Tuesday, August 4, 2009

US Tax Court rejects IRS position on deducting losses in LLC's

LLCs, LLPs, and tenancies-in-common should be aware of this US Tax Court decision:
In a recent Tax Court case, the IRS asserted that interests in LLCs, LLPs, and tenancies-in-common were limited partnership interests, thereby disallowing losses to the individual owners generated by passive investments. However, the Tax Court determined that the ownership interests were not the same as limited partners and that the losses were therefore fully deductible.

The IRS argued that the Petitioners' interests in the tavpayers' various companies should be considered as limited partners in limited partnerships, which then presupposes that the subject interests' income is generated from passive activities. Underlying the IRS position was inability of the subject interests to control the parent entities, and the limited liability the interests received in exchange for the lack of control. The holding companies were disregarded by the IRS.

The taxpayers argued that § 469(h)(2) was not applicable because none of the companies in which they owned interests were limited partnerships and because the subject interests were general partner interests rather than limited partner interests.

The Court disagreed with the IRS position and cited the legislative history of the regulations in finding that that although Congress considered limited liability in the enabling legislation, limited liability was not the only determinative factor.

Further, Congress believed that statutory restriction on a limited partner's ability to manage the business meant the limited partner did not materially participate. The Tax Court believed such logic did not apply to the taxpayers' interests in this case, as their interests were not restricted statutorily from participation in company management. Accordingly, the Tax Court ruled the taxpayers' interests were general partners' interests within the meaning of the regulations. Therefore the losses generated by the interests were allowed by the Tax Court.

Paul D. Garnett and Alicia Garnett v. Commissioner, 132 T.C. No. 19, Docket No. 9898-06, June 30, 2009.

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