Courts Clarify Application of Passive Loss Rules to LLCs

In two recent cases, the United States Tax Court and the United States Court of Federal Claims each ruled in favor of the taxpayer that certain interests in limited liability companies (“LLCs”) would not constitute limited partnership interests for purposes of applying the passive activity loss limitation rules of Internal Revenue Code section 469. Generally, where an investor holds an interest in an activity through a limited partnership interest, the investor’s involvement is presumed to be passive and losses from that activity may only be used to offset income from other passive sources. An investor may rebut this presumption only by satisfying one of three regulatory tests. By ruling that an investment through an LLC should not be treated as presumptively passive, the decisions effectively allow LLC members to establish their active involvement in the activity by meeting one of seven regulatory tests.

Passive Activity Loss Rules

In 1986, Congress enacted Internal Revenue Code section 469 to limit the losses and credits available to taxpayers from “passive” activities. Of motivating concern to Congress was the participation of taxpayers in certain tax shelters. These tax shelters afforded investors the opportunity to reduce or avoid tax liability with respect to their salary or other income items by making available deductions and credits potentially in excess of the real economic costs borne by the taxpayer. For example, high income individuals were investing in real estate activities unrelated to their occupations principally to reap tax benefits allotted to those industries. The typical tax shelter would provide these tax benefits to investors despite the fact that the investors lacked a significant interest in the economic performance of the actual activity and were not materially involved in the operations of the activity. To remedy the problem typified by the passive investment in business activities unrelated to the investor’s principal occupation, the passive activity rules were enacted to prohibit the offset of deductions in excess of income (i.e., losses) from passive activities against income from other sources such as salary, interest, dividends, gains, and active business income.