In this blog post, we discuss how corporate loss limits are handled differently in partnerships and limited liability companies (LLCs) for the benefit of interested readers.
Corporate Loss Limits in Partnerships
According to a partnership agreement, a company’s partners should split any profits or losses among themselves. But if there isn’t a written or verbal agreement between the partners, the law mandates that they split gains and losses equally.
A salary of INR 600,000 per year that an active partner is permitted to receive under the terms of their partnership agreement cannot be deducted as an expense from the profit and loss statement. The law does not regard any compensation given to a partner by their company as a cost.
The profit and loss account’s net profit is transferred to the profit and loss appropriation account by:
- Crediting the profit and loss appropriation account and debiting the profit and loss account
- In the event of a net loss, the profit and loss appropriation account will either be debited or credited.
Any payment made to a partner, such as interest on fixed capital, a salary, a commission, a bonus, etc., is debited from the profit and loss appropriation account and credited to the relevant partner’s current account.
Any charge made by the company to the partners (such as interest on drawings) is credited to the profit and loss appropriation account and debited from the relevant partner’s current account.
Corporate Loss Limits in Limited Liability Companies
As the year’s end approaches, three main issues should be the focus:
- Loss allocation under the LLC operating agreement’s clauses
- Restrictions on the deduction of allocated losses
- Benefits of using preferred equity
1. Loss allocations
Before a business loss can be claimed and fully utilized on the individual owner’s tax return, it must pass through several constraints. The most significant obstacle is likely to exist before a loss even encounters those restrictions—a correct allocation of the loss by the rules of the LLC operating agreement.
Before beginning any year-end estimates and analyses, be sure you have a firm grasp of the contract’s conditions.
- Is there preferred equity in the LLC? If so, check to see if the agreement is written so that income allocations must be made to the preferred return, even if the year as a whole is a loss. This part can lead to unanticipated surprises depending on how the agreement is written.
- Does the agreement have cash distribution waterfalls that will affect how any income or loss is distributed in a way disproportionate to the total number of units owned?
- Are accurate capital account records kept as required by the operating agreement’s terms? The so-called Section 704(b) capital accounts are the starting point and the final destination for accurate income and loss allocations.
- Has the LLC received any fresh capital contributions this year? If so, does this necessitate or lead to a “chargeback” of losses from earlier years supported by debt but now being covered by the new equity?
2. Limitations on loss deductibility
After the LLC members have been fairly distributed the year’s income or loss, there are still four obstacles that could prevent an individual taxpayer from fully utilizing the loss in the current year, as listed here:
- Tax basis
- Amount at risk
- Passive activity limitations
- Business loss limitations (for 2021 and beyond)
Tax basis
The capacity to currently deduct losses, whether distributions are taxable or not, whether distributions are subject to tax, and the size of any gain or loss recognized on the liquidation of the interest are all impacted by the tax basis for a member’s LLC stake. Changes in the size and nature of the debt will directly affect each member’s tax base. They may lead to increased loss deductibility or, in the alternative, income recognition if a member’s share of the liabilities is decreased.
Amount at risk
After determining whether there is enough tax basis to claim a loss, the at-risk restriction under Section 465 must be considered. This cap is determined by how much of the LLC member’s money is “at risk.”
Passive activity limitations
The Internal Revenue Code has included the following loss limits for numerous decades: It would not have been surprising to see passive investors make substantial loans to companies with passive interests in 2020, either as a temporary fix or a more long-term investment. In this case, any interest revenue might be used to partially offset the interest costs incurred by the company and charged to that LLC member.
Excess business loss limitations
The capacity to use pass-through losses has a new restriction due to the Tax Cuts and Jobs Act. This new rule, included in Section 461(l), restricts taxpayers’ ability to deduct their business losses to a maximum of INR 250,000 per year (or INR 500,000 for taxpayers filing jointly). Any unused business losses from one tax year will be carried over to the next. This could be a useful consideration if a corporation has the flexibility to incur losses or expenses in 2020 rather than waiting until 2021, when the limitation is supposed to go into effect.
3. Use of preferred equity
As the end of the year draws near, it is important to carefully assess if any of these loans would be better off being set up as preferred stock. A better balance sheet, a better ability to control the cash-flow impact of servicing the preferred stock, and, for the investor, the more favourable tax treatment of losses suffered if the investment is not recovered are a few advantages of preferred equity. It will also aid the LLC in avoiding certain business interest expenditure limitations that could otherwise be encountered under Section 163(j), depending on the general facts and circumstances surrounding the preferred stock transaction.
4. Other considerations
Will any residual investment in an LLC qualify for an ordinary or capital loss? Will any loans to such a company qualify for the more lenient business bad debt treatment, or will the less lenient nonbusiness bad debt treatment be necessary? Suppose an investor has this situation and is aware of it before the end of the year. In that case, it is advisable to speak with their tax advisor as soon as possible to examine these problems and comprehend the predicted tax return positions.
