IRS Proposes New Treatment of LLC Members, Limited Partners Under Passive Loss Rules

The IRS on November 25 issued proposed regulations (REG-109369-10) that would redefine “interest in a limited partnership as a limited partner” for purposes of determining material participation under the Sec. 469 passive loss rules.

Under Sec. 469(h)(2), losses from an interest in a limited partnership are presumptively treated as passive losses by providing that no limited partner in a limited partnership will be treated as materially participating in that interest. This treatment was originally put into the Code at a time when state laws (following the Uniform Limited Partnership Act of 1916) generally forbade limited partners from participating in the control of the partnership.

The IRS notes that under the Revised Uniform Limited Partnership Act of 1985, many states have adopted laws that allow limited partners to participate in the management and control of the partnership without losing their limited liability. In addition, under state LLC laws, LLC members do not lose their limited liability by participating in the management and conduct of the LLC’s business.

Nevertheless, the IRS has treated members of LLCs as limited partners for purposes of this rule. Various courts have disagreed with the IRS and have allowed LLC members to be treated as general partners (and therefore allowed them to prove material participation under the passive loss rules).

With Friday’s proposed regulations, the IRS is changing its position on this issue and more narrowly defining when a partner’s interest will be treated as a limited partnership interest for purposes of the passive activity rules. Under the proposed regulations, an interest in an entity will be treated as an interest in a limited partnership under Sec. 469(h)(2) if:

1. The entity is classified as a partnership for federal tax purposes; and
2. The holder of the interest does not have rights to manage the entity at all times during the entity’s tax year under the law of the jurisdiction in which the entity was organized and under the entity’s governing agreement. Rights to manage include the power to bind the entity.

The IRS emphasizes that these rules are provided solely for purposes of the passive activity rules and not for any other provision that makes a distinction between a general partner and a limited partner.

Comments on the proposed changes are due February 27. The regulations would apply to tax years beginning on or after the date of their publication in the Federal Register.

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