An advance of money by a member to a limited liability company (LLC) classified as a partnership may be in the form of a capital contribution or a loan. This distinction has significant tax consequences. For example, a capital contribution increases the contributing member's basis in his or her LLC interest on a dollar-for-dollar basis, but a loan increases the member's basis only by an amount equal to his or her increased share of LLC liabilities under Sec. 752. (However, a loan from a member or member affiliate generally is allocated 100% to that member for basis purposes under the Sec. 752 rules.)
Bona fide debt
If an advance from a member to an LLC is bona fide debt, the transaction is treated as a loan from a third party. Under such an arrangement, payments of principal and interest are taxed as if the loan were between unrelated parties. The lender/member reports interest income according to his or her accounting method. Likewise, the LLC deducts the interest paid to the member according to the LLC's accounting method. However, the deductibility of the interest payments may be subject to related-party rules controlling the timing of the deduction.
For the loan to be respected as a third-party debt, the parties should execute a promissory note to evidence the loan in the same way a note would be executed if the loan were made to an unrelated third party. The debt instrument should have a fixed payment date and provide for adequate stated interest. Other factors that suggest an LLC loan from a member is bona fide debt are (1) the member's right to seek a security interest in LLC property (it may be a good idea to give the member a secured interest in LLC property), and (2) terms that reflect commercial reasonableness--such as waiver of demand, presentation, and notice; right to attorney's fees; and guarantee by other members. See PK Ventures,T.C. Memo. 2006-36, for a good discussion of what constitutes bona fide debt.
Members should be aware that third-party lenders may require subordination of the member debt as a condition of making a loan, particularly if the member's debt is secured by LLC property.
If a member makes loans to the LLC throughout the year and the LLC routinely repays the loans, the practitioner may want to consider setting up a master loan arrangement that permits the LLC to establish a line of credit with the member. The master loan agreement should contain the normal terms and language includible in a line-of-credit agreement. This alleviates the need to document each loan in writing and allows the practitioner to review the loan terms annually.
Example 1. Loan from a member to an LLC: D owns a 25% interest in P LLC, which is classified as a partnership. D lends the LLC $52,000 on Sept. 1 to cover unusual operating expenses for the year. Both D and P are cash-basis taxpayers. The LLC signs a demand note calling for annual payments of simple interest on Dec. 31 of each year at an adequate interest rate.
D has carefully documented this transaction. He has a signed note from the LLC calling for payment of principal plus interest at an adequate rate. The note should be treated as a loan for tax purposes and not as a capital contribution. The LLC deducts the interest expense as a trade or business expense. D's Schedule K-1, Partner's Share of Income, Deductions, Credits, etc., from the LLC does not reflect the interest payment from the LLC. D reports the interest payment on his individual return as interest income.
If the amount loaned to the LLC is actually contributed capital, the interestlike payments are taxed as guaranteed payments.
If the LLC loans money to a member, the parties must be careful to ensure the repayment is not treated as a distribution. This is especially true if the amount exceeds the member's basis in his or her LLC interest, since such distributions can produce taxable gain. As with a loan to the LLC, the transaction should be carefully documented. The member should pay interest to the LLC as in any other loan arrangement. The authors suggest that interest on such loans be paid monthly (or at least quarterly) to more closely mirror commercial loan terms. The LLC records...