Tax Law and Business Organization Strategy

Tax Court Clarifies Classification of LLP and LLC Interests Under PAL Rules

The Tax Court held that the taxpayers' ownership interests in limited liability partnerships (LLPs) and limited liability companies (LLCs) are excepted from classification as “limited partnership interests” under the temporary regulations by operation of the general partner exception. Thus, they could use all seven tests for material participation in the temporary regulations, instead of only the three available for participation of individuals that are limited partners.

Under the Code Sec. 469 passive activity rules, passive activity losses cannot offset nonpassive activity income, such as wages, dividends, or profits from nonpassive activities. Passive activities include the conduct of trade or business activities in which the taxpayer doesn't materially participate and, generally, rental activities without regard to whether the taxpayer materially participates in them. (Code Sec. 469(c), Reg. § 1.469-1T(e)(1))

The regulations provide seven exclusive tests for material participation in an activity:

(1) The individual participates in the activity for more than 500 hours during such year;

(2) The individual's participation in the activity for the taxable year constitutes substantially all of the participation in such activity of all individuals (including individuals who are not owners of interests in the activity) for such year;

(3) The individual participates in the activity for more than 100 hours during the taxable year, and such individual's participation in the activity for the taxable year is not less than the participation in the activity of any other individual (including individuals who are not owners of interests in the activity) for such year;

(4) The activity is a significant participation activity (within the meaning of paragraph (c) of this section) for the taxable year, and the individual's aggregate participation in all significant participation activities during such year exceeds 500 hours;

(5) The individual materially participated in the activity (determined without regard to this paragraph (a)(5)) for any five taxable years (whether or not consecutive) during the ten taxable years that immediately precede the taxable year;

(6) The activity is a personal service activity (within the meaning of paragraph (d) of this section), and the individual materially participated in the activity for any three taxable years (whether or not consecutive) preceding the taxable year; or

(7) Based on all of the facts and circumstances (taking into account the rules in paragraph (b) of this section), the individual participates in the activity on a regular, continuous, and substantial basis during such year. (Reg. § 1.469-5T(a))

Under Code Sec. 469(h)(2), a limited partner's interest in a limited partnership isn't treated as an interest in an activity in which the taxpayer materially participates, except to the extent provided in the regulations. The regulations permit a taxpayer to establish material participation in a limited partnership but constrain the taxpayer to only three of the seven regulatory tests that ordinarily are available. (Reg. § 1.469-5T(e)(1) and (2)). Reg. § 1.469-5T(e)(3)(i) provides that a partnership interest is treated as a limited partnership interest if:

A. the interest is designated a limited partnership interest in the limited partnership agreement or the certificate of limited partnership, without regard to whether the liability of the holder of the interest for obligations of the partnership is limited under the applicable state law; or

B.   the liability of the holder of the interest for obligations of the partnership is limited under the law of the state where the partnership is organized to a fixed amount. For example, state law could limit the liability of the partner to the sum of the partner's capital contributions to the partnership and contractual obligations to make additional capital contributions to the partnership.

However, under Reg. § 1.469-5T(e)(3)(ii), a partnership interest isn't treated as a limited partnership interest for the individual's tax year if he is a general partner as well as a limited partner in a partnership during the partnership's tax year ending with or within the individual's tax year (the general partner exception).

Tax Court's decision. The Tax Court was faced with partial summary judgement motions on whether the "presumption" contained in Code Sec. 469(h)(2) applied to the LLP and LLC interests owned by the taxpayers. The Court ruled that the "presumption" did not apply by reason of the general partner exception. Since the Court did not overturn any portion of the temporary regulations, I conclude that the Court, in effect, held that LLP interests and LLC interests are both limited partner and general partner interests.

The Court stated that the IRS's view overlooked the fact that the operative condition for applying Code Sec. 469(h)(2) wasn't simply that there be an “interest in a limited partnership” but rather that there be an “interest in a limited partnership as a limited partner.” The Court rejected IRS's approach as narrow and literal.

The Court reasoned that if the general partner rule in Reg. § 1.469-5T(e)(3)(ii) applied, then an ownership interest can't be treated as a limited partnership interest subject to the "presumption" of Code Sec. 469(h)(2). Members of LLPs and LLCs, unlike limited partners in State law limited partnerships, aren't barred by State law from materially participating in the entities' business. Accordingly, it cannot be presumed that they do not materially participate. Rather, it is necessary to examine the facts and circumstances to ascertain the nature and extent of their participation. The Court concluded that this factual inquiry was appropriately made pursuant to the general Code Sec. 469 tests for material participation. The Court found that the Garnetts held their ownership interests in the LLPs and the LLCs as “general partners” within the meaning of the temporary regulations. While the taxpayers' status in these entities differed significantly from the status of general partners in State law limited partnerships, the Court recognized that their status also differed significantly from that of limited partners in State law limited partnerships.

Conclusion

While a taxpayer victory, taxpayers may not have actually gained as much from the decision as may appear at first blush. The Court did not rule that the taxpayers met any of the tests of material participation. It only expanded the number of tests the taxpayers could use to prove material participation. The temporary regulations already allow limited partners to attempt to prove material participation through tests (1), (5), and (6). The Court's decision now adds the significant participation tests (including the 100 hour tests) and the facts and circumstances test. These are significant additions; but they do not assure material participation for LLP and LLC owners.

It also remains to be seen whether the ruling in this case will have implications in the self employment tax area. Will LLP and LLC owners also be considered general partners (in addition to or in lieu of being limited partners) when applying the self employment rules? Presumably, such an argument will be among the IRS' next steps on this issue.

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