Deducting LLC Losses

The Tax Court held that a managing member of a California LLC and S corporation was not prevented by the passive activity loss limitation rules of IRC § 469 from deducting his share of the entities’ net losses. The holding thus extended the reach of the court’s similar holding last year with respect to a member of an Iowa LLC (Garnett v. Commissioner, 132 TC no. 19; see also “Tax Matters: Losses From Interests in LLCs and LLPs Not Presumptively Passive,” JofA, Oct. 09, page 68).

Lee E. Newell owned 100% of California Custom Millworks Inc., an S corporation that manufactured and installed cabinetry and architectural wooden millwork. He also held a 33% interest in Pasadera Country Club LLC, which built, owned and managed a golf course and club. In the tax years at issue, 2001 through 2003, Newell actively engaged in Millworks’ business. He devoted 250 hours to it in 2001; 300 hours in 2002; and 350 hours in 2003. He also was Pasadera’s managing member, responsible for overseeing the construction and operation of a clubhouse. He signed checks and handled filings with state and county agencies. He was also personally responsible for all loans to the LLC. He devoted 450 hours to Pasadera in 2001 and 400 hours in each of the next two years.

Newell deducted Millworks’ losses of $458,379 in 2001; $1,270,452 in 2002; and $798,431 in 2003. He also deducted his share of Pasadera’s losses, amounting to more than $5 million for the three years combined. The IRS denied the losses from both companies, arguing they were incurred in a passive activity within the meaning of section 469. Newell was a limited partner in Pasadera, the IRS said, which presumptively made those losses passive. Newell argued that he met the material participation rules for both businesses as a “significant participation activity” under Temp. Treas. Reg. § 1.469-5T(a)(4), and therefore his losses were not limited.

In general, section 469 disallows recognition of net losses or related credits from trade or business activities in which taxpayers do not materially participate. Material participation is that which is regular, continuous and substantial (section 469(h)(1)). However, section 469(h)(2) denies material participation treatment with respect to a limited partnership interest held by a limited partner. Temp. Treas. Reg. § 1.469-5T(e)(3) provides that a limited partnership interest is one so designated in the partnership agreement or certificate, or where the partner’s liability for the partnership’s obligations is limited under state law to a fixed, determinable amount. It also provides an exception to treatment as a limited partnership interest for one held by an individual who is a general partner. Under California law (as under Iowa law), members of an LLC—especially managing members—are not restricted from participating in management while maintaining limited liability. Similarly to its holding in Garnett, the Tax Court found that Newell did have limited liability under state law, but because he functioned as a general partner would, managing the enterprise’s day-to-day operations, the general partner exception was broad enough to apply to him. Newell also met other relevant material participation tests, and his losses were properly deducted, the court held.

In a footnote, the Tax Court referred to Thompson v. U.S. (87 Fed. Cl. 728 (2009)), in which the Court of Federal Claims also decided this issue in the taxpayer’s favor, on the grounds that an LLC is not a limited partnership. On March 8, the IRS released an action on decision memo acquiescing to the result only in Thompson.

  Lee E. Newell v. Commissioner, TC Memo 2010-23

By Edward J. Schnee, CPA, Ph.D., Hugh Culverhouse Professor of Accounting and director, MTA Program, Culverhouse School of Accounting, University of Alabama, Tuscaloosa.