A limited liability company (LLC) and a subchapter S corporation have certain similarities. Both allow profits to be passed through to members and shareholders without paying corporate income taxes. An S corporation is not a legal form of organization, but rather a tax status conferred by the Internal Revenue Service. An LLC is a legal form of organization, but each state enacts its own rules regarding LLCs. An LLC can also be an S corporation if it meets all of the requirements. The passive loss limits are similar for both an LLC and an S corporation.
Definition of Passive Activities
The IRS defines two types of passive income. The first category is rental activity, which includes real estate and equipment. The second is business activity that does not require the taxpayer to participate in a material, continuous, substantial and regular basis. Passive activities, under IRS guidelines, do not include investment or portfolio income. The IRS does not consider salaries as passive income. Passive losses are directly related to passive activities.
General Rules for Passive Losses
You can only deduct passive losses from passive income, effectively limiting the deduction to no more than your net income from passive activities. In addition, passive losses are subject to the amount of your investment that is at risk. You might be able to carry forward to subsequent years the portion of your losses not allowed for the current year.
At-risk limits apply to shareholders and partners of S corporations, partnerships, trusts, estates and C corporations with more than half of its stock owned by no more than five shareholders. The IRS defines at-risk amounts as the funds and property you supply to the passive activity. You can include borrowed funds if you are personally liable for the debt or provide property as collateral. The property pledged cannot be used in the passive activity. The IRS does not consider your investment at risk if the creditor has an interest, or is related to someone with an interest, in your business.
Passive Income Limitations
An S corporation's passive income is limited to no more than 25 percent of gross annual revenue. Exceeding the limit for three consecutive tax years can result in revocation of the company's S corporation status by the IRS. The IRS does not subject an LLC to the same limits. An LLC passes the loss to members on a form K-1. Each individual must then determine his material participation in the enterprise to see whether to claim the income as passive or active on his personal income tax return.
- Internal Revenue Service: Passive Activity Losses – Real Estate Tax Tips
- Internal Revenue Service: Publication 925 (2010), Passive Activity and At-Risk Rules
- Companies Incorporated: Comparing the LLC vs. the Sub-Chapter S Corporation
- Journal of Accountancy: Managing S Corporation At-Risk Loss Limitations
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