By Peter Watts
The IRS has lost a key tax credit case in its efforts to limit tax deductions available to investors in small businesses. The case, which can still be appealed, could have wide implications for entrepreneurs and small business owners.
The U.S. Tax Court decision allows some investors in certain types of entities to deduct losses against unrelated salary and investment income. The IRS had argued that investors can only deduct losses in a business against future profits from that business. This IRS interpretation can prevent taxpayers from using the deductions.
In Garnett v. Commissioner, 132 T.C. No. 19 (2009), the U.S. Tax Court issued a summary judgment saying the Garnetts were active investors who could properly deduct farming losses against other income. The Garnetts sought to deduct losses from their chicken and pig operations.
Despite the agricultural fact pattern, the ruling is seen by commentators as widely applicable. The Wall Street Journal quoted Carolyn Turnbull of the certified public accounting firm of Moore, Stephens & Tiller who stated: "This decision was about hog and egg operations, but it could just as easily have been about a tech start-up, restaurant or manufacturer." It is likely that many investors will take the deductions based on the U.S. Tax Court ruling.
The decision specifically applies to investors in limited liability companies and limited liability partnerships. Its primary benefit is to investors who also actively work in or own other businesses. Under this decision, losses from one of two businesses could offset salary or investment income earned by the other.
The IRS had previously lost one Oregon District Court case on the same issue, Gregg v. United States, 186 F. Supp. 2d. 1123 (D. Ore. 2000). This benefited Oregon clients, but could not be relied upon outside of the state. Because Garnett was decided by the U.S. Tax Court, it has national impact.