As a member in a limited liability company that is taxed as a partnership, your ability to deduct losses from passive activities may be limited.
A passive activity is any activity which involves the conduct of any trade or business, and in which you do not materially participate. You are treated as materially participating in an activity only if you are involved in the operations of the activity on a basis which is regular, continuous, and substantial. You are treated as materially participating in an activity for the tax year if and only if you meet one of the following criteria:
(1) you participate in the activity for more than 500 hours during the year;
(2) your participation in the activity for the tax year constitutes substantially all of the participation in such activity of all individuals (including individuals who are not owners of interests in the activity) for the year;
(3) you participate in the activity for more than 100 hours during the tax year, and your participation in the activity for the tax year is not less than the participation in the activity of any other individual (including individuals who are not owners of interests in the activity) for such year;
(4) the activity is a significant participation activity for the tax year, and your aggregate participation in all significant participation activities during the year exceeds 500 hours;
(5) you materially participated in the activity for any 5 tax years (whether or not consecutive) during the ten tax years that immediately precede the tax year;
(6) the activity is a personal service activity, and you materially participated in the activity for any three tax years (whether or not consecutive) preceding the tax year; or
(7) based on all of the facts and circumstances, you participate in the activity on a regular, continuous, and substantial basis during the year.
The material participation tests generally do not apply to rentals, except for the rental real estate of a real estate professional.
Although you are a member in an LLC, the IRS sometimes tries to treat that the same as a limited partnership interest in a limited partnership. This is important because losses from interests in limited partnerships are presumptively treated as passive. Thus, a limited partner is generally treated as not materially participating in the partnership and such partner’s losses are only deductible against passive activity income. According to the IRS, this treatment can be negated only if the limited partner worked more than 500 hours for the year in the activity, materially participated for five of the last ten years, or materially participated in a personal service activity for any three prior years.
There has been a lot of controversy over whether or not an interest in an LLC is treated the same as a limited partnership interest for purposes of these rules. The courts have disagreed with the IRS position in some cases. For example, one court concluded that the limited partner exception did not apply to LLC members. Another court found that the taxpayers’ ownership interests in limited liability partnerships and LLCs were not interests in limited partnerships because their interests fit within an exception in the IRS regulations for general partners. Another court concluded that the IRS regulations require the taxpayer’s ownership interest to be in a partnership under state law rather than a partnership under federal income tax law. Accordingly, because an LLC member is not a limited partner under state law, the court concluded that the limitation for limited partners did not apply to an LLC member. Another court concluded that the limited partner exception did not apply to the managing member of an LLC and that the member fell within the general partner exception in the IRS regulations.
As a result, the IRS issued rules on how members in an LLC will be treated for the material participation test. Under those rules, an interest in an entity is treated as an interest in a limited partnership (and thus presumptively passive) if:
(1) the entity in which such interest is held is classified as a partnership for federal income tax purposes, and
(2) the holder of such interest does not have rights to manage the entity at all times during the entity’s tax year under the law of the jurisdiction in which the entity was organized and under the governing agreement.
Rights to manage include the power to bind the entity.
Obviously, these rules could affect your ability to deduct losses from the LLC. If you have any questions regarding the above rules or would like to meet to discuss the options available to you, please give me a call.
Please contact the office of Don Fitch Accountancy at (760)567-3110 or Email Don.Fitch@CPA.com if you have any questions or would like additional information.
DON FITCH, CPA
74478 Highway 111 #3
Palm Desert, CA 92260
Toll Free: (877)CPA-Help or (877)272-4357
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Email: DonFitchCPA@paylesstax.com
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(Updated 07072021-1 320-640)