Taxpayers have several choices to make when starting a business. One of these choices is how to fund the business.
They can fund the business with capital contributions or debt (or a combination thereof). The IRS and courts will usually follow the method the taxpayer uses.
Many taxpayers do not consciously decide this issue. They just fund the business venture as needed and leave this decision up to their tax return preparer at the end of the year. The tax return preparer then files returns and sets up the accounting transactions.
This can have a number of tax consequences. This is why some taxpayers engage tax attorneys and the start-up funding process as part of their tax planning.
The recent Hohl v. Commissioner, T.C. Memo. 2021-5, case provides an opportunity to consider a few of the implications of funding a start-up business with loans rather than capital contributions. How do you fund an LLC? Can you loan money to your LLC?
- 1 Facts & Procedural History
- 2 What is Capital Contribution in an LLC?
- 3 Is Capital Contribution Taxable?
- 4 Are LLC Capital Contributions Tax Deductible?
- 5 Are Capital Contributions Required for an LLC?
- 6 How to Loan Money to Your LLC (Not Shareholder Loans)?
- 7 How to Fund an LLC?
- 8 Which Option is Preferable Depends
- 9 The Takeaway
Facts & Procedural History
The case involves an LLC taxed as a partnership. The LLC had three members who did not make any capital contributions. The three members contributed services instead of capital.
The fourth member contributed all of the money for the business.
The LLC Company Agreement provided that the three partners received a 30% interest in the venture. It provided that the fourth member received a 10% interest in the venture.
The partnership tax returns reported guaranteed payments to the partners that resulted in tax losses. The losses resulted in negative capital accounts for the members. The members picked up the losses on their individual income tax returns each year.
The LLC reflected the contributions to the venture from the fourth member as a loan from a member (i.e., a note payable).
The members originally treated the contribution by the fourth member as a loan. When the business failed seven years later, the loans were not repaid. The final year partnership tax return reflected a loan on the balance sheet, but none of the members were allocated the liability.
The IRS conducted an audit. The members took the position that the loan was a capital contribution and not a loan. The IRS auditor concluded that the capital contribution was a loan, that the loan was canceled, and that the loan cancellation triggered the cancellation of debt income for the three non-contributing members.
Tax litigation ensued. The court was asked whether the loan was a capital contribution or actually a loan.
What is Capital Contribution in an LLC?
A capital contribution is an equity investment. This usually means a contribution of money. It can also include contributions of property. These in-kind contributions are typically recorded at fair market value.
A capital contribution can also include the contribution of interests in other legal interests.
These contributions are usually described in the LLC’s Company Agreement or in a stand-alone LLC contribution agreement. These agreements should also list the LLC ownership percentage for each member. The ownership percentage and contributions have to be considered to determine whether partnership or LLC level items are taxable to the members.
Is Capital Contribution Taxable?
Our tax laws say that most capital contributions are not taxable for the LLC owner or the LLC.
Are LLC Capital Contributions Tax Deductible?
Our tax laws say that capital contributions are not tax deductible.
Are Capital Contributions Required for an LLC?
Capital contributions are not required for LLCs. In fact, it is very common for LLCs to be started with no capital investment. This is often possible with service businesses or businesses that develop an intangible product, such as computer software.
Loans to LLC owners are often referred to as member loans. This differs from shareholder loans–which are loans made by the LLC to the member or members.
Member loans are made just as any other loan would be. They are funds advanced to the LLC and, hopefully, memorialized in a promissory note or loan document and secured by a guarantee or security interest.
The loan should have a specified interest rate, set repayment terms, and even say what happens in the event of default. As explained below, a convertible note option in the event of default may be advisable. The taxpayers in this case could have benefitted by including this type of provision in their loan.
The member loan is usually not taxable to the member or members or the LLC. It is also not treated as a distribution to the member or members. Distributions do not come with an offsetting obligation for the member or members to repay the funds. An LLC profit distribution can be taxable in some instances.
How to Fund an LLC?
This brings us back to the question of how to fund an LLC? This is a fundamental question for those who have an ownership interest in an LLC.
This is not just an accounting entry decision. The distinction has significant tax consequences.
LLC members can generally structure contributions to a business as capital contributions or loans. Each member may have their own preferences when it comes to this decision. The IRS will usually follow the form of these transactions selected by the taxpayers.
In this case, the contributions were documented by the taxpayers as being loans. This was reflected on the partnership tax returns. It is also consistent with allocating out guaranteed-payment induced losses to the partners equally each year. It is also consistent with the partnership not tracking the capital contributions in the fourth partner’s capital account.
The court applied a “substance over form” analysis to conclude that the contribution was a loan:
We focus on the substance of the transaction, not the form. Among the factors we consider are: “(1) The presence of a written agreement; (2) the intent of the parties; and (3) the likelihood of obtaining similar loans from disinterested investors.”
Having determined that the contribution was a loan, the court had little difficulty in concluding that the loan triggered the cancellation of debt income when it was not repaid.
For the fourth member who made the contributions, he would be entitled to a bad debt deduction for the loan.
So the three members who did not make capital contributions were able to take tax losses for several years but then had to pay tax on cancellation of debt income. The fourth member received a smaller tax loss for several years and then received a larger bad debt loss at the end.
Which Option is Preferable Depends
As in this case, those who only contribute service to an LLC that fails may prefer that the funds put in are treated as capital contributions. The members may not be able to fully deduct their losses each year if the LLC is not profitable, but they will not have cancellation of debt income if the business fails.
The same result is reached if the funds are non-recourse loans (non-recourse loans are those that a party is not liable for if they are not repaid). In that case, the cancellation of debt income would only be triggered for the member who made the loan. The other non-recourse members would not have this income. In fact, the three members made this argument in the Hohl case. The court did not accept the argument as the evidence suggested that it was a recourse loan.
Compare this to the member who makes the capital contribution. He may prefer that the capital contribution. The capital contribution would allow him to take his losses in full each year and, if the business fails, he could take a loss for the capital account.
There are additional considerations in making these decisions. Suffice it to say that proactive tax planning is required here. One should not leave this decision up to their tax preparer to make at the end of the year. The tax preparer may not have the bigger picture in mind and may report the transaction in a way that is not advantageous. This tax reporting creates the paper trail that the IRS and the courts may follow.