When setting up a new LLC or partnership, a common question is how to fund the new entity. Should it be funded with a personal loan, or should you invest money into the entity in the form of equity? This might seem like a simple question to answer, but going the wrong route can cost you money in the long run if you’re not careful.
LLCs and partnerships are often financed by loans from their members; but, while it’s a common option for financing, it may have significant negative tax consequences if certain events arise.
One such event is the instance in which the entity defaults on the loan because of its inability to pay back the borrowed sum. Under this circumstance, if the lending member(s) forgave the loan, tax law treats the amount that was forgiven to the entity as “cancellation of debt (COD)” income to the borrowing entity. Since the borrower is a pass-through entity for tax purposes, the COD income will be reported to the members of the entity as ordinary income to be included in their current year individual returns, and taxed at the members’ regular tax rate.
You might ask what happens to the original amount lent by the LLC or partnership members to the entity, and is there a deduction for the uncollectable receivable? Yes, but it comes with limitations. In a loan default transaction such as this one, typically a lender is allowed to claim a bad debt deduction; but the character of the loss may limit the deductible amount. Generally, the loan is categorized as a non-business bad debt under the U.S. tax law (related party loan made outside of the taxpayer’s ordinary trade or business). As such, the members are allowed to take a short-term capital loss for the portion of the loan that is deemed to be uncollectable or worthless. In other words, your offset to the COD income passed through from the partnership is likely to be a capital loss. A capital loss is limited in how much can be used to reduce your ordinary income, and can only be used to offset other capital gain. If there is no capital gain to offset, you may take a deduction of up to $3,000 to offset ordinary income, and the rest is carried forward until it is fully utilized in future years.
From a tax perspective, perhaps the safest method of funding an LLC or partnership entity is categorizing cash contributions as equity. Equity increases your basis in the entity, and allows you to take ordinary loss as it is realized. The biggest benefit of this is that there will be no COD income if your entity fails to be profitable. You can realize a loss up to the amount of your equity (basis) in the entity. Keep in mind, a partner’s loan to a partnership also increases the lending partner’s tax basis to the extent the other partners do not have an economic risk of loss with respect to that debt. But, if the partnership will not be able to repay the debt upon liquidation, the loan will generate COD income.
Potential tax ramifications for incorrectly structuring an entity or its financing can be extremely costly. Our experienced staff of professionals at FF&F are familiar with the process of structuring partnerships and LLCs, and we are available to assist you throughout each step of the process. In addition, we have an expert Corporate and Partnership team that can provide you with a full range of services as needed for your business. For questions about this topic or for other information about our services, please contact us at firstname.lastname@example.org or 212-245-5900.
Jonathan Niyazov, CPA is a Tax Manager with FF&F. He has over 9 years of combined tax and accounting experience compromised in both, closely held private companies, and large international accounting firms. Jonathan has a strong background in individual, corporate, and partnership taxation. His experience in the private and public sectors grants him a unique understanding of taxation that provides our clients with tax savings strategies at every level.