Losses From Interests in LLCs and LLPs Not Presumptively Passive

BY TINA QUINN, CPA, PH.D. AND JOHN F. ROBERTSON, ESQ., CPA

The Court of Federal Claims recently ruled that an interest in a Texas limited liability company (LLC) was not a limited partnership interest held as a limited partner for purposes of the passive loss rules and therefore losses from the interest should not be treated as presumptively passive. The Tax Court ruled similarly with respect to interests in both LLCs and limited liability partnerships (LLPs) under Iowa law.

 

A passive loss generally is one from activities in which a taxpayer does not materially participate and may be deducted only to the extent of income from passive activities during the tax year. Any excess loss may be carried forward.

 

In the Tax Court case, Paul and Alicia Garnett owned interests in seven LLPs, two LLCs and two other business ventures referred to as “tenancies in common,” most of which they owned either directly or through five holding LLCs. The LLPs and LLCs were engaged in agribusiness operations. The tenancies in common listed their principal business activity as “rental real estate.”

 

The LLP agreements generally provided that each partner would actively participate in control, management and direction of the business. The LLPs filed forms 1065 and K-1 identifying either the holding LLC or Paul Garnett as a “limited partner.”

 

The business of the LLCs was conducted by a manager whose responsibilities included carrying out the regulations and decisions of the members. The LLCs reported on a Form 1065 and identified the holding LLC or Garnett as a “limited liability company member.”

 

The tenancies in common had three partners, and the Garnetts owned their interests indirectly through the holding LLCs. The businesses filed Form 1065, one listing the holding LLC as a general partner and the other listing it as a limited partner.

 

On joint returns for 2000, 2001 and 2002, the taxpayers reported income and losses from their interests in the LLCs, LLPs and holding LLCs. The IRS disallowed certain of the losses on the grounds that the activities were passive.

 

The issue for the Tax Court was whether the taxpayers’ interests in the LLPs, LLCs and tenancies in common were interests in limited partnerships as limited partners and therefore presumptively passive activities. In general, IRC § 469(h)(2) provides that no interest in a limited partnership as a limited partner shall be treated as an interest with respect to which a taxpayer materially participates.

 

Although the Code and regulations provide no general definition of “general partner” or “limited partner,” Temp. Treas. Reg. § 1.469-5T(e)(3)(i) provides that a partnership interest shall be treated as a limited partnership interest if it is so designated in the partnership agreement or certificate or if state law provides liability protection for the owner of the interest.

 

The IRS contended that the Garnetts’ ownership interests in the LLCs and LLPs were limited partnership interests under the second prong of the definition because Iowa law provided them with liability protection. The Tax Court rejected this argument, noting that section 469(h)(2) refers to not just a “limited partnership interest” but such an interest held “as a limited partner.” The latter term is not defined in the Code and regulations. The taxpayers argued that section 469(h)(2) did not apply because none of the companies were limited partnerships. The Tax Court also rejected this argument, finding it too narrow. The Tax Court noted that when section 469 was enacted in 1986, LLCs were authorized only in Wyoming and LLPs did not yet exist, and neither has been explicitly addressed in the Code or regulations since. Instead, looking at the legislative history, the Tax Court found a suggestion that Congress contemplated that some ownership interests in entities similar to limited partnerships would be treated as limited partnership interests under regulations to be issued by the Treasury secretary.

 

Having determined it was possible that the LLP and LLC interests could be considered limited partnership interests, the Tax Court then looked to see if Temp. Treas. Reg. § 1.469-5T(e)(3)(ii), which provides an exception to that treatment for partners who hold a general partner interest, applied. The Tax Court recognized that this section applies to situations where a partner holds both a general and a limited partnership interest but determined that it is not confined to such situations. The court agreed with the taxpayers that because they were not barred by state law from participating in the management of the LLCs and LLPs, they held their ownership interests as general partners within the meaning of the temporary regulations.

 

Accordingly, the ownership interests were not presumptively passive as limited partnership interests. As for the taxpayers listing themselves and the holding entities on some tax returns as limited partners, the court accepted their argument that they did so only because the form did not afford a “limited liability partner” option. And in any event, such inconsistencies were not material, the court held.

 

The court issued a partial summary judgment for the taxpayers, saying a further facts-and-circumstances inquiry

would be necessary to determine their material participation under the requirements of section 469(h)(1) (“regular, continuous and substantial”) and the seven exclusive tests of Temp. Treas. Reg. § 1.469-5T(a).

 

On July 20, three weeks after the opinion in Garnett was issued, the Court of Federal Claims cited it in reaching the same result regarding a Texas LLC owned by James R. Thompson, an aircraft charter services provider. The Court of Federal Claims concluded that membership interests in LLCs are not partnership interests and Temp. Treas. Reg. § 1.469-5T(e)(3) does not apply to such interests. The court discussed the difference between general partners and limited partners more in terms of management participation than the IRS’ focus on limited liability.

 

Both opinions cited Gregg v. U.S. (186 F. Supp. 2d 1123), in which a district court in Oregon ruled in 2000 that a member of an LLC could be considered a general partner under that state’s law and so treated for purposes of the passive loss rules.

 

Taken together, the decisions call into question whether the statutory presumption that interests in limited partnerships are passive necessarily extends to LLCs and LLPs. Taxpayers and advisers contemplating making such an argument, however, should take into account state laws governing those entities. Also, taxpayers still will be required to document material participation before the activity will be treated as active, which could also trigger self-employment tax liability.

 

  Garnett v. Commissioner , 132 TC no. 19

  Thompson v. United States , docket no. 06-211T (Fed. Cl.)

 

By Tina Quinn, CPA, Ph.D., professor of accountancy, and John F. Robertson, Esq., CPA, LL.M., associate professor and chair, both of the Department of Accounting, Arkansas State University, Jonesboro, Ark.

 

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