In two recent cases, the Tax Court and Court of Federal Claims lowered the hurdle for taxpayers who invest in a limited liability company ("LLC") or limited liability partnership ("LLP") to prove they materially participate in the business to avoid the limitation on the use of passive activity losses.
An individual's ability to use losses or credits from a business to offset income from wages, dividends, interest and profits from non-passive activities is limited unless the individual satisfies the "material participation" exception. To satisfy the "material participation" exception, an individual generally must meet one of seven tests; however, a holder of an interest in a limited partnership (other than a general partner holder) can satisfy the "material participation" exception only if his participation in the business exceeds 500 hours during the current year, or did so during a certain number of prior years. The IRS' view is that LLC and other similar interests providing limited liability should be characterized as limited partner interests in a limited partnership.
The Tax Court in Garnett v. Comm'r, 132 T.C. No. 19 (June 30, 2009) and the U.S. Court of Federal Claims in Thompson v. United States, 2009 U.S. Claims LEXIS 250 (July 20, 2009) rejected the IRS' view and held that interests in an LLP or LLC were not "interest[s] in a limited partnership as a limited partner" under Section 469(h)(2) despite their limited liability. As a result, losses from these entities were not per se passive losses. The taxpayer could use the losses to reduce other taxable income if they could satisfy any of the seven tests of "material participation." (To be clear, these cases do not hold that ownership interests in LLCs/LLPs are per se active, only that they are not per se passive.)
Garnett v. Commissioner (Tax Court)
In Garnett, the IRS disallowed the taxpayers' use of the losses from seven LLPs and two LLCs against other income. The IRS argued that the interests in the LLPs and LLCs were properly characterized as limited partnership interests because limited liability should be the "sole relevant consideration" in determining limited partnership status.
Rejecting the IRS' argument, the Tax Court weighed whether the taxpayers were more akin to "limited partners" or "general partners." The Tax Court found most germane to this inquiry the taxpayer's "ability to participate in the partnership's business" (not unlimited liability). Because the taxpayers were not precluded by state law from actively participating in their LLCs'/LLPs' businesses, they were "general partners." As a result, if the taxpayers can satisfy one of the seven "material participation" exceptions, they will avoid the limitation on passive losses.
Thompson v. United States (U.S. Court of Federal Claims)
In Thompson, the IRS disallowed the taxpayers' use of losses attributable to membership interests in an LLC. The parties stipulated that the taxpayers could not meet the limited "material participation" tests available for limited partners, but could satisfy "material participation" under one of the seven tests available for non-limited partners.
The Court held that the Regulations' use of the phrase "under the law of the State in which the partnership is organized" required the entity to be a state law partnership for the limited partnership limitations of Section 469(h)(2) to apply -- not just be taxed like a partnership under the Code like an LLC. It further concluded that an LLC is not "substantially equivalent" to a limited partnership.
Further, the Court agreed with the holding of the Tax Court in Garnett that the "general partner exception" could also be used by the taxpayer to avoid the restrictions on limited partnership interests.
Both courts held that the taxpayers' interests were not "interest[s] in a limited partnership as a limited partner," but they did so partially on different grounds. The U.S. Court of Federal Claims held that Section 469(h)(2) can apply only to interests in state law partnerships; however, the Tax Court left open the possibility that Section 469(h)(2) could apply to entities other than state law partnerships if they were "substantially equivalent" to a state law limited partnership. Nevertheless, both courts concluded that an individual could apply any of the seven tests if the individual's interest was more akin to a "general partner" interest rather than a "limited partner" interest.
Potential Negative Consequences
Although the cases are generally favorable for individuals who have losses attributable to LLC/LLP interests, they may have some negative consequences for individuals with profitable LLC/LLP investments. Under Section 1402, income subject to self-employment tax includes an individual's distributive share of income from a partnership other than as a limited partner. Although Section 1402 (like Section 469) does not define "limited partner," Garnett and Thompson make it more difficult for taxpayers to argue that their LLC/LLP interests are "limited partner" interests for purposes of self-employment tax. Further, taxpayers with profitable LLC/LLP interests may be precluded from off-setting such profits with losses from other passive activities.
If you are a partner or member in a loss-generating LLC or LLP and participate in the entity's business activities, these recent cases may provide you with an opportunity to deduct the losses against your non-passive income (e.g., wages, dividends, interest, and profits from non-passive activities). However, if you are a member of a profitable LLC or LLP, planning may be necessary to avoid potential negative consequences associated with these recent decisions.