I teach undergraduate and graduate courses in-between consulting with entrepreneurs. When delivering the first course in taxation to future accountants, I inevitably reach a point in the discussion where I disclose the worst kept secret of taxation. Tax law and IRS policy doesn’t always, “make sense.”
Given that shocking introduction, I’m happy to report that a recently announced IRS policy on deductible loss limits for LLC owners makes better sense than the alternative. If you are an LLC owner/operator, you probably have some notion of what I mean about limitations to deducting your LLC losses. If you’re not in that camp, then the rest of this discussion is going to get technical, so stop here and come back for my next article!
If you’re still reading then you probably know or are interesting in knowing that the losses generated by an LLC may not be deductible to the owner, if they do not have any investment at risk. The at risk rules in Section 465 of the Internal Revenue Code were written very simply and detailed regulation was never provided. Essentially the purpose of the at-risk rules was to prevent a business owner for claiming losses on their tax return that exceeded the investment they are actually at risk of losing.
How is possible for a business to lose more money then the owner risked with investment? Well… imagine a business that borrows from others, loses their money and the owner can’t be held personally liable for the debt. For example, assume an owner invests $50K, borrows $50K and the business losses the entire $100K during the tax year. When the lender asks the owner for their $50K the owner says, “Sorry, I have limited liability.” I know what you are thinking… “What kind of business can do that and how do I get in on that deal?” This scenario must be rare.
What’s not as rare is an LLC that borrows, and losses, money from a bank or other lender on the strength of the owner’s guarantee. Thanks to some poorly worded proposed regulations by the Treasury, many taxpayers and their advisers were uncertain as to whether such a guarantee would actually make the owner at risk, as defined in the law. Consequentially taxpayers may have been conservatively limiting the deduction of such losses on their tax returns.
In recent Legal Advice issued by the Associate Cheif Counsel at the IRS, the issue was clarified. The IRS has stated that an LLC owner who guarantees the LLC debt is at risk unless that owner can seek contribution or reimbursement from others or otherwise is protected from loss related to their guarantee.
Some business operating agreements will have clauses that allow owners who are pursued for business debts to seek reimbursement from the other owners. However this is counter intuitive to the concept of having limited liability for LLC owners and in my experience isn’t very common.
The IRS policy that a personal guarantee can make an owner at risk for the LLC debt makes more sense than the alternative.
Please contact me if I can assist you with determining your amount at-risk with regard to an LLC and the losses you are entitled to deduct on your tax return.