23 March 2018
In a recent decision, the Tax Court in Garnett 132 TC No. 19 (2009) determined that losses from limited liability company (LLC) and limited liability partnership (LLP) interests could offset compensation income. This decision offers an opportunity for entrepreneurs and venture investors to utilize losses generated in LLCs and LLPs against compensation and other ordinary income.
The Internal Revenue Code limits an entrepreneur's or investor's ability to offset “passive losses” against non-passive income such as compensation, interest, and profits from other businesses. Losses are passive (and limited) if they are generated in a business in which the investor does not “materially participate.” Importantly, the passive loss rules provide that losses attributable to a “limited partner” are per se passive unless the IRS grants special relief. For many entrepreneurs/investors, these rules often create a tax problem-business losses that cannot be used currently against taxable ordinary income.
The taxpayers, Paul and Alicia Garnett, invested in LLCs and LLPs that operated farming businesses in Iowa and deducted their share of the losses from these entities against their ordinary income. On audit, the IRS disallowed the losses on the grounds that the Garnetts did not materially participate in the business activities. The result was a tax deficiency of more than $360,000. The Garnetts took the IRS to court.
The IRS argued in Tax Court that the Garnett's LLC and LLP interests were limited partnership interests and not general partner interests for purposes of the passive loss rules. According to the IRS, the sole relevant consideration in determining whether an interest is a limited partnership interest is the limited liability afforded to its owner. Therefore the IRS argued each of the Garnett's LLC and LLP interests should be treated as a limited partnership interest.
The Garnetts argued that none of the entities was a limited partnership and that their material participation in the management of the businesses resulted in them being general partners for purposes of the passive loss rules.
The Tax Court observed that under state law, unlike a limited partner in a limited partnership, LLC and LLP owners do not compromise their limited liability by participating in management. Therefore, the Tax Court concluded that LLC and LLP owners are not per se limited partners for purposes of the passive loss rules.
Since the 1990's, LLCs have been the entities of choice for most new businesses. Investors have become more comfortable with the LLC vehicle and thus the percentage of private investment transactions involving LLCs has risen dramatically. The Garnett decision should encourage further LLC investment by active entrepreneurs and investors by removing a possible tax limitation. Furthermore, the decision presents an opportunity to review prior tax returns to determine the availability of tax refunds. We encourage entrepreneurs and investors to consult with counsel to evaluate their current holdings and to structure their future investments to ensure they are achieving maximum tax efficiency.