After nearly two decades with no guidance addressing the correct characterization of a limited liability company’s activities under the passive activity loss rules, investors are finally receiving the answer they have patiently sought. Several courts, the Service’s acquiescence and newly issued proposed regulations have recently clarified that ownership interests in limited liability companies are not all treated as presumptively passive limited partnership interests. Instead, the more lenient general passive activity loss rules set forth in the temporary regulations are used to determine the active or passive nature of many activities. These decisions have been accurately hailed as a significant taxpayer victory. Taxpayers investing in limited liability companies may now deduct the company’s losses with confidence that the risk of an IRS challenge is low. Despite this generally pro-taxpayer result, this article shows that the recent decisions also have negative implications for certain investors and for the economic efficiency of our tax system. Moreover, even though the courts correctly apply the existing passive activity loss rules to limited liability companies, the recent case law does not present the proper policy answer. Therefore, the article argues that Congress should abolish the passive activity presumption applicable to limited partners and eliminate the existing dichotomy between limited partners and general partners for tax purposes.
Orly Sulami, Good News in a Bad Economy: Service Acquiesces on Pro-Taxpayer Application of Passive Activity Loss Rules to Limited Liability Companies, 65 The Tax Lawyer 81 (2011)