Julie S. Pleshivoy
GR Review

A recent U.S. Tax Court decision and a U.S. Federal Court of Claims decision can be read as extending the ability of investors in limited liability companies (LLCs) and limited liability partnerships (LLPs) to deduct expenses and other losses incurred by the LLC or LLP as against the investor’s salary and investment income.  Prior to these decisions, the IRS had long taken the position that investors in LLPs and LLCs can only deduct losses against future profits from that business or other passive activity income from similar passive investments.

Pursuant to provisions of the Internal Revenue Code, losses and deductions that arise out of a business activity in which one is merely a “passive” investor may only be used to offset income that is likewise passive in nature or gains arising from the complete disposition of the taxpayer’s interest in the passive activity.  For these purposes, the IRS generally treats all “limited partners” as “per se” passive as to the activities of the partnership.

In Garnett (a decision that was published on June 30), which involved Nebraska farmers seeking to deduct losses from their chicken and pig operations, the U.S. Tax Court held that the taxpayers’ interests in an LLP, an LLC, and as tenants in common (TIC) need not be treated as limited partner interests.  While the Tax Court recognized that the taxpayers’ status in these entities differed significantly from the status of general partners in state law limited partnerships, it also recognized that the taxpayers’ status, arising out of their significant personal efforts in the business, differed significantly from that of limited partners in state law limited partnerships.  As a result, the Court ruled that the taxpayers were not per se passive investors as a result of the class of interest owned in the business entity. 

Although this ruling deals with the ability to deduct losses against salary and investment income for certain active businesses, it should be noted that, on the flipside, the income from “active participation” LLPs and LLCs will be subject to self-employment tax.

Julie Pleshivoy is an associate in Gould & Ratner's Tax and Financial Group.  She may be reached via telephone at 312.899.1614 or jpleshivoy@gouldratner.com.