Tax Court Helps Active Entrepreneurs
A recent article in the Wall Street Journal points to a ruling of the Tax Court that lets an active investor in a limited liability company (LLC) offset his losses in the LLC against income from other sources, including compensation and investment income. The Tax Court ruled that a set of “temporary” guidelines, in place since 1988, which let an active investor in a limited partnership (LP) offset losses against other income, should also apply to an LLC investor.
The ruling is good news for “active” investors, although it will have little impact in the larger world of private equity, where most investors are passive. That’s because the criteria for being deemed an “active” participant in a business are quite stringent. The investor must have “regular, continuous and substantial involvement” in the business. In the case of limited partners in an LP, under the temporary regulations, active participation can be established only if one of the following criteria is met:
(1) The individual participates in the activity for more than 500 hours during such year;
(2) The individual materially participated in the activity for any five taxable years (whether or not consecutive) during the ten taxable years that immediately precede the taxable year; or
(3) The activity is a personal service activity, and the individual materially participated in the activity for any three taxable years (whether or not consecutive) preceding the taxable year.
Oddly, given the huge popularity of LLCs over the past decade, the IRS has never expanded these guidelines to make them applicable to LLCs in the same way as LPs. The recent ruling of the Tax Court fixed that. Now, because the Tax Court ruling has national impact, an LLC member who meets one of the criteria cited above can offset his allocable share of the losses in the LLC against any other income. Before, those losses would be trapped in the LLC, possibly never to be utilized.
The fact that the IRS never got out in front of this issue is remarkable. Instead, the taxpayers here (Nebraska farmers) had to litigate with the agency for years and the Tax Court had to write a lengthy opinion to fill the gap.
