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The Tax Court and the U.S. Court of Federal Claims agree: Members of LLCs and LLPs are not to be treated as limited partners*

AgDM Newsletter
October 2009

In a decision in late June 2009, the United States Tax Court held that ownership interests in a limited liability company (LLC) or limited liability partnership (LLP) should not be treated as limited partners in a limited partnership. About a month later, the U.S. Court of Federal Claims decided a case that went a notch beyond the holding in the earlier Tax Court case. That provides major support for the view that the statute which states “. . .[e]xcept as provided in regulations, no interest in a limited partnership as a limited partner shall be treated as an interest with respect to which a taxpayer materially participates” does not require members of LLCs and LLPs to be limited in how the material participation test can be met. That at least expands the opportunities to meet the material participation test to the seven tests that are ordinarily available to taxpayers rather than the three tests specified in the temporary regulations for limited partners, thus increasing the chances for meeting the required standard of material participation on a regular, continuous and substantial basis. As noted below, the decision by the U.S. Court of Federal Claims goes a step further in favoring the taxpayer.

The regulatory framework

Losses from passive trade or business activities, to the extent deductions exceed passive activity income (exclusive of portfolio income), in general may not be claimed against other income, only against passive activity income. An activity is considered to be a passive activity if the activity involves the conduct of a trade or business and the taxpayer does not materially participate in the activity. A taxpayer is treated as materially participating in an activity only if the person “. . . is involved in the operations of the activity on a basis which is - (A) regular, (B) continuous, and (C) substantial.” LLCs and LLPs are not mentioned specifically in the statute or the temporary regulations inasmuch as in 1986, when the passive activity statute was enacted, only two states (Wyoming in 1977 and Florida in 1982) authorized entities denominated as limited liability companies and LLPs did not come into existence until the 1990s.

As noted, the statute states that “. . . no interest as a limited partner shall be treated as an interest with respect to which a taxpayer materially participates.” The temporary regulations specify seven tests for material participation under the passive activity loss rules:

(1) participation for more than 500 hours during the year,
(2) for situations requiring less than 500 hours of involvement, “substantially all” of the participation in the activity,
(3) more than 100 hours per year and the participation is not less than that of any other individual,
(4) the aggregate participation in “significant participation” activities exceeds 500 hours,
(5) material participation for five of the last ten taxable years in the activity,
(6) for personal service activities, any three preceding taxable years and
(7) material participation based on all of the facts and circumstances.

Farm taxpayers are permitted to qualify as materially participating if they participated materially for five or more years in the eight year period before retirement or disability.

The temporary regulations hold limited partners to three tests for material participation:
(1) more than 500 hours during the year,
(2) the limited partner materially participated in the activity for five or more of the ten preceding years and
(3) for personal service activities, any three preceding years.

Position of LLCs and LLPs

In general, a partnership interest (and, for tax purposes, an LLC or LLP is considered a partnership) is treated as a limited partnership interest if so designated in the organizational documents or the liability of the holder of the interest is limited to a fixed, determinable amount under state law such as the amount contributed to the entity. However, a general partner who holds an interest in a limited partnership is not necessarily treated as a limited partner. As we noted in a 2008 article, the temporary regulations would seem to indicate that, if the focus is on limited liability of the LLC member for obligations of the LLC, an LLC member would be treated as a limited partner. However, if the focus is on participation in management, the position of an LLC member is different in that a limited partner cannot be active in the partnership’s business and if a limited partner becomes active in management, the limited partner may lose the feature of limited liability.

The Congressional Committee Reports lend support to that interpretation.

A case decided in 2000, Gregg v. United States, recognized that LLCs are designed to permit members to engage in active management of the business without losing their limited liability feature which can occur with a limited partner. The court in Gregg v. United States held that, inasmuch as the regulations did not state that members of an LLC were to be treated as limited partners, it was inappropriate to treat LLC members as limited partners. The court made it clear that an LLC member could show material participation based on the seven tests in the temporary regulations rather than the higher standard specified in the temporary regulations for limited partners.

Garnett v. Commissioner
The 2009 Tax Court case of Garnett v. Commissioner, citing Gregg v. United States, involved taxpayers who owned seven limited liability partnerships and two limited liability companies in Iowa, all engaged in farming and agribusiness operations. The LLP agreements provided that each partner would actively participate in the control, management and direction of the LLP’s business. The LLC operating agreements provided that business was to be conducted by a manager.

The Tax Court focused on the application of the “general partner exception” and believed the LLP and LLC members had the right to participate in management, as do general partners, which justified that exception inasmuch as state law did not preclude the members from actively participating in the management and operations of the LLPs and LLCs. Accordingly, the members were entitled to apply all seven of the tests for material participation and were not limited to the three prescribed for limited partners. The Internal Revenue Service had also treated two interests in tenancy in common as limited partnerships which the Tax Court rejected.

Thompson v. United States
The decision of the U.S. Court of Federal Claims, Thompson v. United States, cited approvingly both Gregg v. United States and Garnett v. Commissioner but went beyond those decisions in stating that the regulation “. . . is simply inapplicable to membership interests in an LLC.” That suggests that the current I.R.C. ยง 469 does not limit the losses in question.


*Reprinted with permission from the July 31, 2009 issue of Agricultural Law Digest, Agricultural Law Press Publications, Brownsville, Oregon. Footnotes not included.


Neil Harl, Charles F. Curtiss Distinguished Professor in Agriculture and Emeritus Professor of Economics, Iowa State University, Ames, Iowa, Member of the Iowa Bar, 515-294-6354, harl@iastate.edu