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 interes t , 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.

LLC Alert: New FTB Ruling Regarding LLC Fee For Sale of Real Estate Inventory

By: Tamara B. Pow

Are you calculating the LLC fee correctly for an LLC’s sale of real estate?

The Franchise Tax Board just released FTB Legal Ruling 2016-01 (July 14, 2016) regarding the calculation of the limited liability company fee under California Revenue and Taxation Code Section 17942 for real property held for sale to customers in the ordinary course of business, as well as real property held for investment purposes. The FTB analyzed two fact situations. In the first scenario, a California LLC classified as a partnership holds real property for sale to customers in the ordinary course of its business and sells it during the 2016 taxable year. In the second scenario, the same LLC instead sells a parcel of unimproved real property held for investment purposes during the 2016 taxable year. The FTB ruled that the term “cost of goods sold” for purposes of RTC 17942(b)(1)(A) includes real property held for sale to customers in the ordinary course of a trade or business. “Therefore, LLCs that are dealers in real property must add the cost of goods sold (based on real property) back to gross income in calculating the LLC fee.” In the first scenario, the LLC’s adjusted basis in the real property will be added back to gross income for calculating the LLC fee due. In the second scenario, where the LLC sold investment property instead of inventory property, the adjusted basis in the property will not be added back to gross income for calculating the LLC fee.

The FTB’s analysis focuses on legislative history regarding the use of the term “cost of goods sold” as it may relate to real estate. The ruling states that the Legislature’s intent was that the LLC fee be based on gross receipts for all LLCs, including LLCs that are dealers in real property. Similarly, Congress has also used the term “cost of goods sold” in relation to construction of real property by a taxpayer in the ordinary course of business, in the American Jobs Creation Act of 2004. The Tax Court has also used “costs of goods sold” to refer to the cost of the property sold, regardless of whether or not it was inventory. The US Supreme Court has also used the term “gross profit,” which is associated with cost of goods sold, in a case dealing with a real property dealer’s sale of real property. The FTB concludes that if “costs of goods sold” in RTC 17942 could not include real property, then Congress, the IRS and the courts would have been incorrect in their usage. As a result, “LLCs that are dealers in real property must add the costs of goods sold (based on real property) back to gross income in calculating the LLC fee.”

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 and operations, and both inventory and investment real property sales. Her consistent and extensive work with LLCs keeps her up to date when advising owners of LLCs and other business entities of Secretary of State updates and other changes in structuring real estate transactions and the legal requirements of maintaining business entity liability protection.

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.

LLC ALERT: New California LLC Forms!

By: Tamara Pow

The Secretary of State is revising LLC forms again. Back in May, I wrote that the Secretary of State does not revise its forms often, but when it does, it is critical that business owners are aware of the changes so that they file the correct form because the Secretary of State will reject outdated forms. In May I noted that the California Secretary of State had revised the LLC Statement of Information form which had been in use since January of 2014.

Now the California Secretary of State has revised four more LLC forms:

  1. Articles of Organization;
  2. Certificate of Dissolution;
  3. Certificate of Cancellation; and
  4. Short Form Certificate of Cancellation.

The new Articles of Organization include a cover sheet for mail submission. However, this does not mean that the Articles must be filed by mail. The instructions make it clear that you will get faster service if you deliver the document in person, and even faster service if you pay a guaranteed expedite drop off fee. I once got a phone call from a client who was in her car on her way to Sacramento to file her LLC in person because she needed proof of filing a soon as possible. A road trip to our state capital is not necessary if you need your documents in a hurry. We have a relationship with a filing agent in Sacramento who will happily receive our forms for filing by email and walk them into the Secretary of State’s office for a small fee (well worth saving the cost of gas and time in the car).

Filing the correct forms, and getting them back quickly, can make or break a business deal. Be sure you know what you are doing, or use an attorney experienced in entity formations to take care of it for you.

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, sales, conversions and dissolutions. Her consistent and extensive work with LLCs keeps her up to date when advising owners of LLCs and other business entities of Secretary of State updates and other changes in the legal requirements of maintaining business entity liability protection.

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.

Crowdfunding: Are you the Right Investor?

If you have always wanted to invest in a start-up business , whether a high tech emerging growth company or a low tech products company, you have no doubt heard of the new SEC rules allowing crowdfunding. Part of the excitement comes from being able to make investment opportunities available through crowdfunding internet portals, and part of the excitement comes from more relaxed investor standards. Let’s take a look at the new regulation, which the SEC has title “Regulation Crowdfunding”. You can find it at https://www.sec.gov/rules/final/2015/33-9974.pdf . My last blog regarding crowdfunding ( click here to read ) focused on the requirements for an issuer. In this blog, I’ll focus on the requirements concerning investors.

Crowdfunding is generally thought of as the use of the Internet by small companies to raise modest amounts of funds from investors. The new regulation allows investments to occur online. Only a broker-dealer or online portal registered with the SEC and a member of the Financial Industry Authority (“FINRA”) or other national securities association registered with the SEC, however, is allowed to offer and sell securities to the investing crowdfunding public. A company can’t offer a crowdfunding opportunity directly. To see if a broker-dealer is properly registered with FINRA, check http://brokercheck.finra.org/ , and to check if a portal is properly registered under FINRA, check http://www.finra.org/about/funding-portals-we-regulate .

Although Regulation Crowdfunding relaxed investor suitability standards, some still exist. The standards limit the amount that can be invested. During any 12 month period, an investor can invest up to:

  1. the greater of either $2,000 or 5% of the lesser of the investor’s annual income or net worth IF the investor’s annual income or net worth is less than $100,000; or
  1. up to 10% of the investor’s annual income or net worth, whichever is less, but not to exceed $100,000, IF both the investor’s annual income and net worth is each more than $100,000

There are some important caveats when looking at these limitations, and investors should familiarize themselves with these limitations through their own research or discussion with their advisors. First, net worth can NOT include the positive value of an investor’s personal residence. An investor can, however, include the income or net worth of an investor’s spouse even if the income or net worth is not jointly owned. Second, if the investor consolidates his or her spouse’s income or net worth to satisfy the above criteria, the investment amount limitations are still determined based on the individual investor’s income or net worth.

Investors need to be careful. Crowdfunded securities are not like public company stock. There are limits on reselling crowdfunded securities. An investor may not sell these securities for one year after purchase except to the original issuer, to an accredited investor, as part of a registered public offering, to a family member or trust created for the benefit of a family member, or in connection with the death or divorce of the purchaser. Each of these classes of persons have specific definitions under the securities laws. Although Regulation Crowdfunding doesn’t state this, transfers of the crowdfunded securities after the one year holding period can’t be done unless the transfer complies with applicable federal and state securities laws. Because of this, crowdfunding securities will be extremely illiquid. Investors will have to be prepared to hold the stock indefinitely, or at least until the issuer goes public or is sold to another company in exchange for cash or publicly tradeable securities.

Crowdfunding provides opportunities for both issuers and investors. Investors needs to carefully evaluate the risk of investing in the issuer, and need to be prepared to hold their investment for a long period of time, or lose it altogether.

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.