By Garrett Sutton, Esq. Copyright 2009
Not all entities and their owners are created equal. Corporations and shareholders, LLCs and members, Limited Partnerships and limited partners are all treated differently in certain circumstances under the tax code.
Under the passive activity loss rules, an individual’s losses from a passive activity are only deductible against any passive activity income (which doesn’t include interest or dividend income.) This rule generally limits the amount of losses one can take on their tax return, since the losses must be offset against other gains, which may not occur for a period of years.
Typically, a limited partner in a limited partnership is presumed to be a passive participant. A key issue is that active participation can cause a limited partner to lose their limited liability protections. A member of a limited liability company does not face such limits. Members can be active in the business and not lose their limited liability protections. (The same is true for shareholders in a corporation.)
Now, this subtle distinction between LLCs and LPs can make a huge difference for taxation purposes. In Garnett v, Commissioner, 132 T.C. No. 19 (2009), the court found that member interests in an LLC are not the same as limited partnership interests in an LP. Unlike limited partners, if members of an LLC can show they materially participated in the LLC’s activity they can escape passive activity limits and freely write off their losses.
If you want the liability shield of protection as well as the favorable write off of losses you will use an LLC instead of an LP. Be sure to work with your tax advisor to take advantage of this new legal interpretation.