How to Effectively Structure Loans Between Real Estate Owners and their LLCs
There is a difference between a member giving money to a LLC that’s classified as a partnership when it is in the form of a loan or a contribution. Both have very different tax consequences. When it’s a loan then it is allocated 100% to that member for basis purposes. When it’s a contribution then it increases a member’s basis or interest in the LLC on a dollar for dollar basis.
If a member gives the LLC money and it’s considered debt then the whole transaction is treated as a loan from a third party and the principle and interest and payments are taxed like a normal loan between unrelated parties. The best way to ensure the loan is treated as a third party debt is to execute a promissory note to evidence the loan the same way it would be with an unrelated third party. It should be noted that other third party lenders might require the member’s loan to the LLC subordinate as part of the conditions of making a loan, especially if the member’s debt is secured with LLC property. The thetaxadviser.com had some other good information regarding loans between members and LLC’s.
If a member is going to consider making loans to the LLC throughout the year that the LLC has been repaying regularly then it probably makes sense to come up with a master loan agreement that would establish a line of credit with the member. It would include normal terms and language just like a normal agreement would. This would save the time and hassle of creating a new document each time money is given and can be updated annually or as the parties see fit. If the money contributed is considered contributed capital, then the interest like payments would be taxed as guaranteed payments.
Here are some other quick points to consider:
- In the case of the LLC loaning money to a member, it must be determined that repayments are not treated as a distribution, that can produce taxable gains
- Member should pay interest as like any other loan
- Loan terms should closely mirror other commercial loans
- Can be collaterized or a right of setoff (LLC keeps distributions or allocated member capital in the case of a default on the loan) can be included
- Advances that create a capital deficit is not necessary a loan even if by operating agreement or law the member is required or agrees to restore the deficit
- If loan is given, and later the debt is cancelled then the cancellation is considered distribution at the time of the cancellation
- Passive activity loss rules that self charged interest where a member is owing the interest because of a loan given, and is has some level of LLC-level interest expense, the interest income is treated as portfolio interest
- In some cases, the interest can be re-characterized so that interest income is offset by the members share of the LLC’s passive interest expense
- These rules only apply to interest income and not other self-charged items like management fees, rent, or compensation arrangements.
- These rules also apply to loans between pass through entities
- Self-charged interest rules apply only for interest charged during the same tax year
- A member can elect out of self-charged interest if they need portfolio income to increase a net operating loss or needs portfolio income in order to deduct investment interest expense
- There may be a circumstance where a member borrows money from a lender and then turns around and lends that money to the LLC. In that case, it’s a back-to-back loan arrangement and the member can re-characterize a portion or all of the interest expense as passive if the LLC is using the funds for a passive activity
- The self-charged interest rules also apply to pass through entities if each owner of the borrowing entity has the same proportionate ownership interest in the lending entity
- An accrual-basis LLC can’t deduct accrued expenses owed to a cash-basis member until the expenses are paid and included in the income of the cash-basis member
- If the LLC can’t repay a loan to a member then the member can claim a bad debt deduction
- Must be able to prove that the bona fide debt existed
- Some cases were able to prove that their loans to their partnerships were made in the course of their trade or business, and then they were able to attribute the trade or business to themselves
- In other cases a member can guarantee the LLC’s debt rather than loaning them money. The tax payers payment on the guarantee is treated as creating a debt
- The taxpayer’s agreement to act as a guarantor produces a worthless debt if the taxpayer can demonstrate that reasonable consideration was received for entering into the agreement, if certain requirements are met then the payments on the guarantee produce a bad debt loss. The deduction depends on whether or not the debt was a business or nonbusiness debt
These are just some of the rules and guidelines that have been given in regard to loans between members and LLC’s. There are a lot of factors to consider and such loans should not be given or executed lightly. As always, we suggest you work with a knowledgeable tax adviser who is experienced in these matters to help you figure out which route is going to be best for you personally and the business. These loans can quickly complicate things, or they can be great if they are executed correctly with consideration given to all of the most important points.
For more information on the structure of loans for LLC, contact our advisors
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