Your client has invested in an LLC or LLP that sustains losses. Since the IRS considers him or her to be a limited partner, the losses are considered passive and the client is unable to offset salary and investment income with the losses.
Situation: Your client has invested in an LLC or LLP that sustains losses. Since the IRS considers him or her to be a limited partner, the losses are considered passive and the client is unable to offset salary and investment income with the losses.
Solution: A ruling by the Tax Court on June 30 has potentially changed things to your client's benefit. However, there may be a downside when the LLC or LLP starts reporting a profit.
In Garnett vs. IRS, the Internal Revenue Service claimed a deficiency in the Garnetts' tax returns for 2000, 2001 and 2002 and denied a deduction for losses incurred by various LLCs and LLPs in which they invested. The service's position was that code section 469(h)(2) treats losses from an “interest in a limited partnership as a limited partner” as presumed to be passive. The Garnetts claimed that since none of the entities were “limited partnerships,” they should be considered “general partners” under the tax code, thus allowing them to fully deduct the losses in the year incurred without regard to the passive income limitations.
The IRS had previously lost a similar case in an Oregon District Court (Gregg vs. United States, 2000), but that ruling applied only to Oregon residents. The Garnetts and the companies were located in Nebraska and Iowa. In addition, the IRS claimed in Tax Court that Gregg had been decided incorrectly.
Temporary regulations issued in 1988 (before LLCs and LLPs existed, with the exception of Wyoming's 1986 LLC statue) generally precluded a limited partner from claiming to materially participate in a partnership and be allowed to deduct passive losses against non-passive income. However, an exception was made for a “limited partner holding general partner interest.”
The court found that even though investors in an LLC or LLP have limited liability, state law permits them to participate actively in management and operations of the entities. Generally, a limited partner is precluded from such participation. Furthermore, neither the code nor regulations contain a general definition of either a limited or general partner. The court also found that the status of investors in LLCs and LLPs differs significantly from the status of general and limited partners under current law. Finally, the court determined that, based on the legislative history, the purposes of Section 469(h)(2) “are more nearly served by treating LLP and LLC members as general partners.”
Based on this finding, the Tax Court allowed the Garnetts to fully deduct the losses for the years in question. As of now, the IRS has not indicated whether it will appeal the ruling; it is available for use by all U.S. taxpayers. It is also possible that Congress will take action to better define limited partners and overrule the court's reading of the law.
Now for the downside. Generally, limited partners are not subject to self-employment taxes on profits from their investments. If a taxpayer decides to claim general partner status for an LLC or LLP investment and takes passive losses against non-passive income, they later may be ruled subject to self-employment tax on profits made in future years.
Update: On July 20, the U.S. Court of Federal Claims granted a motion for summary judgment in Thompson v. United States declaring that the member's interest in an LLC that chooses to be taxed as a partnership is not a limited partnership interest. The court quoted extensively from Garnett and Gregg in its ruling.
