How Do LLC Losses Affect Personal Taxes?

Forming an LLC can be a great way to protect your personal assets, but understanding how its financial performance affects your personal tax return is where things get interesting. When an LLC generates a loss, you might be able to use that loss to lower your personal taxable income, but it's not always a straight line from business loss to tax savings. This article explains the series of tests your LLC losses must pass before they can be deducted on your personal tax return.

How LLC Losses Flow to Your Personal Return

Limited Liability Companies (LLCs) have a unique flexibility in how they are taxed. By default, the IRS treats them as "pass-through" entities, meaning the business itself doesn't pay income tax. Instead, the profits and losses are passed directly to the owner's or owners' personal tax returns.

• Single-Member LLC: By default, this is a "disregarded entity." The owner reports all business income and losses on Schedule C (Form 1040), Profit or Loss from Business, which is filed with their personal Form 1040. The LLC loss directly offsets other income on the owner's return, such as wages.
• Multi-Member LLC: The default classification is a partnership. The LLC files an informational return, Form 1065, U.S. Return of Partnership Income. Each member then receives a Schedule K-1, which reports their specific share of the LLC's income, deductions, credits, and losses. The members use the information from their K-1 to report the loss on their personal Form 1040.

Just because a loss appears on your Schedule K-1 doesn't mean you can automatically deduct the full amount. This is where a series of loss limitation rules come into play. These rules are applied sequentially, and a loss must clear each hurdle to be deductible.

The First Hurdle: Tax Basis Limitation

Your ability to deduct an LLC loss is first limited by your tax basis in the company. Think of your basis as your economic investment in the LLC. You can't deduct losses greater than what you have financially invested and stand to lose.

The calculation for your basis starts with your initial investment and is adjusted annually:

Initial Basis:

• The amount of cash you contributed
• The adjusted basis of any property you contributed
• Your share of any LLC debt

Annual Adjustments:

• Increased by: Additional contributions, your share of LLC income, and your share of any increase in LLC debt.
• Decreased by: Distributions you received, your share of LLC losses, and your share of any decrease in LLC debt.

If your share of the LLC's loss for the year is greater than your basis, you can only deduct the loss up to your basis amount. Any loss you can't deduct is not permanently lost—it's suspended and carried forward indefinitely. You can deduct that suspended loss in a future year once you have sufficient basis, either by making additional contributions or when the LLC generates income.

Example: You contribute $15,000 to start an LLC partnership with one other member. At the end of Year 1, your share of the LLC's loss is $20,000. Your basis is only $15,000, so you can only deduct $15,000 of the loss on your personal return this year. The remaining $5,000 loss is suspended. In Year 2, you contribute another $10,000. Your basis is now $10,000, which allows you to deduct the $5,000 suspended loss from Year 1.

The Second Hurdle: At-Risk Limitation

After a loss clears the basis hurdle, it must be tested against the at-risk rules defined in IRC Section 465. These rules are designed to prevent you from deducting losses that you are not personally at risk of losing. Your "at-risk" amount is often similar to your basis, but there's a key difference related to debt.

You are considered at risk for:

• The amount of cash you've contributed to the LLC.
• The adjusted basis of property you've contributed.
• Amounts borrowed for the activity for which you are personally liable (recourse debt).
• Amounts borrowed for the activity for which you have pledged personal property (not used in the LLC) as security.

The critical distinction is nonrecourse debt—a loan for which you are not personally liable. A common example is qualified nonrecourse financing secured by real estate. While nonrecourse debt can increase your tax basis, it does not increase your at-risk amount. This is why a loss might be allowed under the basis rules but blocked by the at-risk rules.

Example: You and a partner form an LLC. You each contribute $10,000 cash. The LLC then obtains a $50,000 nonrecourse loan from a bank to purchase equipment. Your share of the loss for the year is $40,000.

• Your tax basis is $35,000 ($10,000 cash contribution + $25,000 share of the nonrecourse loan). The loss is first limited to $35,000. A $5,000 loss is suspended due to the basis limitation.
• Your at-risk amount is only $10,000 (your cash contribution). The nonrecourse loan doesn't count. Therefore, even though you have $35,000 of basis, you can only deduct $10,000 of the loss. The remaining $25,000 is suspended under the at-risk rules.

Similar to basis limitations, losses suspended under at-risk rules are carried forward until you have a sufficient at-risk amount in a future year.

The Third Hurdle: Passive Activity Loss (PAL) Rules

The final and often most complex hurdle is the passive activity loss limitation under IRC Section 469. These rules are in place to prevent investors from using losses from paper investments or hands-off business ventures to offset their active income from wages or other businesses.

The rules segregate your income and losses into three buckets:

1. Active: Income from activities in which you "materially participate," like a salary from a full-time job.
2. Passive: Income or loss from rental activities or businesses where you do not materially participate.
3. Portfolio: Income from interest, dividends, royalties, and capital gains.

The core principle is simple: passive losses can generally only be deducted against passive income. If you have no passive income, your passive losses are entirely suspended and carried forward to future years. They can then be used to offset future passive income or are fully released when you dispose of your entire interest in the passive activity.

What constitutes "material participation?"

The IRS has seven tests for determining material participation. If you meet any one of them for a tax year, you are considered a material participant. The most common tests include:

• You participated more than 500 hours during the year.
• Your participation was substantially all the participation in the activity for the year by all individuals.
• You participated more than 100 hours, and that was not less than the participation of any other individual.

Most rental activities are automatically considered passive, regardless of participation, unless you qualify as a "real estate professional."

Example: You work full-time as an accountant (active income). You also invest in a restaurant LLC managed by your friend, but you don't work there at all (passive activity). This year, your share of the loss from the LLC is $12,000. This loss clears the basis and at-risk rules. However, you have no other sources of passive income. As a result, the entire $12,000 loss is suspended under the PAL rules. You cannot use it to offset your accounting salary. The loss carries forward until you have passive income or sell your interest in the restaurant.

The Final Step: Excess Business Loss Limitation

A final limitation to be aware of is the excess business loss rule (IRC Section 461(l)). This rule, which applies after the other limitations, disallows overall business losses above a certain threshold for a given tax year. The threshold is adjusted for inflation annually. For 2023, the thresholds were $289,000 for single filers and $578,000 for joint filers.

Any loss disallowed under this rule is not permanently lost but is carried forward to the next year as a net operating loss (NOL).

Final Thoughts

Deducting LLC losses on your personal tax return involves clearing a sequence of specific hurdles: the tax basis limitation, the at-risk rules, and finally the passive activity loss rules. Each test must be passed in order, and understanding how they interact is fundamental for any tax professional advising business owners.

Keeping track of basis calculations, at-risk amounts, and participation hours for multiple clients across various entity structures can be demanding. When questions arise about nonrecourse debt or material participation tests, having a fast way to verify the specifics of IRC Sections 465 and 469 is invaluable. For times like these, Feather AI can provide you with instant, citation-backed answers, allowing you to give confident advice without spending hours digging through tax codes and revenue rulings.