USA Tax Court: LLCs Not Subject to Limited Partnership Passive Loss Disallowance Rule

Tax Court: LLCs Not Subject to Limited Partnership Passive Loss Disallowance Rule Section 469(h)(2) treats a limited partnership interest as presumptively passive for purposes of the passive loss rules, with the result that partnership losses cannot offset the limited partner's salary or investment income. In Garnett v. Commissioner, 132 T.C. No. 19 (June 30, 2009), the Tax Court held that LLC interests are not subject to § 469(h)(2), with the result that members of LLCs can deduct LLC losses if they can prove that they materially participated in the LLC under the general rule of § 469(h)(1),

The Wall Street Journal discusses the importance of the Garnett decision in Entrepreneurs Win Tax Case Versus IRS; Losses on Business Investments Can Be Deducted Against Salary, Other Income; An Appeal?, by Laura Sanders:

The IRS lost a key battle in its long-running fight to limit tax deductions that can be taken by investors in small businesses in a case that could have wide implications for entrepreneurs.

The Tax Court decision would allow investors in certain kinds of businesses to deduct losses against salary and investment income. Right now, investors often can only deduct losses in a business against future profits from that business, which in some cases prevents taxpayers from getting to use the deductions at all.

The case, which involved Nebraska farmers seeking to deduct losses from their chicken and pig operations, can still be appealed by the IRS, but makes loss deductions much easier to obtain for some investors. ...

The decision specifically applies to investors in limited-liability companies and limited-liability partnerships and benefits those who actively work in several businesses. One example would be a Microsoft engineer who owns a stake in a local restaurant and tends bar twice a week. His spouse, meanwhile, is a part owner of a money-losing gift shop, where she works a few hours a week. Under this decision, losses from the two businesses could offset salary or investment income earned by both.

The IRS has long taken the position that losses generated by businesses held within LLPs and LLCs can't generally be used to offset salary and investment income. The IRS position has had the effect of forcing investors in LLPs and LLCs to delay loss deductions, sometimes for years.