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A new Tax Court decision could produce a better tax result for many owners of limited liability corporations (LLCs) and partners in limited liability partnerships (LLPs).

Strategy: Use a loss from an LLC or LLP to offset other highly taxed income. Previously, it was presumed that such losses usually could be used only to offset income from other “passive” activities. But the new case has opened the door to bigger tax savings.

This decision could be particularly significant to married couples where one spouse owns a struggling business and the other works full time at a high-paying job. The business loss might completely wipe out the tax due on a joint return!

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Here’s the whole story: The LLC setup is desirable for many small business owners (officially called “members”).

As with other pass-through entities, like S corporations and partnerships, LLC income and loss are passed through to the members. There’s only one level of tax to the members. In contrast, income earned by C corporations is taxed twice—once to the corporation and again when it is paid out in wages or dividends or both. Yet LLC members still are protected from personal liability just like C corp owners.

Potential tax disadvantage: The IRS has long presumed that the strictest version of the passive-activity loss (PAL) rules automatically applies to LLCs. If a business activity is characterized as a passive activity, the loss may be used only to offset income from other passive activities. Therefore, you can’t use a PAL to offset income from wages or other highly taxed income. Any excess loss is suspended and carried forward to future years.

A passive activity is a trade or business in which you do not “materially participate.” The IRS has established seven general tests for determining if you qualify as a material participant (see box). But limited partnership interests are treated as passive activities unless one of the three strictest tests is passed.

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Facts: The Garnetts owned several LLCs and LLPs engaged in agribusiness operations. All LLP partners were treated as active participants in the management of business, but the LLC agreements limited these responsibilities to a general manager. Neither spouse was the general manager of the LLCs.

The Garnetts deducted losses of more than $300,000 against their other income, but the IRS disallowed the write-offs. Reason: Based on the presumption that the taxpayers were limited partners, the IRS said that the losses were restricted by PAL rules.

Taxpayer victory: The Tax Court disagreed with the IRS. Unlike a limited partner in a limited partnership, LLC and LLP owners do not compromise their limited liability under state law by participating in management. Therefore, the Tax Court concluded that the Garnetts should not automatically be treated as passive investors. If they qualify as material participants by passing any of the seven tests available to general partners, they can deduct the losses against other income. (Garnett, 132 TC No. 19)

Tip: Examine past returns to see if you qualify for a refund under the new interpretation of the rules.

 

By staking your claim now, without delay, you can take your share of the tax-saving windfall – starting this year.

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