Forgot to carry forward disallowed losses way back in time

[lexster333]

Not sure if I will present all info correctly but I'll try

Many years ago (2014/2015) we (myself and partner) invested in some R&D (pharma). Myself and partner and some investors put in approximately 1 million through our company - a partnership LLC. The research although great ended up in a legal fight for years (8  in fact) due to other researchers spending the money on something else. We sued and eventually reached a settlement in 2022 and got 600k back of the 1 million spent.

I had recorded my share of these bills in 2014 and 2015 as disallowed losses on my tax return. I didn't claim anything for them - they were just there for record. In 2016 I had to switch accountants and somehow they forgot to carry over these disallowed losses onto 2016 personal return and this is what has been carried over since. My current accountant is telling me I must pay my share of the profits (so 50% of 600K) even though I have made nothing (in fact I've lost money) as all that 600k went back to paying back the original investors. I hope there is a way around this as it seems unfair to me that I must pay a huge tax bill because something was not carried forward years ago and I legitimately have the correct business filings for each year.

[Anonymous_]

Does your current accountant have any reason or rationale as to why the former passive loss you incurred cannot be carried forward?

Did you have any passive income from this activity after the 2015 tax year? 

Was the LLC dissolved?

[lexster333]

His only rationale seems to be its not documented as carried losses on personal last years return so doesn't count as too far back in history to amend.

The 2022 return of 60% of the original investment as a legal settlement I guess could be counted as income. From years 2014 to 2021 there was increasing losses (original investment then legal fees) with most of the losses (disallowed) counting in 2014/2015. All in all we spent 1.1 million between 2014 and 2015 and got 650k back or so in 2022.

The LLC was dissolved at the end of 2022.

[Anonymous_]

I will page @Rick19744 since the LLC was dissolved and, presumably, the settlement was paid to the LLC and then distributed.

[lexster333]

This is correct. I think you can see what this is about. Although the LLC was dissolved I beleive it can be brought back pretty simply.

Quite confusing that I'm supposed to pay taxes on something I (and everybody else) made no money on when i claimed no credit for these losses as disallowed until now - everyone lost money on the deal in total.

[Rick19744]

I am somewhat confused based on the original facts:

• The original facts indicate that a LLC that you were a member of invested in the R&D project.
• Then the facts indicate that you, and I'm assuming other members, then recorded your share of the "bills" on your personal tax return.
• At this point, I believe we are missing some details:
  • Were you active or passive in the LLC?
  • Did the LLC pay the legal fees for the lawsuit?
  • What exactly were you "deducting" on your personal tax return?  
  • The LLC should have had an "investment in R&D" line on the balance sheet of the original $1 million
  • When the $600,000 was received, this would have just been a return of capital of the original investment.
  • All of this activity should have been reflected on the LLC tax return and the member's should have received a K-1.
  • When was the last year the LLC filed a tax return?
  • Did you have tax basis in your LLC when all of this took place?
  • What was the trade or business of your LLC?
  • I'm not sure why there isn't documentation.  I assume there is support for the original $1 million of funds to the R&D project?
• Addressing the above will allow at least a start in addressing your questions and issue.
• I'm also going to suggest that you find a new accountant once we begin to piece together the history.

[lexster333]

Probably easiest to answer this by answering each bullet point at a time:

• The original facts indicate that a LLC that you were a member of invested in the R&D project.

Yes - I owned 50% of the LLC and had 7% of the investment costs (yes llc ownership was different to investment split - the majority of the investors were not LLC owners and were SEC registered investors).

• Then the facts indicate that you, and I'm assuming other members, then recorded your share of the "bills" on your personal tax return.

Mostly no - I was allowed losses of 7% of the total because thats what my investment share was - the rest were disallowed losses

• At this point, I believe we are missing some details:
  • Were you active or passive in the LLC?

Yeah sorry - never understood the rule on this and not sure what I am listed as

• Did the LLC pay the legal fees for the lawsuit?

Yes - to avoid confusion original R&D was about 700k (2014/2015) then +400k in legal fees (2105 through 2022)

• What exactly were you "deducting" on your personal tax return?  

My 7% was allowed as that was my money - those were allowed deductions so about 80k or so total (yes I fully expect to compensate the gov back for that since i got 50k returned to me). The disallowed losses were recorded but not taken (and this is where issue seems to be as the carried forward nature of these was lost in 2016)

• The LLC should have had an "investment in R&D" line on the balance sheet of the original $1 million

Id have to check how the business filed and what it called this each year and what they called it - there is a filing every year for the LLC from 2014 through 2022

• When the $600,000 was received, this would have just been a return of capital of the original investment.

Thats what I assumed. It was then disbursed to all investors (I got 7% back)

• All of this activity should have been reflected on the LLC tax return and the member's should have received a K-1.

Yes but to add a little clarity only 2 of us were members of LLC so received K1s. The rest were investors with profit interests so just received a statement and 60% of their money back.

• When was the last year the LLC filed a tax return?

2022

• Did you have tax basis in your LLC when all of this took place?

Not sure what this means

• What was the trade or business of your LLC?

Pharmaceutical investment R&D

• I'm not sure why there isn't documentation.  I assume there is support for the original $1 million of funds to the R&D project?

There are all records and business filing for business entity for every year that show losses mounting until the end. I think the main hangup seems to be around the disallowed losses on my personal return which somehow got reset in 2016 when they were forgotten to be carried forward. The business filings show consistent losses from 2014 to 2021 up to over a million then obviously a positive of +600k in 2022.

• Addressing the above will allow at least a start in addressing your questions and issue.
• I'm also going to suggest that you find a new accountant once we begin to piece together the history.

Hoping someone would say that because at the moment I'm not particularly loving the idea of paying +150k in taxes for something I lost money on.

[Rick19744]

Well, I am going to deliver the bad news; or at least it is bad based on limited facts:

• The economics of the LLC appear to be convoluted.
• Your facts indicate that you own 50% of the LLC but only 7% of the investment.  Having an allocation that is not in accordance with the member's interest (known as PIP partners interest in the partnership) in the LLC, must now meet the requirements of the very complicated Section 704(b) regulations.  These regulations are not for the unseasoned tax professional.
• Your facts indicate that there are other "investors" that only had a profits interest.  That doesn't make any sense in the partnership world for your fact situation.  A profits interest is typically provided to a member that is a key "employee" to the LLC.  A profits interest member only receives an allocation when an LLC generates income or has positive tax capital to allocate losses.  A profits interest member also does not contribute capital to an LLC.  So based on the limited facts, I'm not sure how the profits interest member's receive any allocation if there was no profit; certainly there was no profit generated by the R&D project based on the facts.
• Without actually seeing a form 1065 and how everything was presented, there is not much more I can provide here.
• I strongly suggest that you find a tax professional that is strong in partnership tax and can work through the issues.
• Based on the limited facts, the investors that you are saying are "profits interest only" should most likely be treated as individuals that loaned $$ to the LLC to fund the R&D project.  These individuals would not receive any K-1 but would just have their loan $$ repaid as received from the lawsuit.
• Bottom line, I think someone started down this path not understanding partnership tax, but I certainly don't believe there is $600,000 in income to be reported.
• At the end of the day, if you truly have unused passive activity losses, since these are carried forward indefinitely, you won't lose the ability to utilize them when the LLC terminates.  This assumes you have tax basis; which is a whole different discussion.
• Get qualified help.  Don't be penny wise and pound foolish here.  And get it done this summer when tax professionals have more time to deal with this before the extended return deadlines.

[lexster333]

Yes - unfortunately I'm not a tax expert so rely on people with the formal qualifications to do all of this and seems like a few things slipped between the cracks here - and they were certainly not at the penny end of the cost scale when setting this up - large firms with high rates.

That seems sensible - are you for hire here or know someone?

From you what you said of the loan suggestion Im pretty sure my LLC partner (the guy with the other 50% ownership) handled it this way with his accountants - different state though. I can probably get a copy of his return to see how he handled it - he did not owe tax (well apart from reimbursing the allowed losses he 60% got back) on his.

[Rick19744]

A few follow-up comments:

• First, you need to understand a forum such as this is not the best for addressing complicated partnership tax issues.  There are just too many questions and no documents to review to get a complete understanding of what has occurred.
• I am not for hire.  Just someone with a significant background in the partnership tax arena attempting to provide some direction to those struggling in this area of tax; all volunteer, not part of TT.
• Not sure your definition of "large firm", but the rates can be high.  
• Part of the problem is a firm may have set this up, and an understanding of the tax consequences to the members was not passed down.  That happens.  Additionally, it appears that now smaller firm(s) are attempting to understand the transaction, and as I indicated previously, the partnership tax arena is not for the unseasoned.
• Check with your area Chamber of Commerce for tax professionals and call a few to get a feeling for their understanding of the situation and whether they believe they can be of assistance. 
• But once again, I don't believe you have a significant tax liability.  Hopefully you have a copy of all of your K-1's (and your personal tax returns) since the inception of the LLC.  This will be key for any tax professional.
• A copy of the operating agreement should also be provided to your tax professional.
• Good luck.

[lexster333]

Hey appreciate it rick - your comments have been super helpful and I guess I will get on with doing a deep dive with firms who can handle the partnership stuff (which is a bit tricky to assess as people tend to say they can do it but when it gets down to it cant answer half the things you just provided clarity on)