Category: Partnerships
Subject: Basis and Losses
Title: Preserving Basis Limited Losses
IRC Sections: 704(d)
Filename: 1009.html
Date Produced: 3/98

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I understand the facts to be the following.

There are two limited liability companies (LLC's) each with four members. Each has ownership of 10%, 20%, 35%, and 35%. It is possible that the two 35% members are really one 70% LLC. The 10% and 20% members are individuals. The 35% members are foreign corporations which already file Form 1120F.

The two LLC's were formed in 1997 and report on a calendar-year basis. One LLC is based in Florida and the other in California. For 1997, the California LLC produced a tax loss of $130,000 and the Florida LLC a tax loss of $164,000. The existing members do not have sufficient tax basis in their partnership interests in order to absorb these losses.

Your concern is how to preserve these losses in the event they cannot be absorbed for 1997. You have suggested using the so-called check-the-box regulations to have the LLC's file as an association taxed as a corporation. By so doing, the loss would be preserved through the ability to carry over the net operating loss.

I strongly disagree with this strategy for the following reasons.

1. Although I have not researched this point, I wonder if it is already too late to make the check-the-box election you suggest.

2. Even if it were possible, electing to be taxed as a regular corporation would have significant and far-reaching tax consequences. I must assume that someone chose the LLC form for some strategic tax purpose. I would be very hesitant to change the tax classification of these LLC's without completely considering the whole choice-of-entity question.

3. Most importantly, as discussed more fully below, I feel the strategy of electing to be taxed as a corporation is not necessary in order to preserve utilization of the current loss.

As it stands now, I presume the LLC's will be taxed as partnerships under the default entity classification rules of Regulation Section 301.7701-1 et seq. As such, any losses passed through to the members for 1997 can be utilized only to the extent the partner (member) has basis in his partnership interest. Section 704(d). The question is what happens to any amounts in excess of such basis.

Section 704(d) provides as follows.

A partner's distributive share of partnership loss (including capital loss) shall be allowed only to the extent of the adjusted basis of such partner's interest in the partnership at the end of the partnership year in which such loss occurred. Any excess of such loss over such basis shall be allowed as a deduction at the end of the partnership year in which such excess is repaid to the partnership. [Emphasis added.]

Note the last sentence of Section 704(d), the highlighted passage above. If a loss passed through in a given year exceeds the partners's basis in his partnership interest, then the excessthe amount the partner could not use due to the general basis limitationcarries over until such time as the partner acquires additional basis, either through additional capital contributions or an increase in the partner's share of partnership liabilities. As long as the partner retains the partnership interest that gave rise to the loss, these unused losses (so-called basis-suspended losses) remain available in the event the partner subsequently establishes sufficient basis to utilize them. Note, however, that basis-suspended losses are personal to the partner. In other words, if the partner disposes of his partnership interest, the basis-suspended loss evaporates.

I refer now to your question concerning California treatment. I assume you are asking about whether California accepts the check-the-box regulations. While California does not literally adopt the federal regulations, it has its own regulations intended to conform California treatment to federal treatment. These regulations, under R&TC Section 23038, are effective January 1, 1997.

Finally, I refer to your comment regarding the possibility that the LLC's will be terminated sometime next year. The issue becomes what happens if one or more partner-members have a Section 704(d) basis-suspended loss at the time of termination. In order to deal with this question intelligently, I would need to understand more about how the entities are expected to terminate. In general, however, I think there is a possibility that any basis-suspended loss remaining at termination could easily be lost. We should discuss this further.

Finally, I understand that you expect that the vast majority of the partner's interest basis will be derived from the partner's share of partnership (LLC) liabilities. In order to deduct losses passed through from a partnership, it is necessary that the partner have sufficient interest basis under Section 704(d). It is also necessary under Section 465 that a partner have sufficient at-risk basis as well. While it may be true that a given liability is allocated to a particular partner under the general basis allocation rules of Section 752, it may not follow that the same liability can be reliably allocated to that partner under the at-risk rules of Section 465. This is particularly the case with respect to partner debt. This matter should be carefully considered. I stand ready to assist you if you so desire.