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LLCs aren't limited partenrships

October 07, 2009

If you are a "limited partner," the tax law's "passive loss" rules make it much more difficult to deduct losses than if you own an S corporation or are a general partner. The IRS has been saying limited liability company owners are "limited partners" for purposes of the passive loss rules, making their deductions much harder to come by.

The Tax Court recently said the IRS approach is wrong, noting the differences under state law between limited partners and LLC members. They applied this approach yesterday in a case involving a couple that operated a charter fishing boat. They couple conducted all of the activity of running the boat, but because it was short of 500 hours, the IRS said they were "limited partners" and their losses were passive, and non-deductible.

The Tax Court disagreed. Victory for taxpayer.

Cite: Hegarty, T.C. Summ. Op. 2009-153

Below: tax law standards for material participation

MATERIAL PARTICIPATION BASICS

The regulations say you achieve "material participation" in non-real estate activities for a tax year if:

-You participate at least 500 hours; or
-You participate at least 100 hours and at least 500 hours in that and other "100 hour" activities; or
-You participate at least 100 hours and more than anybody else, or
-You are the only participant; or
-You materially participated in five of the past ten years )or in any three years for a service activity).

There is also a "facts and circumstances" test, but don't count on it.

A special rule apples to real estate. If you are not a "real estate professional," losses are normally passive no matter what, unless you provide "extraordinary" personal services.

If you are a "real estate" professional," you can apply the normal material participation rules to determine whether you have a passive activity. To be a real estate professional, you have to spend at least half your working hours - not less than 750 hours annually - in "real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade."

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