Limitations on Deductibility of LLC Member’s Share of Losses
Members of limited liability companies (LLCs) enjoy the benefit of deducting their share of the LLC's losses on their personal tax returns, thanks to the pass-through status of LLCs.
Drawing from my consulting experience, I've guided LLC members through the intricate process of understanding and applying these deductions. However, it's essential to recognize the limitations on the amount of losses that can be deducted each tax year.
This guide explores those constraints, aiming to equip LLC members with the knowledge to optimize their tax benefits within legal boundaries.
Quick Summary
- To limit the deductibility of an LLC member's share of losses, members can deduct losses only up to their investment in the LLC due to the pass-through nature of LLCs.
- The at-risk rules further restrict loss deductions to the amount the member has actually risked in the LLC.
- According to the U.S. Chamber of Commerce, around 595,000 businesses close annually, highlighting the critical need for LLC members to understand loss deduction rules.
- In my opinion, careful tax planning is essential for LLC members to navigate loss deductions effectively and maintain financial stability.
What is an LLC Basis Limitations?
The LLC basis limitations are a set of rules that govern how much of an LLC's losses can be deducted by its members. The basis of an LLC is the amount of money that the members have invested in the company.
Generally, members can deduct their share of the LLC's losses up to their basis in the company due to the fact that LLCs are pass-through entities.
At-Risk Rules
An LLC member can only deduct her proportion of LLC losses up to the amount she is exposed to.
A member is at risk if she has given money or property (the adjusted basis) to the LLC and her share of any loans made by the LLC (unless borrowed from a member). Nonrecourse debt does not expose a member to risk.
LLC Losses
There are various types of LLC losses that can be deducted by its members. These include:
- The company's operating losses
- The company's capital losses
- The company's excess business losses
Operating Losses
An LLC's operating losses are its losses from its income. These losses can be deductible by the company's members, up to their basis in the company.
For example, if an LLC has $10,000 in income and $20,000 in operating losses, the members can only deduct $10,000 of those losses on their individual tax returns. This is because they have a base of $10,000 in the LLC.
In light of recent statistics, considering that the U.S. Chamber of Commerce reports that around 595K businesses close every year, understanding and applying these loss deduction rules becomes critical for LLC members to safeguard against business volatility [1].
Capital Loss
An LLC's capital losses are its losses from its non-taxable income. These losses can be deducted by the company's members, up to their basis in the company.
For example, if an LLC has $10,000 in non-taxable income and $20,000 in capital losses, the members can deduct $10,000 of those losses on their individual tax returns. This is because they have a base of $10,000 in the LLC.
Excess Business Loss
An excess business loss is a loss that exceeds the member's basis in the LLC. If a member has an excess business loss, they cannot deduct the excess business loss on their individual tax return. Instead, the excess business loss is carried over to future tax years until it is reduced to zero.
How are LLC Losses Taxed?
The tax treatment of LLC losses depends on the type of loss. Operating losses and capital losses are both taxed as ordinary losses. This means that they are deductible from the member's income in the year they are incurred.
However, excess business losses are not taxable income and are not deducted from the member's income. Instead, they are carried over to the future tax year.
"Failure is not to be feared. It is from failure that most growth comes."
- Dee Hock, Founder & CEO of Visa Credit Card Association
Applying Basis Limitation Rules on Deductibility of Losses
Now that we have a basic understanding of the LLC basis limitations, let's apply them to a hypothetical scenario.
Scenario: John and his wife are the sole members of an LLC. The LLC has $10,000 in income and $40,000 in operating losses.
John and his wife can deduct $10,000 of the LLC's losses on their individual tax returns. This is because they have a base of $10,000 in the LLC.
The remaining $30,000 of the LLC's losses are income that can't be taxed and are not deducted from John and his wife's income. Instead, they are carried over to future tax years.
Tax losses are generally allowed as a business's assets rise, and they can be carried forward indefinitely. Tax losses are possible in practically every industry, especially in the early years of operation or under difficult conditions.
Individual taxpayers may deduct losses from pass-through businesses, such as sole proprietorships, limited liability companies (LLCs) treated as sole proprietorships for tax purposes, partnerships, LLCs treated as partnerships for tax purposes and S corporations, only to a certain extent.
Old Rules
Before the Tax Cuts and Jobs Act (TCJA), an individual taxpayer's business losses were frequently allowed to be fully deducted in the year they occurred.
Unless:
- That result was limited by the passive loss rules or some other tax regulation, or
- The firm's financial loss was so large that it exceeded income from other sources, resulting in a "net operating loss" (NOL).
Prior to the Tax Cuts and Jobs Act of 2017, you could carry back an NOL for up to 20 tax years or carry it forward for up to two tax years.
New Rules
The Tax Cuts and Jobs Act of 2017 changed the rules for deducting business losses for individuals in 2018 through 2025. Unfortunately, the adjustments are not helpful.
If your company or rental activity results in a tax loss, things get more difficult. The PAL rules may apply if you're running a rental business or don't actively participate in the operation.
Given that nearly 20% of new businesses close within their first year and just 34.5% survive 10 years, as found by the Chamber of Commerce, these new loss deduction limitations can significantly impact the financial planning of LLC members [2].
The PAL regulations generally only allow you to deduct passive losses to the extent that they are offset by passive income from other activities, such as positive earnings from other businesses or taxable rental income.
The new law says that you can still deduct losses from companies and rental activities, but only to the extent of your income from other sources.
So, if you have $50,000 in taxable losses from a company, but only $10,000 in income from other sources, you can only deduct $10,000 of the loss. The remaining $40,000 is "carried forward" to future years.
This change is in effect for losses incurred in 2018 through 2025.
Drawing from my experience, if your company or rental activity results in a tax loss, you can only deduct the loss to the extent of your income from other sources.
Passive losses that are not deductible right now are suspended. That is, they're kept in your income statement until you have enough passive revenue or sell the activity responsible for the losses.
The business loss above the threshold is carried forward to the next tax year and can be deducted under the conditions for Net Operating Loss carryforwards.
How to Deduct Business Losses?
Generally, you can deduct business losses from your income in the year they occurred. There are restrictions, however, depending on the type of business you're in.
If your company or rental activity results in a tax loss, you can only deduct the loss to the extent of your income from other sources. This change is in effect for losses incurred in 2018 through 2025. But let's first take it step by step.
Figuring a Net Operating Loss (NOL)
Your income from other sources is what you report on line 43 of Form 1040. So, if you have a net operating loss for the year, it will be reported on line 41 of the form (as "negative income"). This is true whether or not your business is a pass-through entity.
Generally, you can carry back an NOL for up to 20 tax years or carry it forward for up to two tax years. However, the new rules limit the carryback period to two years.
If your business has a net operating loss, you can use it to reduce income from other sources in the two preceding tax years.
In order to do so, file an amended return (Form 1040X) for the year in which the NOL occurred. You can also carry the loss over to the next two tax years.
Deducting a Net Operating Loss
You report the NOL on line 21 of Schedule A (Form 1040), as a "below-the-line" deduction. This means that it reduces your income from all sources, both business and nonbusiness.
For example, if you have an income of $50,000 and a net operating loss of $10,000, your income will be reduced to $40,000.
You can also deduct the NOL on your tax return for the tax year where it occurred. In order to do this, you'll need to complete Form 1045 and attach it to your return.
Note that you can only use the NOL to offset income from other sources; you can't use it to reduce your income below zero.
Carrying Forward a Net Operating Loss
If your business doesn't have enough income to offset the NOL, it can be carried forward to future years. The new law says that you can still deduct losses from companies and rental activities, but only to the extent of your income from other sources.
So, if you have $50,000 in taxable losses from a company, but only $10,000 in income from other sources, you can only deduct $10,000 of the loss. The remaining $40,000 is "carried forward" to the next tax year.
This change is in effect for losses incurred in 2018 through 2025. However, you can still carry them over to the future tax year if the business is sold or there's a change in ownership.
This limitation on the deduction of net operating losses applies to all types of businesses, including sole proprietorships, partnerships, and S corporations. The only exception is for real estate businesses, which can still fully deduct their losses.
As a business owner, it's important to be aware of the changes to the tax laws that went into effect in 2018. One such change is the limitation on the deduction of net operating losses (NOLs).
FAQs
Can You Deduct Losses From an LLC?
Yes, you can deduct losses from an LLC if the company is a taxable entity.
Can a Limited Partner Deduct Losses?
Yes, a limited partner can deduct losses up to the amount of income from other sources.
What Are the Four Limitations on Potential Losses?
There are four limitations on potential losses:
- Carryover of income from other sources to the business
- The owner's share of the business's income
- The owner's share of the business's net operating loss
- The owner's share of the business's capital loss
References:
- https://www.chamberofcommerce.org/small-business-statistics
- https://www.uschamber.com/small-business/small-business-data-center
