A recent Tax Court case, Garnett v. Commissioner, 132 TC 19, could mean you may be able to offset losses from ‘part-time’ business ventures against your salary and other investment income. But the case is not as black and white as some may think it is.
The case involved an Iowa farming family, Paul and Alicia Garnett, who ran their family farming business through several business entities. That included a few LLCs, LLPs and tenancies in common. When it came time to file their income tax returns, the Garnetts lumped all their income from the businesses that made money together. The IRS didn’t object to that. But then the Garnetts lumped together all the losses from the businesses that did not make money.
If they had stopped there, the IRS probably wouldn’t have objected. It was what the Garnetts did next that the IRS didn’t like. They reduced their taxable income by deducting the losses from the gains. The IRS cried foul because it has long argued that you may deduct losses in a business only against future profits from that business. That is, if Business A has a loss, you may not use that loss to offset income from Business B.
Example
Here’s an example in another context. Just because the Garnetts ran a farm, the possible impact of what they did is not limited to farming businesses.
Let’s say that John is an engineer and that he earns $100,000 a year. John also happens to own a restaurant with some buddies from the old neighborhood. He shows up there several nights a week to help manage the place. Mary, his wife, owns an interest in a second-hand clothing store with some of her friends. Together the restaurant and the clothing store lose $80,000 in 2009.
How the IRS Views It
The IRS says the couple has $100,000 of taxable income they must report (and pay tax on) in 2009. Next year, if the restaurant happens to make money, John and Mary may offset some of this year’s loss (which they get to carry over) against next year’s income.
How the Tax Court Views It
Assuming state law where John and Mary live is like that in Iowa, they only have $20,000 of taxable income when they file their 2009 income tax return. They get to net all their income and all their losses.
It’s Not Open and Shut
While some articles you read suggest the law is now settled, you may want to check with your tax adviser before relying on this case.
Here’s the problem. Federal tax law creates a presumption that limited partnership interests are passive interests – meaning they don’t involve active participation in the business. However, the law doesn’t specifically talk about LLCs and LLPs. It doesn’t do that because when Congress created the law, LLPs and LLCs were not nearly as common as they are today.
The IRS says that an interest in a limited liability company or limited liability partnership is just like the traditional limited partnership interest – at least for these purposes.
Not so said the Tax Court after looking at Iowa law. That state, it notes, gives powers to LLC members and LLP owners beyond those allowed traditional limited partners. Under Iowa law, members of LLPs and LLCs, unlike limited partners in Iowa limited partnerships, are not barred by from materially participating in the entities’ business. So, the court decided, “it cannot be presumed that they do not materially participate.” It also said limited liability wasn’t enough to make an owner a “limited partner” as defined in the Internal Revenue Code.
Final Thoughts
So, when you start deciding whether this case applies to your situation, at the very least you need to find out if the law in your state is similar to that in Iowa. Then you need to ask whether your ‘participation’ in the business rises to the level of ‘material’ participation. Anyone who has ever owned a farm knows the work it takes is not ‘passive’ by any stretch of the imagination. The idea of ‘gentlemen’ farmers who play with the horses while others do the work is rare.
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