Passive Losses: L.L.C and L.L.P Partners Considered "Active"

Consider for 2008 Tax Returns and Evaluated Amending Previously filed Tax Returns

By Ron Cohen, CPA, MST
Partner
Greenstein, Rogoff, Olsen & Co., LLP

United States Tax Court
Docket No. 9898-06. Decision File June 30, 2009.

PAUL D. GARNETT AND ALICIA GARNETT, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent

Taxpayer won and avoided $350,000 in tax penalties,

Full Case: http://www.privateequitylawreview.com/uploads/file/garnett_TC_WPD.pdf

Definitions:

Background:

The IRS has long taken the position that losses generated by businesses held within L.L.P.s and L.L.C.s can’t be used to offset a taxpayer’s salary and investment income in the same year and same tax return. They are “passive losses” and therefore, “limited” and carryover for possible deduction in future years when the passive activity has income, is sold or is liquidated.

Internal Revenue Code Section 469(h)(2)says that if a taxpayer is a “limited partner”, the taxpayer cannot “materially participate” in that activity/business. Material participation is required to obtain an “active” or non-passive loss deduction.

It is very interesting to note the Court mentions:

“We can be certain that when it enacted section 469(h)(2) in 1986, Congress did not have L.L.P.s specifically in mind, since L.L.P.s did not come into existence until 1991. See 1 Bromberg & Ribstein, Partnership, sec. 1.01(b)(5) (1998). Similarly, it is doubtful that Congress had L.L.C.s specifically in mind, since only one State, Wyoming, had an L.L.C. statute in 1986. Id. sec. 1.01(b)(4). The temporary regulations, promulgated in 1988, make no explicit reference to L.L.P.s or L.L.C.s.”

Therefore, the Court concluded a taxpayer can be a “limited partner” of an L.L.C. or L.L.P. under state law, but be a “general partner” of the same legal entity for purposes of the passive loss rules, if the taxpayer otherwise meets the material participation rules (spending a required amount of hours in the activity/business.) See: http://www.irs.gov/businesses/small/article/0,,id=147325,00.html for material participation rules.

Therefore, following this case, a taxpayer CAN deduct the current year losses against salary and other investment income in the right circumstances.

Impact:

1. 2008 Tax Returns on Extension?...and you are a Limited Partner that has “material participation?” Consider taking the loss deduction as an “active” loss.
2. Possibly file Amended Tax Return claims for all open years under the Statute of Limitations??...and obtain refunds.

Note: Profitable L.L.C. or L.L.P. partners in this situation may now owe Self-Employment Tax if they are deemed a General Partner for federal tax purposes. That is, if a taxpayer is involved in the business enough to claim “active” losses, then, it is only fair to say they may also be involved in the business enough to be deemed “self-employed”. The Self-Employment tax is only incurred when the business earns profits.

A true limited partner for federal tax purposes is never deemed to be self-employed for purposes of the Self-Employment tax (Social Security and Medicare tax on non-employee business owners)since a limited partner has limited control and involvement. Usually, they just contribute money and have no involvement in day-to-day operations.

PLEASE NOTE: The I.R.S. may appeal this Tax Court decision. We should wait 90 days to see if the I.R.S. files an appeal or writes an “Action on Decision” statement on how they plan to act toward other taxpayers following this decision.

If the case is appealed, the legal issue is not settled – and therefore cannot be relied upon as clear authority -- until the Appeals case is resolved and decided in the taxpayers favor AND the I.R.S. waives an appeal to the U.S. Supreme Court. Tax cases almost never get appealed (and if appealed, are rarely accepted by) the U.S. Supreme Court.

Since Mr. Garnett, a Nebraska farmer, is $350,000 ahead based on this case, other taxpayers with L.L.C., L.L.P. and passive losses should at least consider its application to their facts and tax returns.

UPDATE: 7/23/09

Case on same issue in the U.S. Court of Claims- LLC Interest wasn't equivalent to a limited partnership interest for PAL purposes

Thompson v. U.S., (Ct Fed Cl 7/20/2009)

In a case of first impression for it, the Court of Federal Claims decisively rejected IRS's view that a taxpayer's interest in a limited liability company (LLC) should be treated as a limited partnership interest for purposes of the Code Sec. 469 passive activity loss (PAL ) rules. The Court concluded that the LLC wasn't a partnership under state law and couldn't be treated as the equivalent of a limited partnership for PAL purposes. It also suggested that limited liability wasn't the determining factor in deciding whether a taxpayer's interest in an activity is passive; rather, Congress' primary concern was the level of involvement in the activity.

Coming hard on the heels of a Tax Court decision (see Garnett, above) earlier this month that interests in LLPs and LLCs weren't presumptively passive under the PAL rules, the new decision may lead IRS to revise temp regs. that were issued in '98 to address how the PAL rules apply to LLCs.

Although the Court of Federal Claims decision is a major victory for taxpayers, its applicability is somewhat limited in that it involved a taxpayer who was both a 99% direct owner in an LLC and its only manager.

Here's the full case

I can always be reached for questions or comments at (510) 797 8661 x237 and we are happy to help taxpayers consider their tax filing options.