Limitations on Deductibility of LLC Member's Share of Losses

By: Tamara B. Pow

Will you be denied a deduction for your share of LLC losses?

You may have pass through losses from your LLC membership interest , but that does not mean you can deduct them against your personal taxes this year. Understanding the limitations on deductibility of your share of LLC losses is critical if you don’t want a bad tax surprise.

Limited liability companies are pass-through entities, meaning the profit and loss of the company are passed through to the members to be reported on their individual tax returns. However, not all LLC losses are deductible on a member’s tax return. The deductibility of losses is impacted by the member’s basis, the at risk limitation and the passive loss limitation. This is a very complex area of tax law, which is also affected by statutory changes such as NOL limitations in certain tax years. This analysis is best left to a qualified experienced tax accountant, rather than trying to figure it out yourself by answering simplified questions on tax reporting software. However, here are the basic issues to be aware of, so you know what to ask your accountant.

Basis: An LLC member’s share of losses from the company are only deductible to the extent of the member’s adjusted basis in the membership interest as of the end of the LLC’s taxable year. However, a loss that is disallowed in one year may be carried over to a subsequent year when the member’s adjusted basis is sufficient and then deducted.

At-Risk: An LLC member can deduct her share of LLC losses only to the extent the member is at risk for at least the amount of the loss. A member is at risk to the extent she has contributed money or (the adjusted basis of) property to the LLC, and her share of amounts borrowed by the LLC (unless borrowed from a member). Nonrecourse debt does not put a member at risk, but qualified nonrecourse financing of real estate does put a member at risk for the member’s proportionate share.

Passive Losses: Passive losses can only be used against passive income, not ordinary income. If an LLC member does not materially participate or meet an exception to the participation rules, a loss is considered passive. An LLC member is generally considered to be materially participating if he participates for more than 500 hours in a tax year or has materially participated for 5 out of the last 10 years.

Make sure to plan for these loss limitations and discuss them with your CPA. Just because your LLC has tax losses this year, it doesn’t mean that you get to take those loss deductions.

Tamara B. Pow is a founding partner of Strategy Law, LLP in downtown San Jose, California where she practices business and real estate law including limited liability company formations, operations, transfers, conversions and dissolutions. Her tax background, including time as a tax consultant at Price Waterhouse, LLP, as well as her MBA and real estate brokers license help her spot issues like these when advising owners of LLCs and other business entities.

The information appearing in this blog does not constitute legal advice or opinion. Such advice and opinions are provided by the firm only upon engagement with respect to specific factual situations. Specific questions relating to this article should be addressed directly to Strategy Law, LLP.

Categories: LLC, Tax Planning

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