Forensic Accounting Expert Witness On Passive Activity Limitations

In Limited Liability does not mean Limited Deductions, forensic accounting expert witness Peter H. Burgher writes:

In a victory for taxpayers the Federal Tax Court has recently held that an LC member does not lose the ability to deduct operating losses due to “passive activity”. In Newell v. Commissioner the tax court looked beyond the fact that an LLC member has limitations on liability. The IRS had taken the position that being a member of an LLC per se meant that passive activity limitations applied. The taxpayer incurred losses while participating both as an investor and as a part-time manager of several business projects for a number of years. In general, IRC Section 469 disallows recognition of losses or related credits from trade or business activities in which taxpayers do not materially participate. Temporary Treasury Regulation ΒΆ1.469-5T(c) (3) has several provisions that, among other things, has an exception to limited partnership interests for general managers. Otherwise, partners having fixed liabilities may be deemed to be passive.

In the instant case, the Tax Court found that while the taxpayer did have limited liability his managerial activities functioning as a general partner overcame the passive activity presumption. Passive activity losses can only be used against passive activity income, hence the potential for limitations on deductibility. We note the taxpayer here was only part-time in each of his business interests which fortunately for him did not undermine his managerial status. The IRS has not acquiesced gracefully in this arena. Recently, it issued a memo on another decision that held an LLC is not a limited partnership, but it has so far not given in on Newell. So beware, keep records, maintain proofs and be prepared for a fight unless you have plenty of passive income!

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