From August 6, 2009

A Victory for Entrepreneurs  in Today's Economy

 

A new Tax Court case could have broad implications for taxpayers who operate a business as a limited liability company (LLC) or a limited liability partnership (LLP). The case allowed a couple to use losses from an LLC to offset other highly taxed income. Normally, these write-offs would be restricted by the tax rules for "passive"

General Tax Rules

A passive activity is a trade or business in which the taxpayer does not materially participate. The deductibility of losses from certain passive activities of individual taxpayers are limited under the tax code. (Section 469(a)(1)) Material participation is defined generally as regular, continuous, and substantial involvement in the business operations. There are seven tests for material participation in an activity during a tax year:    1. The taxpayer participates for more than 500 hours during the year.    2. The individual's involvement in the activity constitutes "substantially all of the participation" of all individuals for the year.    3. The taxpayer participates in the activity for more than 100 hours during the taxable year, and the involvement is not less that that of any other individual for the year.    4. The activity is a "significant participation activity" for the taxable year and the individual's aggregate involvement in all such activities during the year exceeds 500 hours.    5. The individual materially participated in the activity for any five taxable years during the ten preceding taxable years.    6. The activity is personal service, in nature, and the individual materially participated in it for any of the three preceding taxable years.    7. Based on all the facts and circumstances, the individual participates in the activity on a "regular, continuous and substantial basis during the year."   Source: U.S. Tax Court, Garnett, 132, No. 9

Most people don't like spending valuable business time keeping records. But it can save money. Good records help: monitor the progress of your business; prepare financial statements and tax returns; identify receipt sources; keep track of deductible expenses; and support items reported to the IRS in the event of an audit.

activities. 

In this particular instance, the couple were farmers in Nebraska, but the same principles could apply to taxpayers in all walks of life. For instance, the ruling might benefit the owner of a restaurant, a manufacturing firm or a retail operation. Before we examine the facts of the case, let's review the basics.

Background: The popularity of the LLC form of business ownership has grown dramatically in recent years. As with an S corporation or partnership, items of income and loss are "passed through" to the LLC owners (officially called members). So the LLC is not subject to double taxation, meaning tax at both the corporate and shareholder levels, which applies when a business is set up as a C corporation.

Yet LLC members are still protected from personal liability for business debts and claims like C corporation owners. For example, if an owner is sued by a vendor or supplier, only his or her business assets are at risk, not a home or other personal assets.

 

The IRS has long contended that the limits for passive activities automatically apply to deductions claimed by LLC members. If a business activity is characterized as a passive activity, losses may only be used to offset income from other passive activities. In other words, you can't use a loss to offset income from wages or investment income.

Any excess loss is suspended and must be carried forward to future years. In other words, the IRS stance has forced some LLC and LLP investors to put off taking loss deduction for years.

For these purposes, a passive activity is defined as a trade or business in which you do not "materially participate." The IRS has established various tests for determining whether you may qualify as a material participant. But certain activities, such as rental real estate and limited partnership interests, are generally presumed to be passive activities under the tax law.

Facts of the new case: The couple owned several LLCs and LLPs engaged in agri-business operations such as the production of poultry, eggs and hogs. Under the operating agreements for the LLPs, all partners were treated as active participants in the control, management and direction of the business, but the LLC agreements limited these responsibilities to a general manager. Neither taxpayer was a general manager of the LLCs. Both the LLCs and the LLPs were registered in Iowa and operated under the laws of that state.

The couple claimed losses of more than $300,000 stemming from their agri-business operations. However, the IRS disallowed the losses. Reason: The tax agency argued that, as a matter of course, the write-offs were subject to the passive activity rules under the presumption in the tax code (the material participation requirements of Internal Revenue Code Section 469 that are listed in the right-hand box).

However, the Tax Court disagreed with the IRS. The court stated that the statutory limits were imposed because a limited partner generally does not materially participate in business activities, but this rule does not necessarily extend to interests in LLCs and LLPs. Members of LLCs and LLPs aren't barred under state law from materially participating in the business activity. Therefore, the Court directed further examination to determine if the taxpayers qualified as material participants. (Garnett, 132 TC No. 19).

Key impact: The new case may enable a couple to use a loss from one spouse's floundering business to offset the highly-taxed salary of the other spouse. It could also have implications for other entrepreneurs and investors involved in LLC and LLP investments. Consult with your tax adviser regarding the possible applications in your situation.