LLC and LLP Losses Held Deductible Against Salary

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.