The passive activity loss rules of the Internal Revenue Code were introduced in 1986 in order to combat tax shelters. These rules prevent an individual taxpayer from deducting his share of losses from certain “passive” activities against that individual’s active income (such as wages) or portfolio income (such as interest and dividends). Generally, losses from passive activities can only be used against income from the taxpayer’s other passive activities, and disallowed passive losses are carried over to the next taxable year. The passive activity loss rules apply to individuals, including those who are partners in partnerships or shareholders in S corporations, and the rules also apply to a certain extent to closely held corporations.
A passive activity is any trade or business activity in which the taxpayer does not “materially participate,” as defined by Treasury Department regulations. On Nov. 28, 2011, the Treasury Department proposed a regulation describing for the first time how members of limited liability companies (LLCs) can materially participate in the LLCs’ activities and deduct their share of the LLCs’ flow-through tax losses against the members’ other income.
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