Most business people who are familiar with the tax treatment of LLCs understand that LLCs are tax-efficient. LLCs are taxed as partnerships (except in the rare event that they elect to be taxed as corporations). Since they are taxed as partnerships, LLC profits and losses are passed through to the members. The pass-through of LLC profits avoids double taxation—profits are not taxed to the LLC and are only taxed to the members. The pass-through of LLC losses allows members to use the losses to offset against their other income, reducing their tax bills.
What is less well known, except by tax lawyers and CPAs, is that the IRS has interpreted its regulations so that LLC losses are presumed to be “passive activity losses” (passive losses). Furthermore, the presumption is difficult to overturn. The result is that under the IRS’s interpretation of its regulations, LLC losses are often treated as passive losses.
For most taxpayers, passive losses are much less useful than active losses (losses not resulting from passive activities). The reason is that passive losses may only be used to offset income from other passive activities, and not to offset “active” income such as wages, interest, dividends, etc. Internal Revenue Code (IRC) § 469. Instead, any passive losses that exceed “passive” income must be carried over to subsequent tax years until the taxpayer either has enough passive income to use the losses or disposes of the activity that generated the passive losses. Active losses, on the other hand, can be used to offset either active income or passive income. The IRS’s position greatly limits the income-sheltering benefits of losses for LLC members.
There are three reported opinions in which courts have ruled on this issue. The IRS lost in all three courts, most recently in Thompson v. United States, 87 Fed. Cl. 728 (July 20, 2009). (The IRS also lost in Garnett v. Commissioner, 132 T.C. No. 19 (June 30, 2009), and in Gregg v. United States, 186 F. Supp. 2d 1123 (D. Or. 2000).)
The plaintiff in Thompson had formed Mountain Air Charter, LLC to operate an on-demand air charter business. Thompson held 99% of the member interests in Mountain Air directly, and 1% through a subchapter S corporation. On his 2002 and 2003 individual income tax returns, Thompson claimed a total of $2.1 million of losses from Mountain Air and used those losses to offset against other income. The IRS disallowed all but $156,000 of those losses, contending that they were passive activity losses and could not be offset against non-passive activity income. Thompson paid the taxes assessed by the IRS and sought a refund, and when it was denied he brought suit, seeking a tax refund of $781,241 plus interest.
The Thompson case turned on the interpretation of IRS regulations that were adopted under the authority of IRC § 469. Section 469 was adopted as part of the Tax Reform Act of 1986 to address the growth in the 1980s of perceived abusive tax shelters. Many of those tax shelters were formed as limited partnerships that allowed investors to use partnership tax losses to shelter their income from wages or self-employment.
Section 469 establishes limitations on passive activity losses and defines a “passive activity” as a business activity in which the taxpayer does not “materially participate.” It also requires, in the case of limited partnerships, that a limited partner’s participation not be treated as “material participation,” except as provided in IRS regulations. IRC § 469(h)(2). Following the passage of IRC § 469, the IRS adopted temporary regulations that define how an investor can demonstrate material participation in an activity, but that also greatly restrict the ways in which a limited partner can demonstrate material participation in a limited partnership. Treas. Reg. § 1.469-5T. Limited liability companies were new and were used very little at that time, so the temporary regulation did not explicitly address LLCs.
The key regulatory provision that was at issue in Thompson provides:
(i) In general. Except as provided in paragraph (e)(3)(ii) of this section, for purposes of section 469(h)(2) and this paragraph (e), a partnership interest shall be treated as a limited partnership interest if—
(A) Such interest is designated a limited partnership interest in the limited partnership agreement or the certificate of limited partnership, without regard to whether the liability of the holder of such interest for obligations of the partnership is limited under the applicable State law; or
(B) The liability of the holder of such interest for obligations of the partnership is limited, under the law of the State in which the partnership is organized, to a determinable fixed amount (for example, the sum of the holder’s capital contributions to the partnership and contractual obligations to make additional capital contributions to the partnership).
Treas. Reg. § 1.469-5T(e)(3)(i).
Although Mountain Air Charter, LLC was formed as an LLC under Texas state law, the IRS contended that the regulation applied to Thompson’s LLC member interests because Mountain Air was taxed as a partnership for income tax purposes and because the liability of the members of Mountain Air was limited under Texas law. Thompson’s response was simply that Mountain Air was not a limited partnership so his member interest could not be that of a limited partner. In short, the IRS wanted the LLC to be treated as a limited partnership for purposes of the regulation, and Thompson wanted the text of the regulation to be applied literally.
The court began its analysis by pointing out that an LLC is not a partnership. After a lengthy analysis of the language and purpose of the regulation, the court concluded that “[o]nce [the regulation] is read in context and with due regard to its text, structure, and purpose, it becomes abundantly clear that it is simply inapplicable to a membership interest in an LLC.” Thompson, 87 Fed. Cl. at 738.
Since the court ruled that the regulation did not apply, Thompson’s member interests were not presumed to be interests in a limited partnership. Thompson still needed to demonstrate that he was a “material participant” in the activities of the LLC, but in his case the IRS had already stipulated that if he did not hold a limited partnership interest under the regulation, his losses from Mountain Air would not be limited by the passive loss rules of Section 469. The upshot was that the court entered a judgment in Thompson’s favor in the amount of $781,241 on July 21, 2009, plus interest until paid.
The court’s holding in Thompson does not mean that all owners of LLCs will be out from under the passive loss rules. Instead, what Thompson stands for is that losses passed through to LLC owners will not be treated as per se passive. Owners of LLCs must still prove to the IRS that they materially participate in the LLC’s activity in order to use losses and credits from that activity against active income, but they can use the more flexible rules of Treas. Reg. § 1.469-5T(a).
For example, assume that one spouse owns a restaurant in an LLC while the other spouse works at a separate job as an employee. The LLC structure was chosen because it offered limited liability to the owner while not requiring the use of a corporation. The spouse who owns the LLC works full time managing the restaurant, including supervision of employees. The owner spouse should have little difficulty establishing that they materially participate in the restaurant business. Therefore, if the restaurant in any year incurs a tax loss, that tax loss should be available to offset the wage income of the employee spouse, assuming the husband and wife file a joint return.
Thompson enhances the flexibility that LLCs offer to entrepreneurs and small businesses. Their use will still require advance tax planning to ensure that owners will be treated as materially participating. Clarification that the per se passive rule does not apply to LLCs, however, means that owners who do materially participate need no longer fear that tax losses cannot be used to offset “active” income.
One last word of caution. The Thompson, Garnett and Gregg cases are not the last word on this issue, even though the IRS is apparently not appealing Garnett or Thompson. All three courts were trial courts, not appellate courts, so their decisions are not binding on the IRS in other taxpayer disputes. Nonetheless, after three at-bats and three strikeouts, it seems unlikely that the IRS would continue to attempt to apply Treasury Regulation § 1.469-5T to LLCs in the same restrictive manner as in Thompson. The Service might, however, continue to assert the same loss-limiting position that it did in these cases, against other taxpayers on audit in order to leverage higher settlements. Or, the Service could change its regulations to explicitly require that LLC losses be presumed to be passive losses. Watch for future developments.