Is an LLC member’s loss currently deductible as an active loss or suspended as a passive loss?
Taxpayer Says: He was an active and material participant in the LLC, and the losses are currently deductible.
Internal Revenue Service Says: The taxpayer’s interest in the LLC was equivalent to a limited partner. The losses are passive, and not currently deductible.
From Internal Revenue Code Section 165(c)(1): Generally, losses incurred in a trade or business are deductible by a taxpayer.
From Internal Revenue Code Section 469(a)(1), (b): The deduction of a passive activity loss is suspended, i.e., the loss is not deductible in the year incurred, but it may be carried forward to the next taxable year.
From Internal Revenue Code Section 469(c)(1): A passive activity is any activity that involves the conduct of a trade or business in which the taxpayer does not materially participate.
From Internal Revenue Code Section 469(h)(1): A taxpayer materially participates in an activity if the taxpayer is involved in the operations of the activity on a regular, continuous, and substantial basis.
From Internal Revenue Code Section 469(h)(2): Interests in limited partnerships.–Except as provided in regulations, no interest in a limited partnership as a limited partner shall be treated as an interest with respect to which a taxpayer materially participates.
From Temporary Federal Tax Regulation 1.469-5T(e)(3)(ii): Limited partner holding general partner interest. — This exception provides that an individual who is a general partner is not restricted from claiming that he materially participated in the partnership.
From Garnett v. Commissioner, 132 T.C. __ (2009): By its terms section 469(h)(2) applies only if the taxpayer has an interest in a limited partnership as a limited partner.
THE CAUSE OF THE DISPUTE
The tax code makes a distinction between active and passive business losses. Active losses, such as those you incur when you operate your own business, are typically deductible in the year you incur them, and can be applied against other types of income. Passive losses can only be deducted to the extent that you have passive income, with the balance “suspended” and carried forward to future years.
Losses from rental activities are generally passive by definition, as are losses from businesses in which you do not participate on a regular, continuous and substantial basis (known as “material participation”). In addition, if you are a limited partner in a limited partnership, losses from that activity are treated as passive. (Limited partners are partners who are not liable for the partnership’s debts.)
In this case, the losses were generated by a California Limited Liability Company (LLC), a business form that has the characteristics of both a partnership and a corporation. Members of an LLC have limited liability for business debts similar to corporate shareholders, but the LLC itself can elect to be taxed as a partnership.
The taxpayer was the managing member of the LLC, which was treated as a partnership for federal income tax purposes. Over three years, he incurred approximately $6 million of losses related to his interest in the LLC. Because he met the material participation requirement of the passive activity rules, he believed the losses were currently deductible.
The IRS agreed the taxpayer met the material participation requirement, but argued his interest in the LLC should be treated as a limited partnership interest, making the losses passive and not currently deductible.
WHAT WOULD YOU DECIDE?
Make your selection, then see “The Court’s Decision” below for a full explanation
THE COURT’S DECISION
HL Carpenter, an experienced investor and a CPA, specializes in reader friendly articles on taxes and investing for individuals and small businesses, and publishes two newsletters: Taxing Lessons and Top Drawer Ink. Visit TaxingLessons.com and HLCarpenter.com.
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