LLC Members and the Passive Activity Loss Rules: IRS Issues Proposed Regulations After Multiple Court Setbacks

By Hale Sheppard

Change is inevitable, particularly in the tax arena.  The world evolves at such a quick pace that the IRS frequently finds itself playing catch up.  Examples of this abound, but a recent event of interest involves the IRS’s attempt to deprive certain taxpayers of losses because of their decision to conduct business through limited liability companies (“LLCs”).

Congress, focused on combating “tax shelters” in the 1980’s, passed Section 469(h)(2).  This provision creates a legal presumption that a taxpayer who owns an interest in a limited partnership, as a limited partner, cannot utilize any losses flowing from the entity to offset the taxpayer’s unrelated, active income from other endeavors.  For its part, the IRS promulgated regulations over two decades ago containing special tests, rules, and exceptions for limited partnerships.  The problem is that time marched on, and the states introduced different types of business entities, such as LLCs.  Taxpayers began participating in activities through LLCs, some of which generated losses.  The IRS, citing the limited partnership regulations from yesteryear, started challenging the LLC-related losses on grounds that they were “passive.”  Tax disputes ensued over the next decade, and the taxpayers were triumphant in each instance.  In light of these repeated judicial defeats, the IRS recently acknowledged that the existing regulations under Section 469(h)(2) were outdated and thus issued new, proposed regulations in late November 2011.

The attached article, “LLC Members and the Passive Activity Loss Rules:  IRS Issues Proposed Regulations After Multiple Court Setbacks,” examines the congressional motives for attacking limited partnerships, the existing regulations that triggered the controversy, the five taxpayer victories in various courts, the IRS’s recent decision to surrender the fight, and the proposed regulations, which radically alter the definition of “limited” for passive activity purposes.  The article was published in the most recent issue of Journal of Passthrough Entities.

Given the frequent use by taxpayers of LLCs and other hybrid entities, the IRS’s propensity to challenge losses based on the passive activity rules, and the new standards introduced by the IRS in the proposed regulations, the debate is far from over.  Taxpayers and their advisors would be wise to follow this issue, both before and after the regulations under Section 469(h)(2) are finalized.

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