LLC Owners and Participants: Be Aware of IRS PAL Regulations

October 30, 2013

If you own a Limited Liability Company (LLC) that you are not actively managing, but you claim tax deductions, this blog post will be of interest to you. Close to 30 years ago, the IRS passive activity loss (PAL) rules (I.R.C. Section 469) were enacted to limit the degree to which money-losing LLCs could be used as tax shelters by their owners claiming losses—such as depreciation, interest, and other deductions. These rules created the passive income or loss category and they apply to all business activities, including real estate rental activity.

There are two types of passive income or losses including income earned from:

  1. Businesses in which you don’t materially participate
  2. All rental properties that you own

Essentially, the PAL rules are intended to prevent individuals from deducting passive losses (such as from rental activities) from their non-passive income. However, if you own or co-own an LLC on a part-time basis or have someone else manage it on your behalf, as long as you are active in the business you can claim any related losses against your non-passive income, if you meet the IRS definition of "material participation." The IRS defines “material participation” as being “involved in the operations of the activity on a basis which is regular, continuous, and substantial.” There are several tests that the IRS uses to define material participation in a business, based on your activity and the amount of time you spend working. Read about it in detail here.

Another point to keep in mind—the PAL rules state that passive losses from a business activity can only be used to offset passive income from other passive activities. Passive losses in excess of your passive income for the year are capped, but they can be carried forward and deducted in future years when and if you have passive income or if you sell or dispose of the activity that generated the suspended losses. For additional information about PAL tax regulations, please visit IRS.gov.

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