Deducting Losses From an LLC: New Wrinkles

What happens if you’re the owner of a limited liability company (LLC) business that generates tax losses, and you only spend a few hours a week in the business?

In this common scenario, the losses might be classified as passive, and your ability to currently deduct them might be severely restricted by the dreaded passive activity loss (PAL) rules. Thankfully, three recent court decisions make it easier for those in your shoes to escape the PAL rules and thereby deduct LLC losses from non-rental business activities sooner rather than later.

(Note, however, that if your loss-generating LLC is a rental operation, this article is not relevant to you. With some very specific exceptions, rental losses, from LLCs or otherwise, are passive losses by definition.)

Using an LLC to own and operate a business shields your personal assets from most business-related liabilities. This liability protection advantage is similar to what you get with a corporation. However, the tax rules for LLCs are more flexible and often more beneficial than the rules for corporations.

Most importantly, if you have an LLC with several owners, it’s called a multimember LLC, and it will generally be taxed under the partnership rules. If so, your share of the LLC’s income, deductions and tax credits are reported on a Schedule K-1 delivered to you by the LLC as part of its tax filing obligations. You then report the LLC tax items on your Form 1040.

However, if you’re the sole owner of the LLC, it’s called a single-member LLC (SMLLC), and its existence is generally ignored for tax purposes. If so, you report the SMLLC tax items directly on your Form 1040, just like you would with a Schedule C sole proprietorship activity.

The PAL rules say passive losses from a business activity can generally be used only to offset passive income. Passive losses in excess of passive income for the year are carried forward to future years. You can deduct the losses in future years when and if you have passive income or when and if you sell or otherwise dispose of the activity that generated the losses. The problem is, many folks have little or no passive income for years at a time, so their passive losses can remain suspended for years at a time.

The good news is you can avoid the PAL rules if you materially participate in the loss-generating activity. In other words, meeting the material participation standard makes the activity non-passive, which means you can deduct the losses currently, assuming no other tax-law provision prevents you from doing so.

IRS regulations say you can meet the material participation standard by passing any one of several tests. The following two tests are by far the easiest.

* Substantially-All Test: You pass if your participation (time spent) in the loss-generating activity during the year in question constitutes substantially all participation by all individuals. Basically, if you do all the work, you pass this test even if it doesn’t take much time.

* More-Than-100-Hours Test: You pass if you participate in the loss-generating activity for more than 100 hours during the year, and no other individual participates more than you. So this test too can be passed without spending a whole lot of time.