Passive Activity Rules Not Presumed to Apply to LLCs and LLPs

By Veronica Valdez, CPA, Holtz Rubenstein Reminick LLP, Melville, NY

Editor: Stephen E. Aponte, CPA

In the Garnett case (132 T.C. No. 19), decided in late June 2009, the Tax Court set precedent for the reporting of losses from LLPs (limited liability partnerships) and LLCs (limited liability companies) by limited liability partners who materially participate in the operations of the businesses in which they are investors.

The taxpayers (Paul and Alicia Garnett) treated the losses from their LLCs, LLPs, and tenancies in common as nonpassive losses and claimed them against income items such as wages and investment income on their 2000, 2001, and 2002 returns. The IRS disallowed certain of these claimed losses on the ground that the petitioners had failed to meet the material participation requirements of Sec. 469, and it assessed the Garnetts over $400,000 in taxes and penalties, leading to this three-year Tax Court battle.


The Garnetts, business entrepreneurs from Nebraska, were investors in LLPs and LLCs that engaged in agribusiness (poultry, eggs, and hogs). They also owned interests in other business ventures that they characterized as tenancies in common.

The LLP agreements provided that each partner would actively participate in the control, management, and direction of the partnership’s business. The agreement also provided that no partner would be liable for the partnership’s debts or obligations. The LLPs issued Schedules K-1 to Mr. Garnett identifying him as a limited partner.

The LLC operating agreements provided that the business was to be conducted by a manager, to be elected by the LLC members, who among other responsibilities was to “effectuate . . . the regulations and decisions of the Members.” Mr. Garnett was not a managing member of the LLCs. The LLC Schedules K-1 identified Mr. Garnett as a “limited liability company member.”


Before this case, the IRS did not distinguish between limited partnerships (LPs) and LLCs and LLPs for purposes of applying the Sec. 469 passive loss rules. Under Sec. 469(h)(2), interests in limited partnerships held as limited partners are presumptively passive. Sec. 469(h)(2) was adopted in 1986, predating the existence of LLPs (which did not come into existence until 1991) and most LLCs (only one state had an LLC statute in 1986). Temporary regulations issued in 1988 (Temp. Regs. Sec. 1.469-5T(e)) also made no explicit reference to LLPs or LLCs. The issue in this case was whether Sec. 469(h)(2) applies to LLP and LLC interests.


Sec. 469(a) limits the deductibility of losses from certain passive activities of individual taxpayers. Passive losses disallowed in one year generally may be carried over to the next year. A passive activity is generally defined as a trade or business in which the taxpayer does not materially participate. Material participation is defined as regular, continuous, and substantial involvement in the business operations (Sec. 469(h)(1)). The regulations provide seven tests to determine if a taxpayer meets the material participation requirement. However, under Sec. 469(h) (2), an interest in a limited partnership as a limited partner is treated as presumptively passive. Under Temp. Regs. Sec. 1.469-5T(e), a taxpayer can overcome this presumption but is allowed to do so using only three of the seven regulatory tests for material participation that are ordinarily available.

The Garnetts challenged the IRS’s position that Sec. 469(h)(2) applied to LLP and LLC interests; however, they did not have specific guidance that would enable them to show that LLP and LLC partners could be general partners with limited liability and not just limited partners. Neither the Code nor the regulations provide a general definition of a limited partner.

The Garnetts asked the Tax Court to interpret the term literally and to conclude that a member of an LLC or an LLP could not be a limited partner because neither the LLP nor the LLC is, strictly speaking, a limited partnership. The Service argued that the differences in treatment between an LP and LLCs/LLPs are “irrelevant,” and the only relevant consideration is that the Garnetts enjoyed limited liability with respect to their ownership interests. Because of this, their interests in the LLCs and LLPs are really limited partnership interests. The Tax Court rejected both their arguments, taking the position that whether the Garnetts’ LLP and LLC interests should be treated as limited partner interests depended on whether the general partner exception of Temp. Regs. Sec. 1.469-5T(e)(3)(ii) applied to them.

The general partner exception says that a partnership interest will not be treated as a limited partnership interest (i.e., presumptively passive) if the individual is a general partner in the partnership. The exception applies when a partner in a state law partnership possesses dual limited and general partnership interests, but it is not confined to those situations. The IRS argued that in the case of an LLP or LLC, the availability of this exception depends on the extent of authority and control that the LLP or LLC member enjoys. The Garnetts were not precluded under state law from actively participating in the management and operations of the LLCs and LLPs; however, the Service argued that the partnership agreements did not give the Garnetts “the authority to take action on behalf of the partnership as a general partner would.”

The Tax Court found that the IRS was asking it to make threshold factual inquiries into the nature and extent of the Garnetts’ authority to take action on behalf of the LLCs and LLPs and that these inquiries seemed closely similar to factual inquiries made under the general tests for material participation. It held that making these inquiries in determining whether Sec. 469(h)(2) applied would “tend to blur that special rule and the general rules for material participation in a manner that is at odds with the statutory framework and legislative intent.”

Instead, the Tax Court looked at the rationale for Sec. 469(h)(2) to make its decision. It found that

members of L.L.P.s and L.L.C.s, unlike limited partners in State law limited partnerships, are not precluded 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. That factual inquiry is appropriately made, we believe, pursuant to the general tests for material participation under section 469 and the regulations thereunder.
Therefore, the Tax Court held that the Garnetts “held their ownership interests in the LLPs and LLCs as ‘general partners’ within the meaning of the temporary regulations” and that under the general partner exception to Sec. 469(h)(2), the Garnetts’ interests in the LLPs and LLCs would not be treated as presumptively passive.


The Tax Court’s decision is a welcome one for taxpayers holding LLP or LLC interests, making it possible for these taxpayers to treat them as nonpassive activities. However, there is a price that comes with it. Partners in LLPs and LLCs that show profits have in the past claimed that such income was not subject to selfemployment tax under Sec. 1402(a)(13), which excludes a limited partner’s distributive shares from self-employment earnings. This position will be much harder to take as a result of this case.


Stephen Aponte is a senior manager at Holtz Rubenstein Reminick LLP, DFK International/USA, in New York, NY.

Unless otherwise noted, contributors are members of or associated with DFK International/USA.

For additional information about these items, contact Mr. Aponte at (212) 792-4813 or

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