Moore Colson :: News & Resource Center

What have you got to lose?
Maximizing deductions for partnership and LLC losses

The deductibility of business losses is one of the most complex and misunderstood areas of federal taxation. Many partners and limited liability company (LLC) members mistakenly believe that, provided they have adequate tax basis in their interests, they can deduct their distributive share of an entity’s losses.

Yet basis is only one of a triad of tax rules that limit losses. To determine whether your losses are deductible, you must also consider the passive loss and at-risk rules.

Partnering up

Partnerships offer several important tax advantages. As pass-through entities, they avoid the double taxation associated with traditional C corporations. Partnerships also provide a business with greater flexibility in allocating income, gain, loss, deductions and tax credits among owners.

One of the partnership’s most attractive features is that its tax basis is increased by certain partnership debt, such as a business loan or line of credit. This allows partners to deduct losses in excess of their cash investments in the partnership.

At one time, obtaining the benefits of partnership tax treatment meant giving up the liability protection of the corporate form. But the advent of hybrid entities, such as S corporations and LLCs, has provided the opportunity to combine limited personal liability with many of the tax advantages of a partnership.

In recent years, the popularity of LLCs has soared. LLCs aren’t subject to the restrictions on the number and type of shareholders that apply to S corporations, and they have greater flexibility in allocating gains, losses and other tax attributes. And, unlike an S corporation shareholder’s basis, an LLC member’s basis can be increased by certain company debt even if he or she hasn’t lent the money to the company.

3 rules for deducting losses

If you have an interest in a partnership or LLC, you can deduct losses in excess of your investment in the business. When doing so, however, you must follow three rules:

1. You may deduct losses only up to your tax basis in your partnership or LLC interest. Generally, your initial basis is the amount you paid to acquire your interest plus the adjusted basis of any property you contributed to the partnership or LLC. During the life of the business, your initial basis is increased by your share of the company’s income, certain liabilities and any subsequent capital contributions.

Your basis is decreased (though not below zero) by your share of any distributions, taxable losses, nondeductible noncapital expenditures and certain other items.

2. You may deduct losses only up to the portion of your basis that’s “at risk.” Generally, the amount you have at risk includes:

Qualified nonrecourse financing means a loan secured by real estate used in the business, provided no person is personally liable for repayment and additional requirements are met.

It can be more difficult for LLC members to meet the at-risk requirements. See the sidebar “Special challenges for LLCs.”

3. You may deduct passive losses only from passive income. Yes, you may have more than enough at-risk basis yet still be unable to deduct partnership or LLC losses.

Why? Generally under the passive loss rules, you can’t deduct business losses against nonpassive income — such as wages, interest, dividends and capital gains — unless you materially participate in the business. Otherwise, the business activity will be considered “passive,” which means you can offset losses only against income from other passive activities.

To satisfy the material participation requirement, you must participate in the business for more than 500 hours a year, perform substantially all of the work for the business, or meet one of several other IRS tests.

Disallowed passive losses may be carried forward until you can offset them against passive income or until you sell your partnership or LLC interest.

Planning to save

As you can see, even if you have sufficient tax basis, losses may still be disallowed under the at-risk or passive loss rules. That’s why it’s important to understand the rules for deducting losses. You not only can avoid having your deduction disallowed, but you also can identify valuable tax planning opportunities.

For example, Pat and Chris form an S corporation called XYZ Inc., contributing $100,000 each in exchange for 50% of the stock. XYZ buys a building for $2 million, paying $200,000 in cash and taking out a $1.8 million mortgage on the property to finance the balance.

In its first year of operation, XYZ reports a $300,000 loss, allocated equally between Pat and Chris ($150,000 each). Because each shareholder’s basis is only $100,000, however, they can deduct only $100,000 of the loss. The remaining $50,000 is carried forward to future tax years.
If XYZ were set up as a partnership, however, Pat and Chris could deduct the entire loss. That’s because each shareholder’s basis would be increased to $1 million ($100,000 cash contribution plus 50% of $1.8 million in debt).

This assumes that both Pat and Chris materially participate in the business and that they satisfy the at-risk rules. Their basis is at risk if they’re personally liable to repay the mortgage or if the loan is structured as qualified nonrecourse financing.

Weighing your options

Of course, the deductibility of losses is just one of many factors to consider when choosing the right type of entity for your company and structuring business debt. Among other things, you’ll need to weigh the potential tax advantages against the risk of expanded personal liability.

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Tick tock
Timing is everything when making philanthropic decisions

If philanthropy is important to you, determining the best time to make charitable gifts can be a complex decision. There are many factors, both practical and financial, to consider.

When today is better

Perhaps the most important decision you must make is whether to make donations during your lifetime or after your death through your will or living trust. One advantage of making lifetime gifts is that you can see how your generosity makes a difference.

Lifetime gifts generally are advantageous from a tax standpoint as well. When you leave property to charity in your will or living trust, your estate can claim a charitable deduction to the extent that the property is included in your gross estate. If you donate property during your lifetime, however, not only is the property’s value excluded from your estate — resulting in the same estate tax benefit as a bequest — but you’re also entitled to a charitable income tax deduction.

Keep in mind that charitable income tax deductions are limited based on your adjusted gross income (AGI), the type of asset donated and the type of organization receiving the gift. (See the chart “AGI limitations on charitable contribution deductions.”) Donations in excess of the limit can be carried over in most cases for up to five years and in some cases up to 15 years.

When later is better

Sometimes, charitable bequests are preferable to lifetime gifts. Here are a few such situations:

If you’re uncertain about your future financial needs, large lifetime gifts may be risky. By making gifts in your will or living trust, you retain the ability to use these resources during your life.
The charitable estate tax deduction generally is unlimited, so a charitable bequest may be preferable if the AGI limits would reduce the benefits of the charitable income tax deduction.
If you wish to benefit a foreign charitable organization, it’s preferable to do so through your will or living trust. You can claim charitable deductions for income tax purposes only for gifts to U.S. charities, while your estate may also deduct donations to foreign charities.

Your gifting strategy and your spouse

If you’re married, you can use a charitable bequest strategy to deduct the fair market value of ordinary income property. For example, if you make a lifetime donation of ordinary income property to a public charity, the deduction is limited to the property’s cost basis and also is subject to the 30% AGI limitation.
An alternative is to leave the property to your spouse in your will or living trust. The bequest is shielded from estate tax by the unlimited marital deduction, and your spouse’s cost basis in the property is “stepped up” to its fair market value. Your spouse can then donate the property to charity and take an income tax deduction for its full fair market value.

Make smart charitable gifts

These are just a few examples of the factors you should consider when planning for charity. To make the most of your charitable gifts, it’s important to understand the differences between charitable income tax and estate tax deductions.

AGI limitations on charitable contribution deductions¹

Contribution type	Public Charities	Private Foundations²
Contribution type	Public Charities	Operating	Nonoperating
Cash and unappreciated property	50%	50%	30%
Ordinary income property³	50%	50%	30%
Long-term capital gains property⁴	30%	30%	20%

¹ For this purpose, adjusted gross income (AGI) is computed without regard to the deduction for charitable contributions and any deduction for a net operating loss carryback.
² An operating foundation spends at least 85% of the lesser of its adjusted net income or its minimum investment return in carrying out its exempt activities and meets certain other tests. Others not meeting this definition are nonoperating foundations.
³ Deduction is generally limited to the property’s adjusted basis.
⁴ Generally, the full fair market value of the property is deductible, subject to the percentage limitations.
Source: U.S. Internal Revenue Code

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Having trouble keeping your employees?
9 ways to plug the drain

Involuntary employee turnover is a huge drain on any business. Just ask Bill Bliss, creator of the Bliss-Gately Tool for calculating the cost of employee turnover. Just think of the costs involved: recruiting, overtime pay or lost opportunities while the position is vacant, training a replacement, and lower productivity while the new employee gets up to speed. According to Mr. Bliss, it’s not unusual for total costs for a single lost employee to reach 150% of the annual salary, especially for higher paid employees.

Here are nine ways to improve your employee retention rate, starting from day one:

1. Hire carefully. It’s not just about skills. Make sure new hires will fit in with the company’s culture. Moreover, don’t hire applicants if the job doesn’t line up with their career aspirations and other demands, such as schooling or family obligations.

2. Give new hires support. Extend orientation periods as long as necessary for the employees to become acclimated and acquire the needed skills and knowledge. Consider pairing new arrivals with experienced employees to serve as short-term mentors.

3. Provide opportunities for challenge and development. Many employees leave because they’re bored or see their jobs as going nowhere. What’s worse is that the people who leave for these reasons are often the ones who are most worth having. Managers, therefore, should work with their subordinates to better understand how to keep them engaged. Inform employees about career paths or development opportunities within the company and encourage them to reach higher. Companies that have highly engaged workforces tend to have much better retention rates than their peers.

4. Have fun. “Fun” shouldn’t be reserved for the occasional holiday party or picnic. Make it part of every workday. Hold impromptu celebrations for minor achievements, for example, or have contests where employees vie for silly prizes. Start meetings with humorous icebreakers. Bringing a little levity to the workplace can improve morale and strengthen relationships — and it costs little or nothing. Involve your employees by asking them for ideas on future “fun.”

5. Empower employees. From a fry cook or customer service representative to a senior manager, the more you allow your employees to make the decisions needed to perform their jobs, the more they’ll value their positions. Push decision making to the lowest level possible.

6. Share information. Too many organizations restrict information to a “need to know” basis. The more transparent you are with your employees on company strategies, performance, operations and key business decisions, the more they’ll feel part of the team.

7. Ask employees what is important to them. Then, whether it has to do with training, hours, advancement opportunities or benefits, try to address your
workers’ issues. Although you can’t please everyone, you may find themes emerging. In those cases, address the situations and make changes when possible.

8. Be sensitive to work-life balance. Businesses that can offer flexible schedules, part-time employment and even telecommuting are better able to hire and retain the best and most qualified employees.

9. Conduct exit interviews. It’s amazing how many organizations either don’t care enough or fail to do a good job of finding out why an employee leaves. Conducting an exit interview can offer critical information about your firm’s culture, salary structure and management policies. To foster frank discussion, make sure exit interviews are conducted by someone other than the exiting employee’s supervisor. And analyze any data gathered from the interviews for trends and warning signs.

With many employees, it’s not about money, it’s about job satisfaction. And the people who most directly impact job satisfaction are your managers. So encourage your managers to apply these strategies, and make retention one of their key responsibilities.

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Be sure your home is adequately insured

If you’re like most people, you never give your homeowners insurance a thought until a storm blows off some shingles and you need to file a claim. But given the fact that your home is possibly your most valuable asset, this could be a costly mistake. Between rising replacement costs, more policy exclusions, and misconceptions about what is and isn’t covered, many homes today are underinsured.

Establish value and replacement cost

Until a few years ago, most insurers offered guaranteed replacement value coverage. So, if your house burned down, the insurance company would pay whatever it cost to build an equivalent replacement. Many insurers have now switched to extended limit policies that cap their payout at 125% of the listed value of the home in the policy.

This highlights how critical it is for your policy to accurately state your home’s replacement value. While insurers tend to automatically increase home values every year by an inflationary factor, it may not be applicable to you — you may be in a local area where construction costs have shot up due to a flurry of home building, or you may have remodeled your kitchen, adding more value to the home. Unique properties, such as those with exotic materials or historic millwork, also require special scrutiny.

Watch out for policy exclusions

What’s covered and what’s excluded in the average insurance policy can be confusing. For example, no homeowner’s policy covers flooding. Flood insurance must be bought separately through a federal program. Without it, you’re covered if a storm causes wind damage to your property, but not (as Katrina victims discovered) if subsequent flooding causes the damage. On the other hand, if you suffer mold damage, you’ll likely be on your own, because insurers have recently limited their liability for this peril.

Don’t overlook liability coverage

If someone is seriously hurt on your property, you may be liable for damages. Check your liability coverage through your homeowner’s policy and any umbrella coverage and make sure it’s adequate. A slight premium increase may provide much needed disaster protection.

Scrutinize your policy … now

If you haven’t had an agent review your policy in the last couple of years, now is the time to do it. And next time you receive one of those form letters from your insurer with an amendment to the policy, maybe it’s worth taking a few minutes to read.

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