The owners of businesses that generate tax losses, such as oil and gas or real estate businesses, maximize the tax benefit of such losses if they can use them to offset taxable income from other sources, such as wages or dividend income. Tax losses that are determined to be "passive losses" under Section 469 may not, however, be used to offset other income. With respect to businesses conducted in LLC form, there has long been a question as to the circumstances under which they will be considered to be passive.
Recently, two significant tax cases have paved the way for LLC members to treat the losses as non-passive and thus deductible against other income. This is big news because it provides an answer to a question that has been around since the early 1990's when LLCs first started being used as a form of doing business. The favorable answer given in these cases is in contrast to the hard-line position the IRS had been taking on the issue. Given the result, we are likely to see the IRS appeal and further litigate the issue but, unless and until contrary case law is made, taxpayers have new support for deducting such losses.
The specific tax question at issue in the cases was the appropriate test for determining whether losses generated by LLCs were "passive losses." The determination of whether losses are passive turns on whether the owner has "materially participated" in the business activity. With respect to limited partnerships, the IRS regulations provide that limited partners materially participate only if they satisfy certain very high hurdles, such as participating more than 500 hours a year. This rule was based on the presumption that a limited partner would not participate in the management or control of the business for fear of losing his or her limited liability status. However, general partners of limited partnerships benefit from much easier to satisfy tests for material participation, such as, in certain circumstances, only 100 hours of participation a year.
When LLCs began to be commonly used as entities treated as tax partnerships that would flow losses through to their members, the immediate next question was whether members of LLCs are limited partners or general partners for purposes of applying the section 469 tests for material participation. Under the state laws governing the formation of these entities, the members are not identified as either general or limited partners. Members of an LLC do, however, enjoy limited liability regardless of how active they are in the management of the business.
The IRS had taken the position in its regulations that characterization as a limited partner depended upon whether the partner had limited liability. Since members of LLCs have limited liability, the IRS position has been that they are subject to the same high hurdles for material participation that apply to limited partners.
In Garnett v. Commissioner, 132 T.C. No. 19 (June 30, 2009), the Tax Court examined the issue and found that LLC members could not be presumed to be limited partners for purposes of section 469. It reached this conclusion based on its examination of the nature of LLCs, pursuant to which it found that the key attraction to the LLC as a form of doing business is that, in contrast to limited partnerships, the members can actively participate in the management and control of the business without losing their limited liability. In Thompson v. United States, 104 AFTR 2d 2009-5381 (Ct. Cl., July 20, 2009), which was released shortly after Garnett, the Court of Claims reached the same conclusion on similar facts.
If LLC members are not limited partners for purposes of applying the material participation tests, they will benefit from the easier to satisfy tests enjoyed by general partners in limited partnerships. These two new cases give LLC members support for the position that they are not restricted to the limited partner tests for material participation, thereby increasing the likelihood that they will be considered to have materially participated and thus that the losses will be non-passive.
These decisions may also impact the selection of the form of entity for a start-up business. For a variety of reasons, including Texas franchise tax rules, limited partnership form has previously been the entity of choice in Texas. With the amendment of the Texas franchise tax and these new decisions, however, a limited partnership may have less advantages over LLC form than has previously been the case, especially if the business is expected to generate up-front losses.
There is a potential downside to the outcome of these cases, relating to the application of self-employment tax. Section 1402 imposes self-employment tax on the income of general partners (in 2009, 15.3 percent of the first $106,800 and 2.9 percent of amounts above that) but not on the income of limited partners. Are members of LLCs general or limited partners for purposes of self-employment tax? If the theory behind the recent decisions were applied to section 1402, members of LLCs could be considered to be general partners and subject to self-employment tax on their income. Self-employment tax would not be an issue, however, unless and until the business has earnings.
Summary: If you own an interest in an LLC that generates losses, such as losses from oil and gas or real estate activities, you may now find it easier to satisfy the tests that will permit deduction of such losses against your (and your spouse's) wages, dividends, interest and profits from other businesses.