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The Service’s Strange Math: LLC = LP. Courts Disagree — For Now . . .

In three separate cases, the IRS has attempted to disallow passive-loss claims of LLC interest holders, arguing that under the Code and Regulations, there is no difference between an LLC interest and an LP interest. All three cases were decided in favor of the taxpayer, but there are still critical issues not sufficiently addressed. First, it does not appear that the IRS has given up on this particular argument, so the question is far from settled. Second, even upon a favorable disposition of the passive-loss claim by an LLC interest holder, there are still other technical hurdles to overcome that may serve to limit the deductibility of a passive-activity loss in a tax year. Third, the cases provide very little guidance on the interplay between passive activities and self-employment taxes.

The most recent case decided, Thompson v. U.S. ,* is a Federal Claims Court case involving a manager-member of a Texas LLC who treated losses from the LLC as non-passive and deducted them on his individual income tax return. The IRS denied this deduction and assessed additional tax, claiming that the taxpayer did not “materially participate” in the activities of the LLC. To support its position, the IRS relied upon the language of the passive-activity regulations, which states that an individual will not be treated as materially participating in an activity where such activity is a limited partnership interest in a partnership.

In general, the passive-activity rules operate as a restriction on the deductibility of losses where the taxpayer reporting those losses has no more than a tangential connection to the activities generating those losses. However, this restriction is not absolute. Where a taxpayer can show a pattern of involvement that is regular, continuous, and substantial — i.e., material — the activity is considered “non-passive” to that taxpayer and outside of the passive-activity loss restriction. Under the Regulations, the ability of limited partners in a limited partnership to avail themselves of the material participation exception is severely curtailed. It is this straw that the IRS has chosen to grasp in arguing that holders of LLC interests cannot materially participate in an activity, because from a liability standpoint, there is no discernable difference between the holder of an LP interest and an LLC interest.

The court in Thompson disagreed with the IRS position, finding that the restriction on LP interest holders does not apply to holders of LLC interests. The court’s decision is based on two arguments: focusing on the liability of the interest holder finds no support either in the statutory language or the relevant legislative history, and the clear language of the statute says limited partnership, not limited liability company. Although the court goes to great pains to give the question full thought, the general tenor of the decision is that the IRS is really barking up the wrong tree with this argument. Judicially, LLC interests and LP interests are not the same, and to treat them as such (at least for purposes of the passive-activity rules) is inconsistent with existing tax law.

The issue is not dead, however. The court did leave future wiggle room for congressional intervention on the question when it noted that at best, the IRS identified an ambiguity in the passive-activity regulations as applied to LLCs. It does, however, assert that for the time being, the ambiguity should be resolved in favor of the taxpayer. More importantly, taxpayers should be aware that ownership of an LLC interest does not automatically permit the deduction of losses from a passive activity. Rather, within the context of a passive activity an owner of an LLC interest is not subject to the heightened inquiry with regard to “material participation” that limited partners are subject to. In some instances, an LLC interest holder may still find their loss limited under separate provisions of the Code. Going even further, an unprepared taxpayer may fall victim to an unexpected consequence: self-employment taxes on their passive activity.

For a more detailed discussion of passive-activity rules and potential loss limitations, or any tax matter, please contact Cara Hoffman at  choffman@BlackmanKallick.com or 312-980-3274, or J. Michael Reese at  mreese@BlackmanKallick.com or 312-980-2907, or your Blackman Kallick representative.

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*Case cited is Thompson v. United States, 87 Fed.Cl. 728 (2009).

This publication is part of Blackman Kallick’s marketing of professional services, and is not written tax advice directed at the specific facts and circumstances of any person and/or entity. Contents of this publication are of a general nature, and you should not act on this information without obtaining professional advice from your business advisor that is appropriately tailored to your individual needs and circumstances. This written advice is not intended or written to be used, and cannot be used by any taxpayer, for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.