In recent decisions, the Tax Court and the Court of Federal Claims have held that interests in a limited liability company (LLC) that elects to be treated as a partnership for federal income tax purposes should not be treated as limited partnership interests per se. Consequently, determining how a member of an LLC electing partnership taxation will be treated for federal income tax purposes in a year that the LLC has losses is a matter of determining whether the member materially participated in the business activity of the LLC in the tax year at issue.
In 1997, in Prop. Regs. Sec. 1.1402(a)-2, Computation of Net Earnings from Self-Employment, the IRS attempted to define when an individual would be deemed a limited partner and thus to clearly distinguish when individuals would be treated as general partners for self-employment tax purposes. Congress reacted adversely to the proposed regulation and passed legislation in the Taxpayer Relief Act of 1997 that placed a moratorium on temporary and final regulations affecting the definition of limited partner under Sec. 1402(a)(13). 1 The moratorium prohibited any administrative action on the matter by the IRS before July 1, 1998. The moratorium expired more than a decade ago, but Congress has not enacted legislation on the issue, and Treasury has not taken further steps to finalize the proposed regulation.
The IRS has challenged the classification of an LLC member as a general partner when there is a flowthrough of losses to the member. In recent court cases the IRS has argued that interests in LLCs electing to be taxed as partnerships are limited partnership interests for purposes of the passive activity rules under Sec. 469 and the regulations and that losses passed through to LLC members should be deemed passive regardless of whether the member materially participated in the LLC’s activities. However, the analysis and decisions in several recent cases support the proposition that the tax treatment of a member’s distributive share of LLC losses should be determined based on the level of the member’s participation in the LLC’s activities. In the absence of either legislation or further Treasury regulations regarding the classification of LLC members, these court decisions provide authority on the classification of members’ interests in an LLC and the taxation of their distributive shares of LLC earnings and losses. 2
Electing Partnership Classification for Federal Income Tax Purposes
Since LLCs are not organized as either C corporations or partnerships under state laws, initially there was a great deal of uncertainty about how an entity organized as an LLC would be treated for federal income tax purposes. In 1988, the IRS issued its first revenue ruling on the subject, 3 which provided that an LLC lacking a “preponderance” of the characteristics of a corporation would be classified as a partnership for federal income tax purposes. Following the determination that LLCs could be structured to be taxed as partnerships, the LLC emerged as a popular entity choice. As more states began to allow the LLC entity form, the IRS responded to numerous requests for private letter rulings on the tax status of LLCs. In 1997, the IRS issued the check-the-box regulations, 4 which permit owners of unincorporated business entities to elect how their organizations will be classified for federal income tax purposes. LLCs with two or more members no longer need to avoid having a preponderance of corporation characteristics but can simply elect to be treated as partnerships for federal income tax purposes. 5
An LLC can also elect to be taxed as an association—i.e., a corporation—for federal income tax purposes. 6 If a single-member LLC does not elect to be taxed as an association, it is “disregarded as an entity separate from its owner and treated as a sole proprietorship for federal income tax purposes.” 7 If a domestic multimember LLC fails to make an election, it will be taxed as a partnership. 8
The issuance of the check-the-box regulations seemed to put to rest the issue of how an LLC member would be treated for federal income tax purposes. LLCs motivated by the desire to reduce taxes by the passthrough of earnings to members could achieve that result with certainty by merely electing to be taxed as partnerships. However, the elimination of double taxation by the passthrough of earnings to members, who would now be treated as partners for federal income tax purposes, is offset by the treatment of net earnings attributed to partners as earnings subject to the self-employment tax.
Regs. Sec. 301.7701-3 does not address whether an LLC making a partnership election is considered a general partnership or a limited partnership for federal income tax purposes and whether LLC members are considered general or limited partners. Therefore, being permitted to elect to be taxed as a partnership did not settle the issue of whether the net earnings or losses attributed to members of LLCs that make such an election are earnings subject to self-employment tax, active losses deductible against ordinary income, passive earnings not subject to self-employment tax, or passive losses subject to passive loss limitations.
Following the issuance of the check-the-box regulations, whether an LLC member’s share of net earnings or losses were treated as active or passive for federal income tax purposes continued to be determined by the existing statutes and related regulations that address earnings from self-employment and interests in passive activities.
General Statutory and Administrative Provisions
In general, Sec. 1402 imposes self-employment taxes on the net income from any trade or business carried on by an individual. The definition of income from self-employment includes not only the income of sole proprietors but partnership income that is attributed to general partners, whether it is actually distributed or not. 9 Sec. 1402(a)(13) further provides that earnings from partnerships that are attributed to a limited partner are excluded from the definition of self-employment income unless the limited partner receives a guaranteed payment for services rendered to or on behalf of the partnership. 10 However, neither the Code nor the regulations provide a definition of “limited partner.” 11
In attempting to determine whether LLC members more closely resemble general partners or limited partners, the contention that members should be regarded as limited partners when an LLC elects to be taxed as a partnership is supported by the fact that members (1) generally have limited liability in that they are not personally liable for the debts of the LLC unless they personally guarantee them and (2) are not liable for wrongful conduct attributed to the entity, although they are potentially liable for their personal misconduct in the performance of duties on behalf of the company. 12 However, since LLC members, unlike limited partners in most states, are allowed to actively participate in the management of companies in which they are members, there is also considerable support for the proposition that they resemble general partners. The IRS chose to address the issue through regulation.
Prop. Regs. Sec. 1.1402(a)-2
In an attempt to clarify the tax treatment of an LLC member’s distributive share of earnings, the IRS in 1997 issued Prop. Regs. Sec. 1.1402(a)-2. The proposed regulation set forth guidelines to determine whether an individual who owns a partnership interest should be treated as a limited partner rather than a general partner by defining when an individual who owns an interest in a partnership would be treated as a limited partner for federal tax purposes. Although the proposed regulation did not specifically address LLCs, the IRS intended the definition of a limited partner in the proposed regulation to apply to members of an LLC that elects to be taxed as a partnership.
Prop. Regs. Sec. 1.1402(a)-2(h)(2) provides that an individual who owns an interest in a partnership will be regarded as a limited partner for self-employment tax purposes unless the individual:
- Has personal liability (as defined in §301.7701-3(b)(2)(ii) of this chapter) for the debts of or claims against the partnership by reason of being a partner;
- Has authority (under the law of the jurisdiction in which the partnership is formed) to contract on behalf of the partnership; or
- Participates in the partnership’s trade or business for more than 500 hours during the partnership’s taxable year.
As noted above, Congress rejected the proposed definition by enacting a moratorium providing that “no temporary or final regulation with respect to the definition of a limited partner under section 1402(a)(13) of the Internal Revenue Code of 1986 may be issued or made effective before July 1, 1998.” 13 Congress believed that Treasury should withdraw the proposed regulation defining limited partner. 14 Since then, Congress has passed no legislation on the issue, and Treasury has chosen not to finalize the regulation. 15
Under most state laws, limited partners are merely investors and are generally forbidden by state law from participating in the management of a partnership as a condition for limiting their liability to their investment in the partnership. 16 While the avoidance of self-employment tax on earnings is the upside of classifying LLC members as limited partners, such a classification has a corresponding downside. In the event that an LLC that has made an election to be taxed as a partnership suffers a taxable loss for the year, that loss is a passive loss for LLC members treated as limited partners, and generally passive losses are deductible only to the extent of passive income. 17
The question of whether losses of members of LLCs treated as partnerships for federal income tax purposes were passive losses was the primary issue in several relatively recent court decisions (discussed below). The reasoning of the courts in these cases may provide some guidance on the classification of LLC member interests, which is undoubtedly the key determinant as to whether members’ distributive shares of LLC earnings are subject to self-employment tax. In these decisions, the courts analyzed Sec. 469 and its corresponding regulations in making their determinations of the classification of LLC members as general or limited partners for purposes of the passive activity rules.
In Prop. Regs. Sec. 1.1402(a)-2, Treasury took the position that determining whether an individual should be treated as a limited partner or a general partner for self-employment tax purposes should depend on the individual’s personal liability, his or her authority to contract on behalf of the partnership, and his or her participation in the partnership. However, in the absence of temporary or final regulations, the courts that have been asked to decide this issue have held that the determination should be made through the application of existing statutes and related regulations.
Sec. 469 prescribes when a taxpayer’s participation in an activity is passive. Generally, a passive activity is any trade or business activity in which the taxpayer does not materially participate. 18 The language in the statute does not restrict the application of the statute to partnerships. Material participation requires a taxpayer’s regular, continuous, and substantial involvement in the trade or business activity. 19 Temp. Regs. Sec. 1.469-5T(a) provides a set of practical tests to determine whether or not the taxpayer has met the material participation standard.
Temp. Regs. Sec. 1.469-5T
A taxpayer will be considered to have materially participated in a business activity if he or she meets one of the seven tests in Temp. Regs. Secs. 1.469-5T(a)(1)–(7):
- The individual participates in the activity for more than 500 hours during the year;
- The individual’s participation in the activity for the tax year constitutes substantially all the participation in that activity of all individuals (including individuals who are not owners of interests in the activity) for the year;
- The individual participates in the activity for more than 100 hours during the tax year, and the individual’s participation in the activity for the tax year is not less than the participation in the activity of any other individual (including individuals who are not owners of interests in the activity) for the year;
- The activity is a significant participation activity for the tax year, 20 and the individual’s aggregate participation in all significant participation activities during the year exceeds 500 hours;
- The individual materially participated in the activity for any five tax years (whether or not consecutive) during the ten tax years that immediately precede the tax year;
- The activity is a personal service activity, 21 and the individual materially participated in the activity for any three tax years (whether or not consecutive) preceding the tax year; or
- Based on all the facts and circumstances, the individual participates in the activity on a regular, continuous, and substantial basis during the year.
As long as an individual meets any one of these tests, he or she generally is regarded as having materially participated in the business activity to which the test was applied. However, a special rule in Sec. 469(h)(2) applies to interests in limited partnerships as defined in Temp. Regs. Sec. 1.469-5T(e)(3).
Sec. 469(h)(2) and Temp. Regs. Sec. 1.469-5T(e)(3)
Sec. 469(h)(2) states: “Except 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” (emphasis added). Temp. Regs. Sec. 1.469-5T(e)(3) explains when a partnership interest will be treated as a limited partnership interest for this purpose and provides an exception, known as the general partner exception, to the rule. Temp. Regs. Sec. 1.469-5T(e)(3) provides in part that:
- . . . a
partnership interest shall be treated as a limited
partnership interest if—
- Such interest is designated a limited partnership interest in the limited partnership agreement or the certificate of limited partnership, without regard to whether the liability of the holder of such interest for obligations of the partnership is limited under the applicable State law; or
- The liability of the holder of such interest for obligations of the partnership is limited, under the law of the State in which the partnership is organized, to a determinable fixed amount. . . .
- Limited partner holding general partner interest. A partnership interest of an individual shall not be treated as a limited partnership interest for the individual’s taxable year if the individual is a general partner in the partnership at all times during the partnership’s taxable year ending with or within the individual’s taxable year. [Emphasis added]
In deciding whether a member’s interest in an LLC electing partnership taxation should be treated as an interest in a passive activity, the courts have consistently held that the determination should be made by applying the general tests for material participation as provided in Temp. Regs. Sec. 1.469-5T(a) to the member’s activities in the tax year in question.
In 2000, in Gregg, 22 a federal district court in Oregon considered whether an LLC member should be regarded as a limited partner or a general partner for purposes of the passive activity rules under Sec. 469. The court observed that the case was one of first impression on the issue.
On November 4, 1994, Stephen Gregg sold his majority interest in Ethix Corporation, a managed health care company that provided insurance companies access to health care professionals. Shortly thereafter Gregg started Cadaja, an LLC that gave insurance companies access to practitioners of alternative medicine. For the year ended December 31, 1994, Cadaja was taxed as a partnership and passed through a loss of $230,723 to Gregg, who reported it as an ordinary loss on his 1994 federal income tax return, which he filed jointly with his wife. An IRS audit of the Greggs’ 1994 return resulted in the loss from Cadaja being recharacterized as a passive loss, which could be used only to offset passive income. The IRS assessed a deficiency of $91,366 plus interest and penalty. The Greggs paid the $91,366 and part of the interest and penalty, filed for a refund (which was denied), and then sued in district court for a refund of the deficiency, interest, and penalty that they had paid.
The taxpayers argued that since Oregon law places no restrictions on their right to participate in the management of the company (unlike limited partners), all the members of Cadaja should be treated as general partners. As such, the losses passed through from the company would qualify as ordinary losses that the members could use to offset ordinary income. The IRS argued that because all the members of Cadaja had limited liability under Oregon law, they should all be regarded as limited partners, with all their losses being appropriately categorized as passive losses. This argument was based simply on limited liability and therefore the standard applied was more narrow in scope than the standard in Prop. Regs. Sec. 1.1402(a)-2.
The court responded to these arguments by observing that Oregon law required limited partnerships to have at least one general partner, and that requirement was not satisfied in Gregg because every member of the LLC had limited liability. 23 Moreover, the court agreed with Gregg’s contention that the members of the LLC should not be regarded as limited partners because they had an unfettered right to participate in the management of the company, a characteristic that would be fatal to the existence of a limited partnership under Oregon law. 24
Although the court found that the members of LLCs should not be treated as if they were limited partners per se, it did not conclude that they should be universally treated as if they were general partners for purposes of the passive activity rules. Instead the court turned its attention to the seven-part test in Temp. Regs. Secs. 1.469-5T(a)(1)–(7) to determine whether Gregg had materially participated in Cadaja. If, after applying the seven-part test, Gregg was found to have materially participated in Cadaja, the court indicated that he would be treated as if he were a general partner for purposes of the passive activity rules and allowed to take the deduction for his 1994 loss as an ordinary loss. However, if he failed to pass at least one part of the test, he would be regarded as a limited partner for federal tax purposes and his 1994 loss would be a passive loss. 25
The IRS chose to base its argument on the first part of the seven-part test: whether Gregg had participated in the activities of Cadaja for more than 500 hours in 1994. Gregg conceded that because the company had existed for a little less than two months in 1994, he had been able to spend only about 120 hours conducting business for the LLC that year. However, he argued that if his time spent on behalf of the company were calculated on a monthly basis and applied to a 12-month period, he would have easily exceeded the 500-hour requirement. The court rejected his argument on the basis that the regulation did not provide for annualizing the taxpayer’s participation hours for a short year and that allowing taxpayers to annualize would defeat the regulation’s purpose of preventing taxpayers from initiating or acquiring passive activities at the end of a tax year and characterizing the activities as nonpassive.
It did, however, allow him to combine his time spent working on behalf of Ethix Corporation, the company he had sold earlier in 1994, with the time he had spent working on behalf of Cadaja because the activities of the two companies were similar enough to allow them to be treated as a single activity under the grouping provisions of Regs. Sec. 1.469-4(a). As it did when it argued that limited liability should be determinative as to whether a partner should be regarded as a limited partner, the government chose to narrowly construe the issue of whether Gregg had materially participated in the activities of Cadaja in 1994. This is noteworthy inasmuch as participation for more than 500 hours is another of the requirements in Prop. Regs. Sec. 1.1402(a)-2 used to determine whether a taxpayer is a limited partner for federal tax purposes.
Following Gregg, additional cases were decided in 2009 in which the central issue was whether members of entities that were not actually partnerships but chose to be taxed as partnerships would be treated as limited partners or general partners for purposes of the passive activity rules. In Garnett, 26 the taxpayers engaged in agribusiness operations through seven LLPs and two LLCs and also owned two other related business ventures (tenancies in common) that they argued were actually de facto partnerships. The taxpayers held six of their LLP interests through LLCs that they had formed solely for the purpose of holding those LLP interests. The owners of the LLPs were allowed to participate in their management but had no liability for partnership debts or obligations other than that required by the law of the state in which they were formed. The Garnetts were allowed to participate in the management of their holding LLCs, but the two other LLCs in which they owned an interest, which were not holding LLCs, were managed by someone who was selected by a majority vote of the LLC members; neither of the Garnetts served as the managing member of either of these two LLCs.
All the Garnetts’ LLPs, LLCs, and tenancies in common elected to be taxed as partnerships, and each filed Form 1065, U.S. Return of Partnership Income, to report profits and losses. The Schedule K-1 filed with each LLP’s return listed either Garnett or the LLC that held his interest in the LLP as a limited partner. The Schedule K-1 filed with each LLC return identified the appropriate holding company or Garnett as a limited liability company member. The Schedule K-1s filed in connection with the returns filed for the tenancies in common, which were held through a common holding LLC, identified the holding LLC as a general partner for one of the joint ventures but as a limited partner for the other one, despite the fact that there appeared to be little difference between them. The holding LLC held a one-third interest in each of the joint ventures, and they both identified rental real estate as their principal business on their tax returns.
In 2000, 2001, and 2002 some of the Garnetts’ business interests realized income, which they reported on their tax returns as not subject to self-employment tax. In those same years, others of the above-described business interests sustained losses that the Garnetts treated as ordinary losses on their joint tax returns. The IRS challenged the ordinary income deductions that the Garnetts took for some of their reported losses on the grounds that they were passive activity losses.
As it had previously done in Gregg, the IRS argued that the taxpayers’ limited liability alone rendered them the equivalent of limited partners for purposes of the passive activity rules. It also argued that the Garnetts should not be treated as general partners because they did not have authority to take action on behalf of the partnership, which is a position that closely resembles another provision in Prop. Regs. Sec. 1.1402(a)-2. Specifically, Prop. Regs. Sec. 1.1402(a)-2(h)(ii) stipulates that an individual who owns an interest in an entity electing to be taxed as a partnership should be treated as a general partner if he or she has the authority to bind the entity contractually.
The court, however, concluded that Garnett’s ownership interests in several LLCs were exempt from classification as limited partnership interests under the general partner exception in Temp. Regs. Sec. 1.469-5T(e)(3)(ii). 27 In deciding that Sec. 469(h)(2) did not require that members of LLCs should per se be regarded as limited partners when an LLC elects to be taxed as a partnership, the court found that the prerequisite for applying Sec. 469(h)(2) is not simply that there be an “interest in a limited partnership” but that there be an “interest in a limited partnership as a limited partner.” 28 It held that the focus of the statute and regulation on material participation and passive activity indicates that Congress was primarily concerned with the taxpayer’s level of involvement in the activity. There is no test of liability in the statute. The court rejected the IRS’s argument, stating:
We do not believe that this rationale properly extends to interests in L.L.P.s and L.L.C.s. . . . [M]embers of L.L.P.s and L.L.C.s, unlike limited partners in State law limited partnerships, are not barred by State law from materially participating in the entities’ business. Accordingly, it cannot be presumed that they do not materially participate. Rather, it is necessary to examine the facts and circumstances to ascertain the nature and extent of their participation. The factual inquiry is appropriately made, we believe, pursuant to the general tests for material participation under section 469 and the regulations thereunder. 29
As additional defense for its argument, the IRS also contended that the Garnetts obtained a tax benefit by failing to designate their interests as general partner interests on Schedule K-1 and thereby avoided self-employment tax (in prior years) under Sec. 1402(a)(13), which excludes from self-employment earnings certain distributive shares of a limited partner. The Garnetts asserted that the only reason that their interests were designated as limited partner interests was that Schedule K-1 does not list “limited liability partner” as an option. The court held that the way Schedule K-1 describes an interest does not conclusively establish the nature of the partnership interest and any alleged inconsistencies in how the interests were listed on the Schedules K-1 were not material. 30
In Thompson, 31 the Court of Federal Claims was also asked to decide whether owners of an LLC that elected to be treated as a partnership for federal tax purposes should be treated as general partners or limited partners. In 2002, James R. Thompson formed Mountain Air Charter, LLC (Mountain Air). Thompson owned 100% of Mountain Air through a 99% member interest and a 1% interest held by an S corporation of which he owned 100%. Mountain Air’s articles of organization designated Thompson as its only manager. On his 2002 and 2003 individual income tax returns, Thompson claimed losses passed through Mountain Air of $1,225,869 and $939,878, respectively. The IRS disallowed the claimed losses, contending that Thompson held a limited partnership interest in an activity in which he did not materially participate. The IRS argued that Temp. Regs. Sec. 1.469-5T treats interests in any entity that limits liability as a limited partnership interest. Thompson paid the resulting tax deficiency and interest thereon and then sued for a refund.
There was no dispute between Thompson and the IRS regarding the facts of the case. Moreover, they agreed that if Sec. 469 and its related regulations caused Thompson to be considered a limited partner, his level of participation in the management of Mountain Air would be immaterial and his losses would be passive. However, if Sec. 469 and its regulations did not cause him to be a limited partner per se, his level of participation in the management of Mountain Air would unquestionably result in his being treated as a general partner for federal tax purposes.
The issues before the court were therefore (1) whether a member interest in an LLC electing partnership taxation is a limited partnership interest and (2) what the proper application of Temp. Regs. Sec. 1.469-5T(e)(3) was in the determination. Both parties moved for partial summary judgment. However, the court observed that its ruling would determine the outcome of the case and concluded that the motions were effectively for full summary judgment rather than partial summary judgment. 32
As it had done previously in both Gregg and Garnett, the IRS argued that because Mountain Air was taxed as a partnership for federal tax purposes 33 and Thompson’s liability was limited under state law, the LLC should be regarded as a limited partnership and its owner should be treated as a limited partner for passive activity loss purposes. The IRS asserted that at the time Sec. 469 was enacted and Temp. Regs. Sec. 1.469-5T was promulgated, there was universal agreement among the states that the deciding feature of a limited partnership interest was limited liability. Thompson countered by pointing out that it was simply not possible for him to be a limited partner because Mountain Air was not a limited partnership.
The court rejected the government’s argument, noting that when Congress passed Sec. 469 the limited partnership was not a novel business entity and that almost every state had adopted some form of the Uniform Limited Partnership Act or the Revised Uniform Limited Partnership Act. Both of the uniform acts provide that a limited partner’s level of participation in the business determines whether he or she enjoys limited liability, but the converse is not true for individuals who do not hold limited partner interests. According to the court, “the surrounding statutory and regulatory framework does not support a ‘dividing line between the two types of [partnership] interests [based on] limited liability,’ . . . but rather a dividing line based on participation.” 34
In reaching its decision in the case, the court followed the Supreme Court’s opinion in Chevron, 35 which supports the proposition that regulations of federal agencies, such as the IRS, should be given deference by the courts because the expertise of the agencies generally exceeds that of the courts in matters over which those agencies have control. In Chevron, the Supreme Court states that “[i]f the intent of Congress is clear, that is the end of the matter; for the court, as well as the agency, must give effect to the unambiguously expressed intent of Congress.” 36
The Court of Federal Claims then looked to the relevant provision, Sec. 469(h)(2), which states that “[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” (emphasis added), and found the language to be unambiguous. The court also found the intent of Temp. Regs. Sec. 1.469-5T to be clear in that it requires an analysis of the law under which the partnership is organized, thereby requiring that a limited partner interest be an ownership interest in a business entity that is, in fact, a partnership under state law (not merely taxed as such under the Code) and that there be an interest in a limited partnership as a limited partner, not simply an interest in a limited partnership. 37 Once the court in Thompson determined that neither Sec. 469 nor the regulations caused Thompson to be regarded as a limited partner simply because he had limited liability—a determination that the court noted was consistent with the holdings of the courts in both Gregg and Garnett—it was then duty bound to decide for Thompson. 38
In February 2010, in Newell, 39 the Tax Court again addressed the issue of whether a member of an LLC that elected to be taxed as a partnership would be treated as a limited partner or a general partner for purposes of the passive activity rules. Neither party disputed that during the years in question Newell had been the managing member of an LLC that owned and operated a country club and had materially participated in the management of a company that produced millwork. Newell was also personally liable for the outstanding loan obligations of the country club. In spite of these facts, the IRS disallowed the Newells’ deduction of ordinary losses passed through from those activities on their federal income tax return. The IRS once again argued that Newell had to be treated as a limited partner because he had an interest in a limited partnership. The court rejected this argument because the business entities that generated the losses were not actually limited partnerships. Because the IRS had already conceded that Newell would pass the material participation test set forth in Temp. Regs. Sec. 1.469-5T(c), and because Sec. 469(h)(2) does not render Newell a limited partner, the court ruled in favor of the Newells.
A Recent Development
Just prior to the Newell decision, Dianna Miosi, special counsel, IRS Office of Associate Counsel (Passthroughs and Special Industries), commented in a presentation at the District of Columbia Bar Taxation Section that despite the 1998 moratorium that Congress used to block Prop. Regs. Sec. 1.1402(a)-2, taxpayers can still rely on the regulation. Miosi is quoted as saying that “[i]f you structure a transaction so that you’re within the four corners of the proposed regulations, that’s a reasonable position and we’re not going to challenge it.” 40 Furthermore, in reference to the outcomes of recent cases such as those discussed above, she observed that “[t]he Service—with this string of losses—is looking at these cases very closely,” adding that, “perhaps today with all the different entities, maybe [the approach in the regulation] isn’t the best test to use.”
Without guidance from Congress or the IRS that specifically addresses taxation of LLC members’ interests, members of LLCs and other entities electing partnership taxation have been faced with uncertainty regardless of whether their distributive shares are passthrough earnings or passthrough losses. Taxpayers seeking to minimize taxes on their passthrough earnings gladly classify themselves as limited partners for federal income tax purposes and exclude all their distributive shares of earnings from self-employment taxes. 41 Conversely, taxpayers with passthrough losses generally would prefer to be classified as general partners so that their losses can be deducted as ordinary losses not subject to passive loss limitations.
In the absence of legislation or a temporary or final Treasury regulation that provides specific guidance on what determines whether a member of an LLC electing to be taxed as a partnership will be treated as a limited partner or general partner for federal income tax purposes, the decisions in Gregg, Garnett, Thompson, and Newell offer judicial guidance on the issue. In these decisions the courts have consistently found that an interest in a limited liability entity that elects to be treated as a partnership for federal tax purposes is not treated as a limited partnership interest for purposes of the passive activity rules under Sec. 469 and the regulations. Rather, the courts have held that the general partner exception in Temp. Regs. Sec. 1.1469-5T(e)(3)(ii) applies to the owner of such an interest and that the classification of an owner’s losses as passive or active should be made on the basis of whether the individual materially participates in the activities of the entity as determined by the seven-part test in Temp. Regs. Sec. 1.469-5T(a).
Although, the courts in the decisions discussed above are all courts of original jurisdiction, the IRS may be willing to accept their interpretation of the law. It recently acquiesced to the decision in Thompson 42 (albeit in result only) and is reportedly working on revised guidance on LLC members who materially participate. 43 However, until such time as Congress or Treasury takes action to fully clarify the LLC member classification issue, practitioners and taxpayers would be well advised to proceed with caution and to carefully consider how an LLC ownership interest will be treated for federal income tax purposes when structuring business entities.
1 Taxpayer Relief Act of 1997, P.L. 105-34, §935.
2 Courts have held that proposed regulations are not entitled to judicial deference and carry no more weight than a position advanced in a brief (see Natomas N. Am. Inc., 90 T.C. 710 (1988), and cases cited therein).
3 Rev. Rul. 88-76, 1988-2 C.B. 360.
4 Regs. Secs. 301.7701-1 through -3.
5 Regs. Sec. 301.7701-3(a).
7 Regs. Sec. 301.7701-3(b)(1)(ii).
8 Regs. Sec. 301.7701-3(b)(1)(i).
9 Sec. 1402(a).
10 Sec. 1402(a)(13).
11 Black’s Law Dictionary defines “limited partner” as a “partner whose liability to third party creditors of the partnership is limited to the amount invested by such partner in the partnership.” General partners, on the other hand, are “personally liable for all debts of the partnership.” Black’s Law Dictionary (West 5th ed. 1979).
12 Note that these are provisions that would generally be applicable across states; however, the laws governing LLCs vary by state.
13 Taxpayer Relief Act of 1997, P.L. 105-34, §935.
14 H.R. Conf. Rep’t 105-220, 105th Cong., 1st Sess. 765 (7/30/97), to accompany the Taxpayer Relief Act, P.L. 105-34.
15 Speaking at a meeting of the District of Columbia Bar Taxation Section, Dianna Miosi, special counsel, IRS Office of Associate Counsel (Passthroughs and Special Industries), indicated that the 1997 proposed regulations continue to represent “the more reasonable or more recent thinking of the Service.” Elliott, “Taxpayers Can Rely on Limited Partner Employment Tax Regs, IRS Official Says,” 2010 TNT 10-2 (January 15, 2010).
16 “A fundamental concept of limited partnerships is that a limited partner may lose limited liability by taking part in control of the partnership.” Garnett, 132 T.C. No. 19 (2009), citing Bromberg and Ribstein, 3 Bromberg and Ribstein on Partnership §11.02(c) (Aspen 1998).
17 Sec. 469(a)(1).
18 Sec. 469(c).
19 Sec. 469(h)(1).
20 That is, the activity is a trade or business activity in which the individual participates for more than 100 hours during the year and it would be an activity in which the individual does not materially participate if material participation were determined without regard to part 4 of the test (Sec. 469(c)).
21 A personal service activity involves the performance of personal services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, or any other trade or business in which capital is not a material income-producing factor (Sec. 469(d)).
22 Gregg, 186 F. Supp. 2d 1123 (D. Or. 2000).
23 Id. at 1127.
24 Id. at 1128.
25 Id. at 1127.
26 Garnett, 132 T.C. No. 19 (2009).
28 Id. The Tax Court in Hegarty, T.C. Summ. 2009-153, citing Garnett, once again found that the government’s reliance on Sec. 469(h)(2) was misplaced and that material participation is determined with reference to any of the seven tests in Temp. Regs. Sec. 1.469-5T(a).
29 Garnett at 221.
30 Id. at 223.
33 Because Mountain Air did not elect to be treated as a corporation for federal tax purposes, by default the Code treats it as a partnership.
34 Thompson, slip op. at 10.
35 Chevron U.S.A., Inc. v. Natural Res. Def. Council, Inc., 467 U.S. 837 (1984).
36 Chevron at 842–843.
38 Quoting Thompson, the Tax Court, in Newell, T.C. Memo. 2010-23, similarly found that Regs. Sec. 1.469-5T(e)(3)(i)(B) “‘literally requires that the ownership interest be in a business entity that is, in fact, a partnership under state law—not merely tax as such under the Code.’”
39 Newell, T.C. Memo. 2010-23.
40 Elliott, “Taxpayers Can Rely on Limited Partner Employment Tax Regs, IRS Official Says,” 2010 TNT 10-2 (January 15, 2010).
41 For a discussion of the self-employment tax impact of these cases, see Ellis and Rosenberg, “Potential Implication of Recent Sec. 469 Court Decisions for Self-Employment Tax Rules,” 41 The Tax Adviser 457 (July 2010).
42 AOD 2010-02 (5/19/10).
43 Robert Crnkovich, senior counsel, Treasury Office of Tax Policy, in remarks to the 26th Annual Texas Federal Tax Institute (113 BNA Daily Tax Report G-4 (June 15, 2010)).
Claire Nash is an assistant professor of accounting at Florida Atlantic University in Boca Raton, FL. James Parker is a professor of business law at Christian Brothers University in Memphis, TN. For more information about this article, contact Prof. Nash at email@example.com.