Tax Court Allows LLC Member’s Losses; Rules Against IRS on Limited Partner Issue

The Tax Court held on Tuesday that an LLC member who materially participated in the management of an LLC is not treated as a limited partner and is therefore not subject to the passive loss limitations under IRC § 469 (Newell, TC Memo 2010-23).

The taxpayer owned one-third of a California LLC that owned and operated a country club, golf course and restaurant. The taxpayer was the managing member of the LLC and actively participated in running the business (under the material participation rules of Temp. Treas. Reg. § 1.469-5T(a)(4)). The taxpayer’s distributive share of the business’s losses amounted to $6,020,519 in the years 2001–2003; the taxpayer deducted those losses on his federal tax returns.

On examination, the IRS disallowed the losses for those years, ruling that the losses were suspended and not currently deductible under the passive activity loss limitation rules of IRC § 469(a)(1). Despite the fact the IRS agreed that the taxpayer materially participated in the business (which would normally exempt him from the passive loss limitations), it argued that the taxpayer’s interest in the LLC must be treated as a limited partner interest, which under section 469(h)(2) and Temp. Treas. Reg. § 1.469-5T(e) cannot be treated as an interest in which the taxpayer materially participates (that is, it is presumptively treated as an interest in a passive activity).

Section 469(h)(2) applies if a taxpayer has an interest in a limited partnership as a limited partner; it treats a limited partner’s losses from a limited partnership interest as presumptively passive. However, the Tax Court has previously held that an interest in an LLC is not an interest in a limited partnership as a limited partner (Garnett, 132 TC no. 19 (2009)). The court followed that holding in this case. It noted that limited partners are generally forbidden by state law from participating in the limited partnership’s business; no such restriction exists in California LLC law, and the taxpayer was permitted in the LLC’s organizing documents to participate in the LLC’s business. Because the taxpayer was the LLC’s managing member and participated in its activities as such, the court held that the taxpayer fell within the general partner exception of Temp. Treas. Reg. § 1.469-5T(e)(3)(ii) and did not hold his member interest in the LLC as a limited partner.

Because section 469(h)(2) did not apply to the taxpayer’s interest, and because the taxpayer materially participated in the business, the Tax Court held that the taxpayer could deduct his share of the LLC’s losses without regard to the passive loss limitations.