LLCs, LLPs, and the Passive Loss Rules

Since the early 1990s, limited liability company (LLC) and limited liability partnership (LLP) entities have been popular vehicles in which to structure a business. Their popularity is due to the fact that they can be used to limit personal liability and to avoid double taxation.

Sec. 469(h)(2) treats a limited partner’s losses from an interest in a limited partnership as presumptively passive. The IRS has taken the position that a taxpayer who is a member of an LLC or LLP that is taxed as a partnership should be treated as a limited partner and therefore any losses passed through to the member are passive activity losses. This is to the taxpayer’s disadvantage because it delays the deduction of losses and increases the amount of taxes currently paid by business owners.

In Thompson, No. 06-211 T (Fed. Cl. 7/20/09), the Court of Federal Claims held that an ownership interest in an LLC should not be treated as presumptively passive under Sec. 469 for two main reasons. First, the court found that Temp. Regs. Sec. 1.469-5T(e) applied only to an entity organized as a limited partnership under state law. Second, the court held that the rationale for treating limited partnership interests as presumptively passive did not apply to LLC interests because an LLC member, unlike a limited partner, is not statutorily prohibited from participating in the entity’s affairs. Therefore, it is possible that an LLC member could materially participate in an LLC’s business, making the passive activity presumption improper.

Background of the Case

In the Thompson case, the taxpayer owned an airline charter that operated as an LLC under Texas state law. The business, Mountain Air Charter, LLC, was owned 99% by the taxpayer directly; the remaining 1% was owned by JRT Holdings, Inc., an S corporation, which was also owned by the taxpayer. During 2002 and 2003, the company incurred substantial losses, which the taxpayer used to offset ordinary income on his personal tax return. On audit, the IRS took the position that the LLC was a limited partnership for purposes of Sec. 469(h)(2), which was accordingly subject to the passive activity rules of Sec. 469. Therefore, the losses had incorrectly been deducted.

The IRS’s Position

The IRS based its position on Temp. Regs. Sec. 1.469-5T(e)(3)(i):

(3) Limited partnership interest (i) In general.—Except as provided in paragraph (e)(3)(ii) of this section, for purposes of section 469(h)(2) and this paragraph (e), a partnership interest shall be treated as a limited partnership interest if—(A) 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 (B) 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 (for example, the sum of the holder’s capital contributions to the partnership and contractual obligations to make additional capital contributions to the partnership).

According to the IRS, because the LLC had limited liability, the LLC interest was a “partnership interest [that] shall be treated as a limited partnership interest” for purposes of Sec. 469(h)(2), and therefore the interest should be treated as an interest in a passive activity.

The Court’s Holding

The Court of Federal Claims found that Sec. 469(h)(2) and the regulations made it clear that a limited partnership interest must be an interest in an entity established under state law as a limited partnership and not merely an entity that elects to be taxed as a partnership. As set forth in Temp. Regs. Sec. 1.469-5T(e)(3)(i)(A), “Such interest [must be] designated a ‘limited partnership interest’ in the limited partnership agreement or the certificate of limited partnership” in order to be considered a limited partnership. Because Mountain Air Charter was a valid Texas LLC, not a limited partnership, the court held that an interest in Mountain Air should not be treated as a limited partnership interest for purposes of Sec. 469.

The court also addressed the application of the general partnership exception in Temp. Regs. Sec. 1.469-5T(e)(3)(ii), which states:

(ii) 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 (or portion of the partnership’s taxable year during which the individual (directly or indirectly) owns such limited partnership interest).

The court found that whether the exception applied depended on the potential for participation in the entity. According to the court, the rationale for treating a limited partnership interest as presumptively passive did not extend to LLC interests because there were no statutory limitations on the partners’ or members’ participation in an LLC under state law, and it therefore could not be presumed that an LLC member did not materially participate.

This led the court to conclude that it was inappropriate to presume that the interests in an LLC were passive. Therefore, the court held that Thompson’s interest should be treated as a general partnership interest that was covered by the exception in Temp. Regs. Sec. 1.469-5T(e)(3)(ii). In Thompson’s case, because the parties had stipulated that Thompson would meet the material participation requirements of Sec. 469 with respect to Mountain Air Charter if Temp. Regs. Sec. 1.469-5T(e) (3) did not apply, the court held that Thompson’s losses from the LLC were not limited.

In making its holding on the general partnership exception, the court cited with approval the Tax Court’s decision in Garnett, 132 T.C. No. 19 (2009), which was issued shortly before the decision in the Thompson case. In Garnett, the Tax Court addressed the same issue as in Thompson with respect to both LLC and LLP interests. While the Tax Court agreed with the Court of Federal Claims on the application of the general partnership exception, it did not agree that an LLC interest should not be treated as a limited partnership interest because an LLC is not a limited partnership under state law. The Tax Court concluded that Congress had contemplated that entities that are substantially equivalent to limited partnerships are considered presumptively passive under Sec. 469(h)(2), so an LLC interest was not excepted from Sec. 469(h)(2) simply because it was not a limited partnership under state law.

Conclusion

These holdings favor LLC members’ ability to take losses currently. In 2009, practitioners probably have many clients with LLCs that have incurred substantial losses either in the current year or in prior years. One way to assist these clients is to reevaluate the position taken on prioryear tax returns to see if losses have been suspended. If losses are substantial, it may be worth the time and cost to amend those returns. However, since there is a higher risk of audit when returns are amended, a practitioner’s best practice would be to sit down with the client and document, in either a written memo or a flow chart, the flowthrough of income and losses and the client’s participation in those companies.

EditorNotes

Mark Cook is a partner at Singer Lewak LLP in Irvine, CA.

Unless otherwise noted, contributors are members of or associated with Singer Lewak LLP.The editor would like to offer a special thanks to Jennifer Allison, J.D., for her assistance with this column.

For additional information about these items, contact Mr. Cook at (949) 261-8600, ext. 2143, or mcook@singerlewak.com.