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June 03, 2012 The Tax Lawyer

Good News in a Bad Economy: Service Acquiesces on Pro-Taxpayer Application of Passive Activity Loss Rules to Limited Liability Companies

Vol. 65, No. 1 - Fall 2011

Orly Sulami


    Four recent taxpayer victories in court, the Service’s acquiescence, and newly issued proposed regulations provide investors with yet another reason to use the increasingly popular limited liability company (LLC) form of business. These recent decisions and Service guidance have finally resolved how the passive activity loss rules apply to LLCs and have done so in a manner that significantly benefits LLC members.

    The passive activity loss rules impose limitations on the deductibility of losses. Given the current economic climate, many investors have experienced considerable losses. An investor’s ability to currently deduct those losses could significantly impact her tax liability. Fortunately, as a result of the recent decisions and proposed regulations, many investors who use the LLC form of business can now use those losses to shelter taxable income from taxation.

    Under the passive activity loss rules, the characterization of an activity as active or passive has significant tax implications. Generally, a person’s ability to deduct losses from a passive activity—an activity in which the taxpayer does not “materially participate”—is limited to income generated from other passive activities. In contrast, losses arising from an active activity can immediately offset taxable income from any source, including the taxpayer’s salary, wages, interest, and dividends. Accordingly, nonpassive losses shelter income that may otherwise be subject to tax.

    For investors using the limited partnership form of business, the correct characterization of an activity as active or passive is clear. It simply depends on whether the investor is a general partner in the business or a limited partner, who holds a presumptively passive interest. But for investors using the LLC form of business, the correct characterization of an activity has been uncertain and the cause of much concern.

    After nearly two decades with no guidance on the correct characterization of an LLC investor’s activities for passive activity loss purposes, investors are finally receiving the answer they have patiently sought. Recently, several courts have clarified that ownership interests in LLCs are not presumptively passive limited partnership interests. Instead, the more lenient general passive activity loss rules set forth in the temporary regulations apply. These rules determine the active or passive nature of an activity. The Service acquiesced—in result only—and issued guidance in the form of proposed regulations, which favorably address how these rules apply to LLC members.

    Although this has quickly been hailed as a tremendous taxpayer victory, is this the right result, and what does it mean for investors? Part II of this Article explains the purpose and operation of the passive activity loss rules. It also explores how recent legal developments apply the passive activity loss rules to LLCs in a pro-taxpayer manner. Part III argues that the courts in the recent passive activity loss cases and the proposed passive activity loss regulations correctly apply the passive activity loss rules to LLCs. By relying on an LLC member’s right to participate in the management of the entity to distinguish between limited partners and general partners, this new guidance is consistent with the passive activity loss rules’ statutory framework, practical interpretation, and legislative intent. Part IV explores the implications of the recent decisions and the Service’s acquiescence concerning an LLC member’s self-employment tax liability, the member’s ability to deduct passive activity losses from other entities when the LLC is profitable, and the tax system’s economic efficiency. Finally, Part V offers a proposal for reform of the passive activity loss rules. Namely, this Article argues that Congress should treat limited partners and general partners uniformly for tax purposes.

Read the full article or download the complete issue.