2020 is a year that will not soon be forgotten. As businesses and their owners approach the end of this tumultuous year, limited liability companies (LLCs), partnerships and other pass-through entities should take some time to evaluate their tax situation. An important part of the focus needs to be on fully understanding the structure of their LLC for the purpose of minimizing potential surprises while maximizing the effectiveness of their income tax structure. In addition, LLC owners will also need to understand how the various limitations within the tax code might affect their ability to currently utilize losses they might be allocated. This article will focus on LLCs and entities taxed as a partnership.
There are three primary areas of focus as the end of the year comes into view:
1. Loss allocations
A business loss needs to pass through several limitations before it can be claimed and fully utilized on the individual owner’s tax return. Before a loss even confronts those limitations lies perhaps the most important hurdle of all — a correct allocation of the loss under the terms of the LLC operating agreement. Preparing a correct allocation of an LLC’s operating loss can be a complex undertaking. It begins with the operating agreement as executed by the LLC members, which represents the ownership contract among the LLC members. This contract should fully and clearly outline the members’ rights as it relates to profit and loss allocations as well as cash distributions and other rights.
In performing any year-end projections and analysis, begin by verifying a correct understanding of the terms of the agreement.
These represent some of the primary considerations the LLC and its advisors need to be on top of in order to accurately project the anticipated allocations for the year. Following a year like 2020, the last thing anyone needs are surprises with unanticipated allocations from their LLC in March 2021. Avoiding such a surprise requires full knowledge of the terms of the agreement and how terms are applied.
2. Limitations on loss deductibility
With the income or loss for the year appropriately allocated to the LLC members, there will be four additional hurdles at the individual taxpayer level that could impact the ability to fully utilize the loss in the current year.
There is typically not a significant amount of proactive year-end planning involved with these limitations. The importance lies more with making sure these attributes are properly understood and correctly applied within the context of any year-end planning or projections. These limitations are presented here in the order in which they are applied for a particular year.
Tax basis. The tax basis for a member’s LLC interest influences all tax implications related to that ownership, including the ability to currently deduct losses, whether distributions are taxable or nontaxable, and the amount of any gain or loss recognized on the disposition of the interest. The tax basis for an LLC member’s ownership interest includes that member’s allocable share of LLC liabilities. In a year like 2020, it will not be surprising for businesses to have undergone a substantial change in either the amount or the nature of its outstanding liabilities. Changes to the amount and the character of the debt will have a direct effect on individual member’s tax basis and could result in either greater loss deductibility or alternatively might result in income recognition if a member’s share of liabilities is reduced. In either event, it will be important for LLC members to be made aware of any significant changes expected for 2020, so their overall tax planning can be properly completed.
Amount at risk. Having determined whether there is sufficient tax basis to claim a loss, the next limit to be addressed is the at-risk limitation under section 465. This limitation is based upon the amount of the LLC member’s investment that is “at risk.” These rules can be complicated and a trap for the unwary. It is important for an LLC member to make sure they or their tax preparer are sufficiently versed in the application of these rules to avoid costly mistakes in planning or in the final tasks of tax return compliance.
Passive activity limitations. The next loss limitation to be considered has been a part of the Internal Revenue Code for several decades. As part of a proper year-end plan, it is necessary to understand what activities might be subject to passive activity rules. Within these broad and generally well-known rules exist subtle rules related to the treatment of interest income received by a taxpayer that has loaned money to an activity in which they are a passive owner. It would not be unexpected in 2020 to have seen passive investors make significant loans to businesses in which they own a passive interest, either on an emergency basis or as a more permanent investment. In this circumstance, any interest income generated could be utilized to offset some of the interest expense incurred by the business and allocated to that LLC member.
Excess business loss limitations. The Tax Cuts and Jobs Act created a new limitation on the ability to utilize pass-through losses. This new provision, contained in section 461(l), limits an individual taxpayer to the deduction of no more than $250,000 of business loss for a year ($500,000 in the case of taxpayers filing jointly). Any excess business loss incurred during a year will carry over to the following tax year. This limitation was originally effective for the 2018 tax year, but the Coronavirus Aid, Relief, and Economic Security (CARES) Act amended this provision so it is not effective until the 2021 tax year. To the extent there is some flexibility in a business to incur losses/expenditures in 2020 rather than delaying until 2021 when the limitation is scheduled to take effect, this could be a helpful consideration.
The bottom line with all of these various limitations is that it is important to be aware of the potential for these limitations to alter the taxable income landscape of a taxpayer.
3. Use of preferred equity
In the year that is 2020, the financing landscape for most businesses has undertaken a significant change. Included in that change can be loans from LLC members, either in the form of short-term emergency loans or as part of a more significant long-term financing plan. Careful consideration should be taken as the end of the year approaches whether any such loans would be better served structured as preferred equity. Some of the benefits to preferred equity are an improved balance sheet, greater ability to manage cash-flow impact related to servicing the preferred equity and, for the investor, more favorable tax treatment of losses incurred in the event the investment is not recovered. Depending on the overall facts and circumstances surrounding the preferred equity investment, it will also help the LLC avoid potential business interest expense limitations that might otherwise be encountered under section 163(j).
4. Other considerations
Given the upheaval that has occurred this year, it is common knowledge that many businesses have permanently ceased operations. For owners of these businesses, it will be necessary to understand the final treatment of any investment remaining in the failed business. In the case of an LLC, will any remaining investment be eligible for an ordinary loss or a capital loss? Will any amounts loaned to such a business be eligible for favorable treatment as a business bad debt, or will the less favorable nonbusiness bad debt treatment be required. If an investor knows prior to the end of the year that they have this situation, it is wise to consult with their tax advisor as early as possible so these issues can be analyzed and the expected tax return positions can be understood.
Summary. For LLCs and entities taxed as a partnership, along with their owners, the end of a year like 2020 requires making certain that all of these factors are understood well in advance of receiving the 2020 tax returns for filing. Avoiding unexpected surprises and ensuring the overall debt and equity structures are positioned for maximum effectiveness is an important aspect to year-end business and tax planning.
The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.