Under Sec. 704(d), a member's allocable share of loss from a limited liability company (LLC) taxed as a partnership is deductible only to the extent of the member's outside basis in his or her LLC interest at the end of the LLC year. In determining a member's outside basis at year end, adjustments for increases and decreases are made in a specific order according to Regs. Sec. 1.704-1(d)(2).
Specific Ordering of Basis Adjustments
First, basis is increased by all positive basis adjustments, including current-year cash and property contributions, income from operations, and nontaxable income (Sec. 705(a)(1)). Next, basis is decreased (but not below zero) to account for current-year distributions. Nonliquidating distributions of cash or property are deemed to have been made on the last day of the LLC year if such distributions are advances or draws against a member's share of LLC income. If both cash and property are distributed in the same transaction, the cash is considered to be distributed first (Sec. 732(a)(2)). Finally, basis is decreased (not below zero) by the member's share of LLC losses for the year, including any carryovers from prior years.
Adjustments to the basis of a member's interest in an LLC must be made in the order outlined above because the order in which adjustments are made can affect the deductibility of LLC losses by the member. For example, assume an LLC makes a distribution of cash to a member and allocates loss to that member in the same tax year, and the net effect is to reduce the member's tax basis below zero. The order in which the member's basis is adjusted for those items determines the tax treatment of the distribution and loss allocation. The proper ordering of the transactions is to reduce basis first for the distribution. Assuming the amount of the distribution does not exceed the member's tax basis, the distribution has no tax consequences. Basis is then reduced by the allocated loss. To the extent the loss exceeds the basis of the member's interest, it is not deductible and must be suspended until such time as the member has sufficient basis to deduct the loss (the "zero basis" rule).
Had the adjustments been made in the incorrect order, basis would have first been reduced by the member's allocable share of the LLC's loss. Assuming the amount of the loss does not exceed the member's basis, the loss is fully deductible. If basis is then reduced by the amount of the cash distribution, the member will...