WHAT HAPPENS IF you’re the owner of a limited liability company (LLC) business that generates tax losses, and you only spend a few hours a week in the business?

In this common scenario, the losses might be classified as passive, and your ability to currently deduct them might be severely restricted by the dreaded passive activity loss (PAL) rules. Thankfully, three recent court decisions make it easier for those in your shoes to escape the PAL rules and thereby deduct LLC losses from non-rental business activities sooner rather than later.

(Note, however, that if your loss-generating LLC is a rental operation, this article is not relevant to you. With some very specific exceptions, rental losses, from LLCs or otherwise, are passive losses by definition.)

LLC Basics

Using an LLC to own and operate a business shields your personal assets from most business-related liabilities. This liability protection advantage is similar to what you get with a corporation. However, the tax rules for LLCs are more flexible and often more beneficial than the rules for corporations.

Most importantly, if you have an LLC with several owners, it’s called a multimember LLC, and it will generally be taxed under the partnership rules. If so, your share of the LLC’s income, deductions and tax credits are reported on a Schedule K-1 delivered to you by the LLC as part of its tax filing obligations. You then report the LLC tax items on your Form 1040.

However, if you’re the sole owner of the LLC, it’s called a single-member LLC (SMLLC), and its existence is generally ignored for tax purposes. If so, you report the SMLLC tax items directly on your Form 1040, just like you would with a Schedule C sole proprietorship activity.

Passive Activity Loss (PAL) Basics

The PAL rules say passive losses from a business activity can generally be used only to offset passive income. Passive losses in excess of passive income for the year are carried forward to future years. You can deduct the losses in future years when and if you have passive income or when and if you sell or otherwise dispose of the activity that generated the losses. The problem is, many folks have little or no passive income for years at a time, so their passive losses can remain suspended for years at a time.

The good news is you can avoid the PAL rules if you materially participate in the loss-generating activity. In other words, meeting the material participation standard makes the activity non-passive, which means you can deduct the losses currently, assuming no other tax-law provision prevents you from doing so.

IRS regulations say you can meet the material participation standard by passing any one of several tests. The following two tests are by far the easiest.

* Substantially-All Test: You pass if your participation (time spent) in the loss-generating activity during the year in question constitutes substantially all participation by all individuals. Basically, if you do all the work, you pass this test even if it doesn’t take much time.

* More-Than-100-Hours Test: You pass if you participate in the loss-generating activity for more than 100 hours during the year, and no other individual participates more than you. So this test too can be passed without spending a whole lot of time.
IRS Claims LLC Owners Must Pass Stricter Tests

The IRS has claimed for years that LLC owners must be treated as limited partners for purposes of the PAL rules, since both limited partners and LLC owners have limited liability.

Unfortunately, a limited partner can meet the material participation standard only if he or she can pass one of the following three tests, which are usually much tougher than the ones explained above.

* More-Than-500-Hours Test: You pass if you participate in the loss-generating activity for more than 500 hours during the year.

* Prior-Year Material Participation Test: You pass if you materially participated in the activity for any five of the 10 immediately preceding years.

* Personal Service Activity Test: You pass if the activity is a personal service activity, and you materially participated in the activity for any three years before the year in question.

Courts Say LLC Owners Can Take the Two Easy Tests

This year, three court decisions have broken in favor of LLC owners. Two of the decisions were from the U.S. Tax Court (the most recent one in October), which is very good news because they hold sway over the entire nation. All three decisions say LLC owners are not treated as limited partners for purposes of the PAL rules. The specific reasons behind these pro-taxpayer decisions don’t really matter. The important thing to understand is that an LLC owner has only to pass one of the two easy tests explained earlier to meet the material participation standard and thereby be exempt from the PAL rules. The IRS doesn’t like it, but too bad.

Bottom line: If you can pass one of the two easy tests (neither of which takes much time), you can deduct your LLC losses currently, unless some other tax rule says otherwise. This is great news for folks who own LLCs that throw off big losses, such as fishing boat charter and air charter operations and start-up businesses. That said, don’t get carried away. If you have a loss-generating LLC, consult your tax pro to make sure you understand all the other tax-loss limitations that can potentially come into play.