James F. McDonough
November 30, 2011
Tax Advisors have often heard this question from taxpayer-clients: “What do you mean I cannot take the loss?” What followed was a discussion that has been characterized as a cure for insomnia. Tough economic times produce losses, but the rules have not always permitted business entities to use them. Given your mix of active and passive activities, it may be possible to make a more efficient use of losses by a careful selection of an appropriate state law and by amending documents to include or exclude management activities so as to achieve active or passive status.
Many years ago, the passive loss rules–passive loss meaning a loss incurred through a business entity, but not an individual–were put into place that would deny taxpayers the use of losses against other types of income. These rules, along with at-risk (IRC §465) and partnership’s substantial economic effect, were imposed to put an end to the tax shelter industry. Losses from activities in which the taxpayer did not participate in a material way were classified as “passive” and could not be used to offset income from salary, dividends or non-passive activities (e,g, Schedule C active consulting business or professional practice). The objective was to extinguish shelters and the rules extinguished a lot more.
One old definition was that income from a limited partnership interest was automatically passive unless one satisfied certain exceptions. Still another old rule held that where one was both a general and limited partner, the limited partnership interest would not be treated as passive. This rule was designed to keep active business interests from converting some part of the income to passive and thereby offset losses. The rules did not keep pace with changes contained in the Revised Uniform Limited Partnership Act
adopted in many states, which permits limited partners to have more say in management without losing their liability shield.
What about a membership interest in a limited liability company? The old rules characterized the membership interest as a limited partnership interest, and thus passive. The new rules, reflecting the outcome of court cases, focus on the member’s ability to participate in management.
What you should do now. Consult with your advisor on how the new rules may better enable you to utilize your losses. Perhaps, more importantly, these changes will encourage capital to be deployed in new investments and thus stimulate our morbid economy. Being able to use losses rather than carry them over, reduces the overall cost of capital. Any increase in business activity would be welcome.