A Farm Couple Scores a Victory Over the IRS

• July 30, 2009
• Paul Neiffer

In the US Tax Court decision – Paul D. Garnett and Alicia Garnett v. Commissioner – rendered in June of this year, the court ruled that farmers who hold business interests in limited liability companies (LLC) and limited liability partnerships (LLP) are not passive investors.  This is a great victory for many farmers and entrepreneurs that own various farm and business interests.

Background

The popularity of the LLC and LLP have increased greatly in recent years.  For almost all of our farm clients, we recommend that the ownership of the land be held in a LLC or LLP.  These entities give you the legal protection of a corporation without the double tax of a C corporation or the extra potential liquidation tax of a S corporation.

This means that if the LLC is sued for business debts, the risk is to the assets of the LLC, not the home or other assets held by the members of the LLC.

The IRS has argued that the passive activity limitations automatically apply to these types of investments.  If the business activity is classified as passive, then you can only offset passive losses against other passive income.  Any excess is carried forward and can not be used to offset wage or business income.

The IRS has various tests to determine if your operation is passive or not.  Most rental real estate and limited partnership interests are presumed to be passive.

Facts of the new case:

A farm couple located in Nebraska owned either directly or indirectly seven limited liability partnerships, two limited liability companies and two tenancies in common.  These entities were involved in the production of poultry, eggs and hogs and it appears the farm was located in Iowa.  Under the LLC agreements, all partners were treated as active participants in the farm operations, however, the LLC agreement limited these responsibilities to a general manager.  All of the LLP and LLC were registered and operated under Iowa state law.

The couple claimed over $300,000 of losses from these operations.  The IRS disallowed the losses by claiming they were passive losses since the members were considered to be limited partners.

However, the Tax Court overruled the IRS.  The court stated that the limited partners in a limited partnership are considered to be passive investors since they are not allowed to materially participate in a business.  With respect to LLC and LLP members and partners, the Court ruled that under state law, the members are allowed to materially participate in the management of the company.  This would allow the members to deduct their losses.

Farmer’s Impact:

This means that if you are currently treating farm operations held in LLC interest as being passive, you may want to consider amending your income tax returns and deducting these losses as regular losses.  This would allow you to offset these losses against any other income that you have.  You can amend any 2006, 2007 and 2008 tax returns and you may be able to amend 2005 tax returns if you had filed for an extension.

Also, for any new investments that you make in farm operations with other farmers or investors, using a LLC or LLP will generally make these a material investment unless your fact pattern reflects otherwise.

Remember that this court case referenced operating LLC and LLP.  They did not involve only the rental of farm land which could still be considered passive.

In any case, make sure to discuss this with your tax advisor to see if this court case applies to you.

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