News & Events

Passive Activity Loss Rules: Members in LLC and LLP Are Not Limited Partners

The Tax Court and the Court of Federal Claims recently held that members of a limited liability company and partners in a limited liability partnership are not considered limited partners with respect to the passive activity loss rules contained in Section 469 of the Internal Revenue Code (the “Code”). In general, the passive activity loss rules only allow losses from a passive activity to offset income from a passive activity.1 Passive activity losses can be carried forward indefinitely and used to offset future income derived from passive activities.2

A passive activity is any activity that involves the conduct of a trade or business in which the taxpayer does not materially participate.3 Material participation is defined as regular, continuous, and substantial involvement in the business operations.4 Generally, if any one of seven tests can be met by a taxpayer, the taxpayer will be deemed to materially participate in a business.5

However, Code Section 469 provides more restrictive rules in determining material participation for limited partners in a limited partnership. The central issue before the Courts surrounded Code Section 469(h)(2), which reads as follows: “[e]xcept as provided in regulations, no interest in a limited partnership as a limited partner shall be treated as an interest with respect to which a taxpayer materially participates.” The temporary regulations restrict a limited partner in a limited partnership to three of the seven tests to prove material participation.6 However, if a taxpayer owns a general partnership interest in addition to a limited partnership interest, the taxpayer will not be treated as a limited partner for purposes of Code Section 469(h)(2).7 This is known as the “general partner exception.”

 Garnett v. Comm’r 8

In Garnett, the taxpayers owned interests in seven limited liability partnerships and two limited liability companies that were engaged in various agricultural businesses (collectively, the “Companies”). The Companies were organized and operated under the laws of the state of Iowa. The limited partnership agreements generally provided that each partner would actively participate in the business, and the limited liability company agreements provided that the businesses were to be operated by a manager with exclusive authority to act on behalf of the company. The Companies were classified as partnerships for income tax purposes. The IRS audited the partnership income tax returns filed by the Companies for years 2000, 2001, and 2002 and proposed to disallow certain losses claimed by the Companies on the ground that the taxpayers had failed to meet the material participation requirements of Code Section 469.

The IRS asserted that the taxpayers’ interests in the Companies should be treated as limited partnership interests for purposes of the passive activity loss rules and were subject to the additional limitations found in Code Section 469(h)(2). The IRS further asserted that the taxpayers did not meet one of the three tests necessary to be considered as materially participating in the Companies. Conversely, the taxpayers argued that they were not limited partners, the Companies were not limited partnerships and they met one of the four tests to determine material participation that is not available to limited partners.

The Court’s analysis focused on the application of the “general partnership exception” to the general rule that places a greater burden on limited partners for purposes of the material participation test. The Court noted that neither the Code nor the treasury regulations define the terms general partner or limited partner. Looking at the legislative history of Code Section 469(h) (2), the Court observed that the basis for the passive presumption applied to limited partners is due to the general prohibition of limited partners from participating in the management of the business. Because members in a limited liability company and partners in a limited liability partnership are allowed to participate in the management of the business, the Court concluded that such interests are more akin to general partnership interests. Therefore, the Court held that the taxpayers were not subject to the restrictive tests that apply to limited partners to determine material participation for purposes of the passive activity loss rules.

Thompson v. U.S. 9

The Court of Federal Claims was faced with the same issue in Thompson v. U.S. In this case, the taxpayer had formed and was the manager of a limited liability company (the “LLC”). The taxpayer reported losses on his 2001 and 2002 individual income tax returns stemming from the business activities of the LLC. Upon audit, the IRS disallowed losses for 2001 and 2002 asserting that the taxpayer did not materially participate in the LLC. Due to the disallowance, the IRS assessed additional tax liability against the taxpayer. The taxpayer paid the additional taxes and filed a claim for refund.

The IRS argued that because the taxpayer enjoyed limited liability as a member of the LLC, the taxpayer’s interest should be treated as a limited partnership interest for purposes of the passive activity loss rules and thus subject to the more restrictive material participation testing. The taxpayer cited Garnett in support of his position that his interest in the LLC qualified for the general partner exception.

The Court held that the temporary regulations literally require the entity to be a state law partnership, and that a limited liability company is not a state law partnership. The Court dismissed the IRS’s argument that an entity taxed as a partnership could also be subject to the limitations of Code Section 469(h)(2). The Court further concluded that a limited liability company is not substantially equivalent to a limited partnership because it is designed to allow its members to participate in the management of the company. The Court also agreed with the decision in Garnett that the general partner exception could be applied to reach the same result.

Unintended Adverse Impact

While both of these cases represent victories for taxpayers in the context of the passive activity loss rules, the decisions could adversely impact profitable limited liability companies with respect to employment taxes. Under Code Section 1402, net earnings from self employment includes income from a partnership, other than as a limited partner. Therefore, based on these decisions, taxpayers may find it more challenging to take the position that income from their interest in a limited liability company or limited liability partnership is not subject to employment taxes.

Conclusion

The Garnett and Thompson cases are significant for members of limited liability companies and partners in limited liability partnerships. The decisions clearly lessen the burden on such members in avoiding the limitations under the passive activity loss rules. On the other hand, the decisions may have an unintended adverse impact on profitable limited liability companies and limited liability partnerships.

[1] I.R.C. § 469(a).

[2] I.R.C. § 469(b).

[3] I.R.C. § 469(c)(1).

[4] I.R.C. § 469(h)(1).

[5] Treas. Reg. § 1.469-5T(a).

[6] Treas. Reg. § 1.469-5T(e)(2).

[7] Id.

[8] 132 T.C. No 19 (June 30, 2009).

[9] 104 A.F.T.R.2d. 2009-5381 (July 20, 2009).