Not all partners are created equal. There are various places in the tax law where limited partners are treated differently from general partners. Yet neither the Internal Revenue Code (“Code” or “IRC”) nor the regulations defines the different types of partners.

One place where the type of partner makes a difference is under the passive activity loss rules. Generally, an individual's losses from a passive activity are only deductible against the individual's passive activity income (which does not include compensation or portfolio income such as interest and dividends). Activities are generally considered passive if the taxpayer does not materially participate in the activity under any of seven tests set forth in Temporary Regulations. However, IRC Section 469(h)(2) provides that a limited partner in a limited partnership is presumed passive unless regulations provide to the contrary. The regulations allow only three of the seven tests to be used to determine whether a limited partner materially participates in the activity of the limited partnership. The main one of the three is whether he devotes at least 500 hours to the activity each year. Moreover, active participation may cause him to lose the limited liability protection that is accorded limited partners.

The question raised in Garnett v. Commissioner, 132 T.C. No. 19 (2009), is whether this same presumption applies to a member of a limited liability company. Although the Temporary Regulations define a limited partnership interest broadly to include an interest where the holder's liability for obligations of the entity is limited under State law (and therefore includes a limited liability company), they do not define when a member holds such interest as a limited partner. Analyzing the legislative history of the passive activity rules, the Tax Court concluded that the presumption was applied to a limited partner because under State law his limited liability was conditioned on not participating in the partnership's business.

A member in a limited liability company, on the other hand, does not face such limitation. Limited liability is not lost merely because the member is active in the business. As a result, the court found the presumption does not apply, and whether the taxpayer materially participated in the limited liability company's business must be determined by applying the full seven factor test.

Shortly thereafter, the United States Court of Federal Claims reached the same conclusion. The court found that the definition of a limited partnership under the regulations on which the government relied – that "a partnership interest shall be treated as a limited partnership interest if ... the liability of the holder of such interest for obligations of the partnership is limited, under the laws of the State in which the partnership is organized" – literally requires that the entity be a partnership under state law. Moreover, the court agreed with the Tax Court's analysis in Garnett that, for purposes of IRC Section 469(h)(2), the hallmark of a limited partner is that a limited partner is entitled to limited liability protection only if it does not actively participate in the business. Unlike a limited partner, a member of a limited liability company has limited liability even if he participates in the management of the business.

The lesson of these cases is that if you wish to use an entity that provides a liability shield but still not be considered a passive activity, you should use a limited liability company rather than a limited partnership.