, the debt is not treated as worthless until the tax year in which the right of subrogation becomes totally worthless (or partially worthless in the case of an agreement that arose in the course of the taxpayer's trade or business) (Regs. Secs. 1.166-9(a), (b), and (e)(2)). However, a payment on a guarantee agreement is treated as a worthless debt only if (1) the agreement was entered into in the course of either the taxpayer's trade or business or a transaction for profit; (2) there was an enforceable legal duty on the part of the taxpayer to make the payment under the guarantee (even if legal action was not brought against the taxpayer); and (3) the agreement was entered into before the obligation became worthless (Regs. Sec. 1.166-9(d)).
Furthermore, the payment and satisfaction of a taxpayer's agreement to act as a guarantor produces a worthless debt only if the taxpayer demonstrates that reasonable consideration was received for entering into the agreement. Reasonable consideration is not limited to direct consideration, such as a payment to the member (Regs. Sec. 1.166-9(e)(1)). However, the actual payment of a guarantee fee should eliminate any doubt that consideration was received. See Seminole Thriftway Inc., 42 Fed. Cl. 584 (1999), for a guide to structuring guarantee fee arrangements.
If these requirements are met, the payment on the guarantee produces a bad debt loss. For noncorporate taxpayers, the deductibility again depends on whether the debt has a business or nonbusiness character. In the case of a payment on a guarantee, this characterization is governed by the same rules that govern the character of direct indebtedness (Regs. Secs. 1.166-9(a) and (b)).
This case study has been adapted from PPC's Guide to Limited Liability Companies, 23d edition, by Michael E. Mares, Sara S. McMurrian, Stephen E. Pascarella II, and Gregory A. Porcaro. Published by Thomson Reuters/Tax & Accounting, Carrollton, Texas, 2017 (800-431-9025; tax.thomsonreuters.com).
|Sheila Owen, CPA, is a senior technical editor with Thomson Reuters Checkpoint. For more information about this column, contact email@example.com.