LLC taxed as partnership has operating loss with investment gains-IRS interpretation?

[global9]

We know that an operating loss from rent, etc. expenses is NOT offset on the 1065 by investment income (interest, dividends capital gains from investments owned by the LLC).  Unlike a C Corp., the operating loss is reported separately on the 1065 and the K-1 from the investment gain.  

We are preparing returns on TurboTax for an LLC which owns operating businesses, but also has investments in traded securities.  The business of the LLC is managing the subsidiaries plus managing the investments.  

The LLC has business operating expenses which show a loss for net income purposes, with a gain on investments (interest, dividends, capital gains) which more than offset the operating loss.  Also the net income from the subsidiaries is positive but does not fully offset the operating expenses.

Our question is whether the operating loss could be deemed by IRS to be a Hobby Loss or similar, because the LLC doesn't show a "profit" even though, if it were a C Corp, it would be showing a profit under same circumstances, ie, the investment income more than offsetting the operating expenses.  Our understanding is that such a Hobby Loss or similar would limit deny the deductibility of the operating loss on the LLC owners' returns.  Talking about risk of Hobby Loss determination after several years of operating losses (and investment gains).  The LLC won't qualify as a Trader, so we have to be cognizant of whether this will sooner or later be called a Hobby Loss by IRS.

Or would IRS ordinarily do an informal calculation to net the investment gains against operating expenses, as in a C Corp., and understand that the LLC is actually making a "profit"? 

Are there any IRS Publications, Q&A, etc. which cover this situation for LLCs taxed as partnerships?

Does it make any difference if the LLC elects to be taxed as corporation and files 1120-S?  It would seem that, since S Corp. is also a pass-through, the same ambiguity applies like LLC filing 1065?

In addition, are there any other considerations to note where an LLC has investment income higher than operating expenses, but can't offset them on the 1065, so the 1065 shows a loss which is wanted to be deductible on the tax returns of the LLC's owners?

[tagteam · Accepted solution]

I am going to page @Rick19744 for this as a result of his vast knowledge and experience in pass-through business entities, but a couple of notes in the interim.

1) You would greatly benefit from local, professional guidance (either a tax professional or attorney).

See https://taxexperts.naea.org/listing/service/business-tax-preparation

See also https://www.avvo.com/tax-lawyer.html

2) Your current entity (entities) structure might not be appropriate for your specific business and may need to be reevaluated.

3) A parent company typically has the ability to file a consolidated return, which could possibly eliminate one (or more) of your issues.

4) Hobby loss rules do not apply to C corporations but do apply to S corporations. Regardless, all factors have to be taken into consideration (not just the mere fact that there are losses).

See https://www.irs.gov/pub/irs-news/fs-08-23.pdf

[global9]

Thank you for your reply and for your page to Rick19744.  Much appreciated.

FYI, I am a local tax attorney and we are preparing returns for our client, which has the situation explained above.

In short, a key question I am asking is whether there is a valid argument to IRS that there really is no loss here, let alone a Hobby Loss.  Yes, this is a LLC taxed as partnership and the items are passed-through individually, but nevertheless, Investment Income does exceed Operating Expenses, so there should be considered, at least informally with IRS, to be no loss / Hobby Loss.  

This is the case with a C Corporation, where this situation (Investment Income exceeding Operating Expenses) would be considered a net profit.

Really interested any input on this issue, including any IRS pronouncements on this or analogous issues.

[tagteam]

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@global9 wrote:

This is the case with a C Corporation, where this situation (Investment Income exceeding Operating Expenses) would be considered a net profit.

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A major difference in that case is that C corporations (and shareholders) are subject to double taxation and do not pass losses through to shareholders but generate NOLs. As a result, there is not much of an incentive to generate and/or use deductible expenses to offset income from what might be considered to be a hobby.

[Rick19744]

I will provide some comments:

• In the analogy of a C corporation, the hobby loss rules do not apply to C corporations, so the "netting" is moot.
• You would have the same issue if the entity were an S corporation as the statute specifically notes S corporations (most likely to differentiate the structure from that of a C corporation).
• Your facts indicate that the business of the LLC is to manage the subsidiaries.  That appears to be a trade or business activity.
• I am sure you have reviewed Treasury Regulation 1.183-2 and the nine areas that the IRS would look to if questioned.
• Section 183 and the related regulations have been close to unchanged since the early seventies.  Therefore the nearly 50 years of case law remains relevant.
• While your facts don't speak to the investments side (other than indicating it doesn't qualify as a trader), were the investments purchased with prior profits / gains (excess cash not distributed to the members)?
• The investment portion is portfolio and will not be considered in looking at the hobby loss rules.  
• Unfortunately, Section 183, as in many other areas, will be determined on your specific set of facts and circumstances.  
• Don't know if you have reviewed Publication 5558 "Activities Not Engaged in for Profit Audit Technique Guide".
• Also take a look at Stephen Whatley TCM 2021-11. While this is only a memo decision, it provides a good summary of the decision making process.