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Choice of Entity – Part I

An LLC is the Best Thing Since Sliced Bread….or Is It?

Background

Limited liability companies (“LLCs”) have been around for quite a while.[1] They have become the most popular form of doing business,[2] and for good reason. LLCs provide its owners (technically called “members”) with the same protection from legal liabilities as do corporations.[3] Most domestic LLCs with two or more members are, in most cases, treated as partnerships for income tax purposes. LLCs with only one member are almost always treated as disregarded entities for income tax purposes. Every LLC has the right to make a “Check the Box” election with which it can elect to be taxed as a corporation.[4]

There are numerous advantages of the taxation of a partnership over the taxation of a corporation, including S corporations. Some of the advantages are:

  1. The contribution of appreciated property to a corporation is taxable unless the contributor(s) control the corporation (i.e., the contributor(s) own 80% or more of the stock of the corporation immediately after the contribution). There is no such control requirement when appreciated property is contributed to a partnership.
  2. The contribution of assets and liabilities to a corporation is taxable to the extent the liabilities assumed by the corporation exceed the tax basis of the contributed assets. It may not be taxable when contributed to a partnership either because that is the result under the tax regulations or, at the very least, the transaction could possibly be tweaked so as to avoid gain recognition.
  3. A distribution of appreciated property from a corporation is taxable to the corporation. In general, it would not be taxable if it was distributed by a partnership.
  4. Corporate distributions are taxable dividends to the extent they are distributed out of current and/or accumulated earnings and profits. Distributions from a partnership are generally not taxable unless it’s a cash distribution in excess of the recipient partner’s tax basis in its partnership interest (“outside basis”) immediately before the distribution.
  5. A partnership can make a section 754 election in certain circumstances; a corporation cannot.
  6. A partner’s outside basis includes a share of partnership liabilities; not so for corporate shareholders.

Trap for the Unwary – The At-Risk Rules

In order to deduct a loss allocated from a partnership, each of three hurdles must be cleared: (i) there must be enough tax basis in the partnership interest (“outside basis”) to absorb the allocated loss; (ii) there must be enough “at-risk basis” in the partnership interest to absorb the allocated loss; and (iii) the loss is deductible under the passive loss rules.

As mentioned above, in determining the amount of a partner’s outside basis, the partner’s share of both partnership recourse and nonrecourse liabilities[5] is included.

The at-risk rules are intended to limit losses from an activity to the amount that the taxpayer has at risk. A taxpayer’s amount at risk at any point in time includes the tax basis of all capital contributions plus income and gain allocated from the activity less losses and expenses allocated from the activity and less any distributions received. In addition, a partner’s share of the partnership’s recourse liabilities (i.e., which represents the partner’s EROL with respect to such liability) is added to the partner’s amount at risk. However, since a partner, by definition, does not have EROL with respect to a nonrecourse liability, a partner’s share of nonrecourse debt is not included in a partner’s at-risk basis.  As such, a loss that might be deductible under the outside basis hurdle might be limited due to the fact that the basis increase attributable to the partner’s share of nonrecourse debt is excluded for purposes of the at-risk basis hurdle.

Since no member has EROL with respect to any liability of an LLC, all liabilities of an LLC are treated as nonrecourse for these purposes. Thus, normal liabilities that arise in the normal course of a trade or business (e.g., accrued expenses, accounts payable, etc.) are considered to be nonrecourse and will not be included in any member’s at-risk basis.[6]

The one exception to this rule is with respect to “qualified nonrecourse financing” which is treated as recourse debt notwithstanding that the debt is, in fact, nonrecourse. Qualified nonrecourse financing is nonrecourse debt that is secured by real estate used in the activity and which is (i) incurred with respect to the activity of holding real property; (ii) borrowed from an unrelated person who is in the business of lending money; and (iii) not convertible debt.[7] If the lender is related to the borrower, then it is still qualified nonrecourse financing provided the financing from the related person is commercially reasonable and on substantially the same terms as loans involving unrelated persons.[8] As a result of this rule, LLCs engaged in the holding of real estate are less likely to be subject to the trap for the unwary due to the at-risk rules.

To illustrate, assume Susan is a 25% member in an LLC that manufactures widgets. She works full-time in the business. Susan’s outside basis on 1/1/16 is $20,000, which includes her $10,000 share of the LLC’s only liability – accounts payable. Susan’s share of the LLC’s 2016 loss is $25,000 and her share of LLC’s accounts payable increases to $15,000 as of the end of 2016. How much of the 2016 loss can Susan deduct?

Under the outside basis hurdle, Susan can deduct the entire $25,000 loss. Her outside basis of $20,000 at 1/1/16 is increased to $25,000 due to her increased share of the LLC’s debt ($5,000). As such, there’s enough basis against which she can deduct the $25,000 loss.

Since a share of nonrecourse debt does not yield at-risk basis, Susan’s at-risk basis at 1/1/16 is only $10,000. The increased share in nonrecourse debt does not result in additional basis for Susan. Therefore, only $10,000 of the 2016 loss is deductible under the at-risk basis hurdle, and the remaining $15,000 loss is suspended until such time Susan generates additional amounts at-risk.

It should be pointed out that had the business been structured as, say, a general partnership and Susan was a 25% general partner, she would have been able to deduct the entire $25,000 loss because her at-risk basis would include her share of the accounts payable for which she has EROL.


[1] The first LLC statute in the US was enacted in the state of Wyoming in 1977. New York State adopted its LLC law on July 26, 1994 (the law took effect 90 days later).

[2] For example, during the years 2004, 2005, 2006 and 2007, of the new business entities formed throughout the United States, LLCs comprised 52.20%, 57.65%, 59.00%, and 63.58% of all business entities formed during each of those years, respectively. LLCs are the New King of the Hill: An Empirical Study of the Number of New LLCs, Corporations and LPs Formed in the United States Between 2004-2007 and How LLCs Were Taxed for Tax Years 2002-2006, Rodney D. Chrisman, Fordham Journal of Corporate & Financial Law (Vol 15, Issue 2, Article 4, 2009).

[3] The general partner(s) of traditional general partnerships and limited partnerships have joint and several legal liability for the repayment of any liability that remains unpaid by the partnership. All members of an LLC are protected from legal liability with respect to unpaid partnership debt, including members who manage or who are otherwise active in the business of the LLC. Even a single-member LLC that is disregarded for tax purposes is still an LLC under state law and protects its member from legal liability.

[4] Care should be taken if the Check the Box election is being made to change the tax classification of an existing entity inasmuch as such a change can be taxable.

[5] A recourse liability is a partnership liability for which at least one partner bears the economic risk of loss (“EROL”) if the partnership fails to repay the liability. EROL exists when a partner would be the one who would be on the economic hook to repay a partnership liability and such partner has no right of recoupment from any other source. A nonrecourse liability is a liability for which no partner bears the EROL.

[6] A member can, by virtue of a guarantee, be treated as having the EROL; in such a case, the guaranteed debt would be included in the guarantor’s at-risk basis.

[7] §465(b)(6) of the Internal Revenue Code of 1986, as amended (“IRC”).

[8] IRC §465(b)(6)(D)(ii)

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