Passive Losses and LLC Members

With the increased number of LLCs operating today, the Treasury Department and the courts frequently are called upon to determine the correct taxation of these entities when they elect partnership treatment. A district court, in a case of first impression, considered how the passive loss rules applied to an LLC.

Stephen Gregg owned and managed Ethix Corp., a managed health care company. He sold his Ethix stock on November 4, 1994, and formed Cadaja, LLC. Gregg created the new company to apply the management techniques he had developed in traditional medicine to alternative medicine clinics. For its first tax year, November through December 1994, Cadaja had a loss. The IRS reclassified the loss as passive on Gregg’s tax return, making it nondeductible under IRC section 469. The IRS assessed additional tax as a result of the loss disallowance. Gregg paid it and then sued for a refund.

Result. For the taxpayer. The first question the court considered was whether to treat the taxpayer as a limited partner or a general partner. The IRS had argued that all members of an LLC were shielded from liability and, therefore, were limited partners. The court rejected this argument, noting that a limited partnership has at least one general partner subject to liability whereas no LLC members are subject to liability. In addition, limited partners have limited rights in management whereas LLCs are designed to permit all members to be active in management. Therefore, the court concluded LLC members who are active in the business should be considered general partners for passive loss purposes.

The second question the court considered was how to compute the number of hours a taxpayer needed to work to be considered as having materially participated in the business. Under temporary regulations section 1.469-5 T (a)(1), a taxpayer is actively involved in a business if he or she works more than 500 hours in the business during the year. Since he had formed the LLC in November, Gregg attempted to prorate the 500 hours over the entity’s shortened life. The court rejected this approach. The regulations specify that a taxpayer must work for at least 500 hours to be considered active. They do not allow taxpayers to prorate this amount simply because an entity’s first tax return covers less than a full 12 months.

Gregg then argued that he met the regulations’ requirement for material participation. He aggregated his participation in Ethix and the new LLC. While the IRS had objected to adding the two separate businesses together, the court concluded the regulations permitted grouping multiple businesses to determine material participation. It said they did not require the businesses to be conducted at the same time. Therefore Gregg could add his years of active participation in Ethix with his year of active participation in the LLC.

This decision will benefit professionals who start new businesses or switch companies by allowing them to deduct losses. Otherwise, the taxpayer would have to wait three years, as provided in the material participation regulations. Gregg answered a number of questions about the application of the passive loss rules to an LLC. It is almost certain there will be additional litigation to resolve other disputes.

Stephen A. Gregg v. United States, 2001-1 USTC 50, 169 (DC, Ore.)

Prepared by Edward J. Schnee, CPA, PhD, Joe Lane Professor of Accounting and director, MTA program, Culverhouse School of Accountancy, University of Alabama, Tuscaloosa.