In the early stages of any business, losses seem to almost be unavoidable. For a limited-liability company, a common business organizational option, the question of how to treat operating losses is important. Since most LLCs are treated as partnerships, net operating losses do not really apply. Losses can be passed along to the LLC’s members, who can generally apply those losses against their personal income.
Net Operating Losses
Net operating losses (NOLs) are deductible losses that derive from participation in a trade or business, employment, or renting property. The most common source of NOLs are business operations. An NOL occurs anytime the deductions exceed the corresponding income. Some deductions that cannot be used when determining NOLs such as capital losses in excess of capital gains from business property, prior NOLs and non-business deductions in excess of non-business income. When you generate an NOL, you may amend the returns from the past two years and apply the losses against prior-year income. This would decrease the taxable income, which would decrease what you owe in taxes. The other alternative is to waive carrying back the NOL and carrying it forward and applying it toward the next 20 years of income.
Limited-liability companies (LLCs) are state-licensed business organizations that combine the benefits of corporations and partnerships. Like a corporation, an LLC offers its owners, or members, a liability shield. This means that members generally are not liable for the legal liabilities and debts of the LLC. But most LLCs choose to be taxed like a partnership. The benefit of partnership taxation is that unlike a corporation that taxes the business’s income when the corporation earns it and then when it distributes the income, partnerships allow the income to “flow through” to the members. This means that the members are taxed on their shares of the LLC’s income and losses for the year. When an LLC chooses to be taxed like a partnership, partnership rules apply to the LLC income and the LLC files its returns on partnership returns.
LLCs and Losses
As most LLCs are treated as partnerships, these institutions cannot claim NOLs. Instead, the individual members can use the income and losses to calculate NOLs for their personal returns. The amount of losses a member can claim on her personal return depends on her basis in the LLC, or the amount of after-tax investment she has made in the business. This amount is calculated as all investment amounts that the member provides the LLC, plus any prior year income from the LLC, minus any distributions to the members and any prior-year losses from the LLC. Any losses in excess of a member’s basis cannot be claimed on a personal return in that year.
Tax Tips and Disclaimer
For complex returns, consult with a tax professional, such as a certified public accountant (CPA) or licensed attorney, as he can best address your individual needs. Keep your tax records for at least seven years, to protect against the possibility of future audits.
- IRS.gov: Publication 536 – Net Operating Losses (NOLs) for Individuals, Estates, and Trusts; 2010.
- IRS.gov: Publication 3402 – Taxation of Limited Liability Companies; 2010.
- IRS.gov: Publication 541 – Partnerships; 2010.
- Business Briefing; Clear 3 Hurdles to Deduct Losses Passed Through Your LLC; Business Management Daily; 2003.