Using an LLC to maximize losses.

• Author: Kalfayan, Garo
• Position: Limited liability companies - Part 1

Owners may seek to use the first few years' passthrough losses on their personal returns, for both income and self-employment (SE) tax purposes. Part I of this two-part article explores the benefits of using an LLC to maintain personal liability protection for business owners, while maximizing the income and SE tax benefits of business losses. (Gains & Losses)

Small businesses are often organized as corporations to provide personal liability protection. If losses are expected in the business's growth years, the shareholders can elect S corporation status to pass through the losses for use on their personal returns. If a shareholder (1) has sufficient basis under Sec. 1366(d), (2) has sufficient Sec. 465 amount at risk and (3) meets the Sec. 469 passive activity loss (PAL) requirements, the S election will allow the shareholder to deduct currently his pro-rata share of the S loss on his or her personal return.

However, this plan ignores self-employment (SE) tax. An S shareholder's pro-rata share of S income or loss has no effect on SE tax. (1) This outcome is favorable if the S corporation allocates income, because it does not increase a shareholder's SE tax liability. However, if the S corporation allocates a loss, the S shareholder cannot use the loss to reduce potential SE tax liability from another business he or she owns.

Example 1: Individuals X and Y each own 50% of the stock of T, a newly formed S corporation. At the end of its first year, T has a $40,000 loss; each shareholder's pro-rata share is $20,000. For income tax purposes, X and Y can deduct the $20,000 loss if each has sufficient basis, amount at risk and meets the PAL rules. However, for SE tax purposes, the $20,000 of allocated loss does not reduce either X's or Y's SE tax liability (if any).

Of course, if an S shareholder has no SE tax liability, the inability to offset it with S losses is not a concern. The S corporation business form may work well in this case, because it does not deprive a shareholder of a usable SE tax loss. (2) However, an S shareholder with SE tax liability from another business would want an allocated loss to be deductible for both income and SE tax purposes.

Example 2: The facts are the same as in Example 1. In addition, X has net income from a sole proprietorship and a distributive share of net ordinary income from a general partnership interest. (3) X's net income from the sole proprietorship and general partnership interest creates an SE tax liability. Thus, X would want the $20,000 S loss allocation to reduce both his income tax and his SE tax liability. Even if X has sufficient basis, amount at risk and materially participates, the S loss allocation will only reduce X's income tax liability, not his SE tax liability.

When business start-up losses are expected, and SE tax is a concern to at least one of the owners, the desired result is that the entity's passthrough loss will reduce both the shareholder's income tax liability and his or her SE tax liability. This article explores the benefits of using an LLC to maintain personal liability protection for owners, while maximizing the income and SE tax benefits of losses.

Choosing an LLC

When a business owner wants to use losses to reduce both income and SE tax, an S corporation will not accomplish this result. General partnerships and sole proprietorships allow for the potential use of losses against income tax and SE tax. However, these business forms do not provide an LLC's personal liability protection. (4) Generally, under state law, an LLC member's personal assets are not subject to the business's debts, (5) even if the member is the LLC's managing member. (6) A limited partnership can...