LLC Law Monitor : Northwest Limited Liability Company Lawyer & Attorney : Doug Batey : Stoel Rives Law Firm : LLC Formation, Tax Liability

Most business people who are familiar with the tax treatment of LLCs understand that LLCs are tax-efficient. LLCs are taxed as partnerships (except in the rare event that they elect to be taxed as corporations). Since they are taxed as partnerships, LLC profits and losses are passed through to the members. The pass-through of LLC profits avoids double taxation—profits are not taxed to the LLC and are only taxed to the members. The pass-through of LLC losses allows members to use the losses to offset against their other income, reducing their tax bills.

What is less well known, except by tax lawyers and CPAs, is that the IRS has interpreted its regulations so that LLC losses are presumed to be “passive activity losses” (passive losses). Furthermore, the presumption is difficult to overturn. The result is that under the IRS’s interpretation of its regulations, LLC losses are often treated as passive losses.

For most taxpayers, passive losses are much less useful than active losses (losses not resulting from passive activities). The reason is that passive losses may only be used to offset income from other passive activities, and not to offset “active” income such as wages, interest, dividends, etc. Internal Revenue Code (IRC) § 469. Instead, any passive losses that exceed “passive” income must be carried over to subsequent tax years until the taxpayer either has enough passive income to use the losses or disposes of the activity that generated the passive losses. Active losses, on the other hand, can be used to offset either active income or passive income. The IRS’s position greatly limits the income-sheltering benefits of losses for LLC members.

There are three reported opinions in which courts have ruled on this issue. The IRS lost in all three courts, most recently in Thompson v. United States, 87 Fed. Cl. 728 (July 20, 2009). (The IRS also lost in Garnett v. Commissioner, 132 T.C. No. 19 (June 30, 2009), and in Gregg v. United States, 186 F. Supp. 2d 1123 (D. Or. 2000).)

The plaintiff in Thompson had formed Mountain Air Charter, LLC to operate an on-demand air charter business. Thompson held 99% of the member interests in Mountain Air directly, and 1% through a subchapter S corporation. On his 2002 and 2003 individual income tax returns, Thompson claimed a total of $2.1 million of losses from Mountain Air and used those losses to offset against other income. The IRS disallowed all but $156,000 of those losses, contending that they were passive activity losses and could not be offset against non-passive activity income. Thompson paid the taxes assessed by the IRS and sought a refund, and when it was denied he brought suit, seeking a tax refund of $781,241 plus interest.

The Thompson case turned on the interpretation of IRS regulations that were adopted under the authority of IRC § 469. Section 469 was adopted as part of the Tax Reform Act of 1986 to address the growth in the 1980s of perceived abusive tax shelters. Many of those tax shelters were formed as limited partnerships that allowed investors to use partnership tax losses to shelter their income from wages or self-employment.

Section 469 establishes limitations on passive activity losses and defines a “passive activity” as a business activity in which the taxpayer does not “materially participate.” It also requires, in the case of limited partnerships, that a limited partner’s participation not be treated as “material participation,” except as provided in IRS regulations. IRC § 469(h)(2). Following the passage of IRC § 469, the IRS adopted temporary regulations that define how an investor can demonstrate material participation in an activity, but that also greatly restrict the ways in which a limited partner can demonstrate material participation in a limited partnership. Treas. Reg. § 1.469-5T. Limited liability companies were new and were used very little at that time, so the temporary regulation did not explicitly address LLCs.

The key regulatory provision that was at issue in Thompson provides:

(i) In general. Except as provided in paragraph (e)(3)(ii) of this section, for purposes of section 469(h)(2) and this paragraph (e), a partnership interest shall be treated as a limited partnership interest if—

(A) Such interest is designated a limited partnership interest in the limited partnership agreement or the certificate of limited partnership, without regard to whether the liability of the holder of such interest for obligations of the partnership is limited under the applicable State law; or

(B) The liability of the holder of such interest for obligations of the partnership is limited, under the law of the State in which the partnership is organized, to a determinable fixed amount (for example, the sum of the holder’s capital contributions to the partnership and contractual obligations to make additional capital contributions to the partnership).

Treas. Reg. § 1.469-5T(e)(3)(i).

Although Mountain Air Charter, LLC was formed as an LLC under Texas state law, the IRS contended that the regulation applied to Thompson’s LLC member interests because Mountain Air was taxed as a partnership for income tax purposes and because the liability of the members of Mountain Air was limited under Texas law. Thompson’s response was simply that Mountain Air was not a limited partnership so his member interest could not be that of a limited partner. In short, the IRS wanted the LLC to be treated as a limited partnership for purposes of the regulation, and Thompson wanted the text of the regulation to be applied literally.

The court began its analysis by pointing out that an LLC is not a partnership. After a lengthy analysis of the language and purpose of the regulation, the court concluded that “[o]nce [the regulation] is read in context and with due regard to its text, structure, and purpose, it becomes abundantly clear that it is simply inapplicable to a membership interest in an LLC.” Thompson, 87 Fed. Cl. at 738.

Since the court ruled that the regulation did not apply, Thompson’s member interests were not presumed to be interests in a limited partnership. Thompson still needed to demonstrate that he was a “material participant” in the activities of the LLC, but in his case the IRS had already stipulated that if he did not hold a limited partnership interest under the regulation, his losses from Mountain Air would not be limited by the passive loss rules of Section 469. The upshot was that the court entered a judgment in Thompson’s favor in the amount of $781,241 on July 21, 2009, plus interest until paid.

The court’s holding in Thompson does not mean that all owners of LLCs will be out from under the passive loss rules. Instead, what Thompson stands for is that losses passed through to LLC owners will not be treated as per se passive. Owners of LLCs must still prove to the IRS that they materially participate in the LLC’s activity in order to use losses and credits from that activity against active income, but they can use the more flexible rules of Treas. Reg. § 1.469-5T(a).

For example, assume that one spouse owns a restaurant in an LLC while the other spouse works at a separate job as an employee. The LLC structure was chosen because it offered limited liability to the owner while not requiring the use of a corporation. The spouse who owns the LLC works full time managing the restaurant, including supervision of employees. The owner spouse should have little difficulty establishing that they materially participate in the restaurant business. Therefore, if the restaurant in any year incurs a tax loss, that tax loss should be available to offset the wage income of the employee spouse, assuming the husband and wife file a joint return.

Thompson enhances the flexibility that LLCs offer to entrepreneurs and small businesses. Their use will still require advance tax planning to ensure that owners will be treated as materially participating. Clarification that the per se passive rule does not apply to LLCs, however, means that owners who do materially participate need no longer fear that tax losses cannot be used to offset “active” income.

One last word of caution. The Thompson, Garnett and Gregg cases are not the last word on this issue, even though the IRS is apparently not appealing Garnett or Thompson. All three courts were trial courts, not appellate courts, so their decisions are not binding on the IRS in other taxpayer disputes. Nonetheless, after three at-bats and three strikeouts, it seems unlikely that the IRS would continue to attempt to apply Treasury Regulation § 1.469-5T to LLCs in the same restrictive manner as in Thompson. The Service might, however, continue to assert the same loss-limiting position that it did in these cases, against other taxpayers on audit in order to leverage higher settlements. Or, the Service could change its regulations to explicitly require that LLC losses be presumed to be passive losses. Watch for future developments. 

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A committee of the Washington State Bar Association is currently reviewing the Washington Limited Liability Company Act, RCW ch. 25.15, with an eye toward recommendations for changes to the statute. One of the issues the committee is considering is whether Washington’s LLC Act should continue to require LLC agreements to be in writing. The Washington Act defines a “limited liability company agreement” as a written agreement (or a written statement of a sole member) concerning the affairs or business of the LLC. RCW 25.15.005(5). The result is that only written agreements of the members will control over the default provisions of Washington’s LLC Act.

The state LLC laws vary. Some require that member agreements (often called operating agreements) be in writing, while some allow oral agreements as well as written. Under Delaware’s LLC Act, for example, a limited liability company agreement can be “written, oral or implied.” In contrast, the New York LLC Act defines an operating agreement as a written agreement of the members, much like the Washington definition.

Business lawyers usually have an emphatic answer if asked about oral LLC agreements: “Of course they should be in writing.” That’s generally the right advice to give to a client considering any kind of business investment or transaction more complicated than getting one’s shoes shined at the shoe-shine stand. But some people inevitably will choose to form LLCs with only an oral agreement about matters such as capitalization, profit and loss allocations, distributions, voting control and so on. Should their oral agreement be disregarded if it would yield results different from the default rules under the statute?

Corporations, of course, are in the “put it in writing” camp. All state corporation statutes require that articles of incorporation, the basic charter document, be in writing and be filed with the appropriate state agency to create a corporation. Many state corporate statutes allow shareholder agreements to vary some of the statutory default rules, but those statutes require that the shareholder agreements be in writing and be executed by all the shareholders. E.g., RCW 23B.07.320. The Model Business Corporation Act, which has been adopted in 24 states, takes the same approach by requiring that shareholder agreements be in writing to override statutory default rules. Model Bus. Corp. Act § 7.32 (2002).

Partnership law approaches the issue differently. Partnerships are based on the agreement of the partners, and both the Uniform Partnership Act (UPA), Section 101(7), and the Uniform Limited Partnership Act (ULPA), Section 102(13), provide that partnership agreements can be written, oral or implied. Thirty-six states have adopted the UPA and 15 have adopted the ULPA, including Washington.

The common law concept of a partnership – an association of two or more persons to carry on as co-owners a business for profit – recognizes that partnerships can be formed informally and by oral agreements. Although the formation of a limited partnership also requires the filing of a written certificate with a state agency, the certificate of formation need contain only limited information such as the name and address of the limited partnership, and the name and address of each general partner. The certificate of formation is simply a notice filing and is not usually used to define the rights of the partners.

Even if a state’s LLC Act allows oral LLC agreements, the state’s statute of frauds will apply. A statute of frauds invalidates certain types of agreements unless they are in writing and signed, such as a guaranty of another’s debt or an agreement that by its terms is not to be performed in one year. E.g., RCW 19.36.010.

For example, last year the Delaware Chancery Court ruled that the Delaware statute of frauds applied to the oral limited liability company agreement of a Delaware LLC. Olson v. Halvorsen, No. 1884-VCL, 2008 WL 4661831 (Del. Ch. Oct. 22, 2008). The court accordingly dismissed a claim under the agreement that called for a multiyear earn-out after a member’s retirement, since by its terms that provision of the agreement could not be performed in a year.

Washington’s and New York’s LLC Acts do not invalidate an oral LLC agreement. Instead they simply define the LLC agreement as a written agreement. Many of their statutory rules may be waived or modified by the members’ agreement, if it is in writing. The New York court has held that if the member agreement is not in writing, the LLC exists but the default rules in the statute govern the LLC, rather than conflicting terms in the oral member agreement. Spires v. Casterline, 4 Misc.3d 428, 778 N.Y.S.2d 259 (Sup. Ct. 2004). Presumably an oral agreement that supplements but does not purport to override the defaults of the LLC Act would still be enforceable.

To return to the question, should state law require LLC agreements to be in writing? The policy in favor of requiring written agreements is similar to that behind the statute of frauds – experience teaches that certain types of agreements are so significant that the higher degree of certainty inherent in a writing should be required. In the event of a dispute, permitting oral LLC agreements will increase litigation costs because of the difficulty of proving the oral terms. It will also be more difficult for new members of an LLC to determine the oral terms governing the LLC.

The policy that supports allowing oral LLC agreements is that of not frustrating the expectations of the parties. LLCs are popular for smaller businesses with few members, who often form an LLC with minimal legal formalities. Many states, including Washington and Delaware, have recognized in their statutes the goal of maximizing the enforceability of agreements between members: “It is the policy of this chapter to give the maximum effect to the principle of freedom of contract and to the enforceability of limited liability company agreements.” RCW 25.15.800(2). That policy is undermined by not enforcing oral member agreements. Also, it seems anomalous to have a different rule on this point for LLCs than for limited partnerships, since in Washington and most other states the limited partnership agreement can be written or oral. RCW 25.10.010(9).

LLCs are used for a wide range of types and sizes of businesses. Large enterprises normally have legal counsel, accountants and written LLC agreements. Smaller, closely held enterprises sometimes don’t have written agreements. An efficient and flexible LLC statute should work well for the widest range of individuals and groups forming an LLC. To do that it should recognize that some LLCs will be based on oral agreements. The need to prove the terms of an oral agreement in the event of a dispute seems an inadequate reason for automatically disqualifying all oral LLC agreements. On balance, the policy reasons seem to tilt in favor of allowing LLC agreements to be oral as well as written.

When I started writing this post I was on the fence on this issue, but I’ve come to the conclusion that the best approach for the Washington LLC Act is to allow LLC agreements to be oral as well as written. But I recognize that people may differ on this point, and I would welcome any comments or input on this issue. Feel free to comment by clicking on the "Comment" link below.

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