Question: I own a 50% membership interest in a limited liability company (“LLC”) which is taxed as a partnership and I also own stock in a S corporation. The corporation advanced funds to the LLC in 2017. Since the LLC is no longer in business, do I as a LLC member have to report income from the non-repayment of the advance?
Answer: Taxpayers are generally required to pay tax on all of their income from whatever source derived. One source of taxable income is income from the cancellation or discharge of indebtedness. If a borrower’s debt is forgiven or not repaid, the borrower must report the discharged debt as taxable income. Among the various exceptions to reporting discharged debt as taxable income is the borrower’s insolvency. If a borrower is insolvent, the borrower is generally not required to report the discharged debt as income. Instead, various tax attributes such as the borrower’s net operating loss carryforwards, capital loss carryforwards and certain tax credits must be reduced to the extent of the amount excluded from income.
To qualify for the insolvency exclusion, the borrower’s debts must exceed the value of the borrower’s assets. The measure of insolvency depends on the nature of the borrowing entity. With a corporate borrower, insolvency is measured at the corporate level meaning the financial wherewithal of the borrowing corporation’s shareholders is disregarded. With a limited liability company which is treated as a partnership, insolvency is measured at the owner level. Thus, if a limited liability company is insolvent but its owners are not, the limited liability company’s insolvency will not, by itself, permit the entity’s discharged debt to be excluded from income.
There are other exceptions to the requirement that discharged debt be reported as income. Among these additional exceptions are debt discharged in connection with certain farming activities and debt in connection with real property used in a trade or business. If either of these exceptions applies, you may have another avenue available to avoid reporting income upon the discharge of the LLC’s indebtedness.
You do not mention how the payments to the LLC were characterized. If the payments were documented as loans, it may be too late to take a contrary position for tax purposes. If instead the advances to the LLC from the corporation were not documented, it may be possible to take the position that the corporation invested in the LLC and the payments were capital contributions. In such case, no debt discharge income will result.
Defaulting corporations enjoy benefits that defaulting partnerships and limited liability companies treated as partnerships do not experience under the Internal Revenue Code. While hindsight is 20/20, had the borrowing entity been a corporation, no debt discharge income would need to be reported. However, if you can properly characterize the payments to the LLC as capital contributions, not loans, the discharged debt need not be reported as taxable income.
The Tax Corner addresses various tax, estate, asset protection and other business matters. Should you have any questions regarding the subject matter or if you have questions you want answered, you may contact Bruce at (312) 648-2300 or send an e-mail to bruce.bell@sfnr.com.
