The U.S. Tax Court has recently ruled in a case that could
have a significant impact on the federal income-tax
treatment of business interests that are held in a limited
liability company (LLC) or limited liability partnership
(LLP).
Attractive LLP and LLC Features
LLCs and LLPs have enjoyed popularity as the business-
entity choice (for new businesses and conversions alike)
over the past decade or two. The combination of the limited
liability protection of a corporation with pass-through
taxation of income for owners, as is the case with a
partnership, represents the “best of both worlds” for many
entrepreneurs. An added wrinkle from a tax perspective
now makes LLCs and LLPs only look more attractive.
Generally, there has been a long-standing federal tax
law principle (and IRS position) that investment losses
generated by businesses held within an LLC or LLP
cannot by used to directly offset an owner’s salary from a
job and/or regular investment income. However, if not
overturned, this case stands to mark a significant
departure from that rule.
Losses Were Not Passive Losses
Prior to the Tax Court’s decision, investor-owners in small
businesses could generally deduct business losses only
against future profits from that business, potentially
postponing for years (or eliminating) the ability to realize
LLP and LLC loss deductions.
The facts of the case involve entrepreneurs – in this
case a husband and wife – who actively work in several
LLCs and/or LLPs that they have established. Historically,
the IRS considered losses relating to a taxpayer who plays
an active role in an LLC or LLP to be passive in nature.
The tax code also presumes that losses from an “interest
in a limited partnership as a limited partner” are passive
losses. And, in general, net passive losses cannot be used
to offset other income, such as salaries, capital gains, or
dividends. Rather, a taxpayer would have to wait until the
particular business entity that generated the passive losses
actually realized a profit (if at all) or was ultimately sold
in order for the losses to be deductible.
The ruling in this case is significant in that the Tax
Court held that since the LLP and LLC interests were not
held by the taxpayers as limited partners, the tax code’s
presumptive passive loss treatment was inapplicable.
Rather, the Tax Court essentially allowed the married
taxpayers to offset the losses of the businesses against the
current salaries or outside investment income earned by
the spouses when computing the couple’s income taxes.
Future of Holding Uncertain
The IRS may appeal the Tax Court’s decision to a federal
appeals court. Alternatively, the IRS may seek a
legislative solution and try to get Congress to enact a new
law to restore the tax treatment of LLC and LLP losses as
it was before the decision in this case.
Doeren Mayhew Can Help
In the meantime, if you have an ownership interest in an
LLC or LLP business that has sustained losses and actually
work in that business, please call Doeren Mayhew today at
(248) 244-3000. Our professionals can analyze your
situation to help you determine whether any losses that
your business has incurred may be used to offset your
other income, such as salary, capital gains, or dividends.
