In a major victory for individuals in limited liability partnerships (LLPs) and limited liability companies (LLCs), the U.S. Tax Court has ruled that the members in such firms were not required to treat losses as passive, as in the case with limited partnership (LP) interests. Garnett v. Commissioner, 132 T.C. No. 19, 2009 WL 1883965 (U.S. Tax Court).
Background
The heart of the controversy before the court was Section 469(h)(2) of the tax code, which treats losses from certain limited partnership interests as passive (and so deductible only against passive income). The section in question specifically provides: "Except as provided in regulations, no interest in a limited partnership as a limited partner shall be treated as an interest with respect to which taxpayer materially participates."
The petitioners here held an interest in one limited liability partnership (LLP) and held interests in six other LLPs indirectly through several limited liability companies (LLCs). The various companies all were engaged in agribusiness operations (production of poultry, eggs and hogs) but the decision here applies broadly to all forms of businesses that operate in the form of LLCs or LLPs. The key advantages of such companies and partnership are to provide (1) the same protection against personal liability as shareholders in a corporation and (2) the elimination of the double taxation that applies to a corporation and its shareholders. The IRS has taken the position that losses of LLCs and LLPs are passive losses and cannot offset income from salaries, capital gains or dividends, but can only offset profits from other passive income LLPs and LLCs.
Ruling
The Tax Court first noted that when Section 469(h)(2) was enacted in 1986, neither LLCs nor LLPs existed. The court began its analysis by considering the differences between limited partnerships (LPs) on the one hand and LLPs and LLCs on the other. A limited partnership (LP) has two classes of partners, general and limited, the latter being "passive investors." An LLP is a general partnership that by making a filing obtains a form of limited liability for its partners. In the Garnett case, the LLP agreements generally provided that each partner would actively participate in the control, management and direction of the business. An LLC is essentially a hybrid of a corporate and a partnership form of business. Notwithstanding these differences, both types of partnerships are treated for federal income tax purposes as partnerships.
The IRS contended that ownership interests in LLCs and LLPs were presumptively passive under the limited partnership rule contained in the statue covering passive activities. However, the court ruled that the petitioners here, by their ownership interests in LLPs and LLCs, could participate in management under state law, unlike a limited partner interest. The court therefore ruled that the petitioners' ownership interests in the LLPs and LLCs are accepted from the classification as "limited partnership interests." As a result, the members of the LLPs and LLCs could deduct the farming losses against their other income if they materially participated in these activities.
Real Estate Focus is provided by Somerset’s Real Estate Team for our clients and other interested persons upon request. Since technical information is presented in generalized fashion, no final conclusion on these topics should be made without further review. For additional information on the issues discussed, please contact Michael Fritton, CPA. Whether you are a building owner, building manager, real estate developer, real estate professional or an investor, we hope to provide you with timely information so you may be proactive in making your business decisions.
This article was written by and published herein with the permission from professionals of BDO Seidman, LLP. Robert Klein is a Tax Partner in the Woodbridge, New Jersey, office of BDO Seidman. Somerset is a member of the BDO Seidman Alliance, a nationwide association of independently owned accounting and consulting firms.
Somerset CPAs,
P.C.
3925 River Crossing Parkway, Third Floor
Indianapolis, Indiana 46240
317.472.2200 • 800.469.7206 • FAX 317.208.1200
www.somersetcpas.com
info@somersetcpas.com
.jpg)