A Win for Entrepreneurs and Investors in Recent Tax Case vs. the IRS

In a potentially far reaching decision  that overturns prior precedent and may provide opportunities for entrepreneurs and venture investors to utilize losses resulting from LLCs and LLPs in ways that have previously been limited, the Tax Court ruled that ordinary income could be offset by losses related to flow through from limited liability company ("LLC") and limited liability partnership ("LLP") interests. 

Summary

The taxpayers owned interest in various LLCs and LLPs engaged in agricultural production activities and deducted their share of losses from these entities against their ordinary income.  The Internal Revenue Service disallowed the losses on the basis that LLC members are always treated as limited partners under state law because of  LLC members' limited liability and because the Internal Revenue Code (the "Code") specifies that a limited partnership interest never qualifies as an interest in which the taxpayer materially participates.

The Code restricts a limited partner's ability to offset losses resulting from "passive activities" against income from non-passive sources such as compensation, interest and profits arising from "active" business activities.  In general, losses are passive when they are generated by an activity in which the taxpayer does not "materially participate."  The passive loss rules presume that limited partners and non managing members of LLCs do not "materially participate" in the organization's business, therefore, losses attributable to limited partners and non managing members of LLCs are per se passive.

In this case, however, the Tax Court distinguished LLC members and LLP limited partners from true limited partners in limited partnerships on the basis that state law does not limit LLC members' and LLP limited partners' right to participate in the management of such entities.  The Court concluded that LLC members are not per se limited partners for purposes of the passive loss rules, thus, the general tests for material participation by general partners should be applied.

What This Means for Investors

• Relaxation of restrictions on a taxpayer's ability to deduct losses against other forms of income should encourage further investment in LLCs by entrepreneurs and investors.

• Those affected by Garnett should consider consulting with their tax advisors to examine the opportunity for potential tax refunds.