The Tax Court held that the taxpayers’ interests in their LLPs and LLCs were not presumptively passive because they did not hold their interests in the entities as limited partners in a limited partnership.
Background
Paul and Alicia Garnett owned interests in seven limited liability partnerships (LLPs) and two limited liability companies (LLCs) that were engaged in agribusiness operations, primarily the production of poultry, eggs, and hogs. For the years 2000–2002, the Garnetts reported income and losses from these LLPs and LLCs on their income tax returns as income and losses from activities in which they materially participated. The IRS disallowed some of these losses from each year, asserting that the losses were passive activity losses because the taxpayers had failed to meet the material participation requirements of Sec. 469.
In determining that the losses were passive losses, the IRS took the position that the Garnetts’ interests in the LLPs and LLCs were limited partnership interests that were subject to Sec. 469(h)(2), which treats a limited partner’s losses from an interest in a limited partnership as presumptively passive. The Garnetts challenged the IRS’s determination in Tax Court and asked for a ruling that Sec. 469(h)(2) was not applicable to their interests in the LLPs or LLCs because the entities were not limited partnerships and they held their interests in the entities as general partners.
Sec. 469(h)(2)
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.” The currently applicable temporary regulations under Sec. 469(h) (2) permit a taxpayer to establish material participation in a limited partnership but allow the taxpayer to use only three of the seven regulatory tests. Temp. Regs. Sec. 1.469-5T(e) provides:
(e) Treatment of limited partners—(1) General rule.—Except as otherwise provided in this paragraph (e), an individual shall not be treated as materially participating in any activity of a limited partnership for purposes of applying section 469 and the regulations thereunder to —(i) The individual’s share of any income, gain, loss, deduction, or credit from such activity that is attributable to a limited partnership interest in the partnership; and(2) Exceptions.—Paragraph (e)(1) of this section shall not apply to an individual’s share of income, gain, loss deduction, and credit for a taxable year from any activity in which the individual would be treated as materially participating for the taxable year under paragraph (a)(1), (5) or (6) of this section if the individual were not a limited partner for such taxable year.
(ii) Any gain or loss from such activity recognized upon a sale or exchange of such an interest.
Temp. Regs. Sec. 1.469-5T(e)(3) explains when a partnership interest will be treated as a limited partnership interest and provides an exception, known as the general partner exception, to the rule:
(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(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).
(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).
The Tax Court’s Decision
The Tax Court held that the Garnetts’ interests in the LLPs and LLCs were not subject to Sec. 469(h)(2) because they were excepted from classification as limited partnership interests by the general partner exception in Temp. Regs. Sec. 1.469-5T(e)(3)(ii). Therefore, the interests were not presumptively passive, and the issue of whether the interests in the entities were passive should be determined under the general tests for material participation under Sec. 469 and the regulations.
The Tax Court first addressed the parties’ arguments on the definition of limited partnership interest in Temp. Regs. Sec. 1.469- 5T(e)(3)(i). The IRS argued that although differences existed between LLPs and LLCs and limited partnerships, the differences were irrelevant in this case. According to the IRS, the sole relevant consideration was the liability of the owners of the entity. Because ownership interests in an LLP and an LLC are subject to limited liability, they are limited partnership interests. The Tax Court rejected this argument, noting that this view was undermined by the fact that Sec. 469(h)(2) referred to “an interest in a limited partnership as a limited partner,” not “in a limited partnership interest.” The Garnetts argued that the entities were not limited partnerships under state law, so the limited partnership rule in Sec. 469(h)(2) could not apply. The Tax Court, citing legislative history, found that Congress intended that entities substantively equivalent to limited partnerships be covered by Sec. 469(h) (2), so a literal reading of the statute to rule out all entities except limited partnerships was not appropriate.
The Tax Court then turned its focus from the definition of limited partnership to the general partnership exception in Temp. Regs. Sec. 1.469-5T(e)(3)(ii). The Tax Court found that under the general rule in Temp. Regs. Sec. 1.469-5T(e)(3)(i), an LLP interest or an LLC interest could be considered a limited partnership interest, but if the general partnership exception in Temp. Regs. Sec. 1.469-5T(e)(3)(ii) applied, it would not be treated as a limited partnership interest.
The IRS asserted that the application of the general partnership exception depended on whether the owners had the same authority as a general partner to act on behalf of or bind a partnership. The Garnetts contended that because the law did not preclude them from participating in the activities of the entities and they participated to some extent, the exception should apply. The IRS argued that the actual LLP and LLC agreements did not give the Garnetts the authority to act on behalf of the entities as a general partner, so the exception did not apply.
The Tax Court rejected using this standard altogether, stating that it would require a threshold inquiry close to the one required under the general test for material participation. According to the Tax Court, making such an inquiry would improperly blur the distinction between the special rule for limited partnerships and the general rules for material participation in a manner that was “at odds with the statutory framework and legislative intent.”
To determine if the general partnership exception applied, the Tax Court instead chose to look at the legislative history of Sec. 469(h)(2) to determine why Congress had decided to treat limited partnerships as presumptively passive. It found that Congress’s main consideration “was the legislative belief that [state law] statutory constraints on a limited partner’s ability to participate in the partnership’s business justified a presumption that a limited partner generally does not materially participate and made further factual inquiry into the matter unnecessary.” The Tax Court further found that this rationale for treating a limited partnership interest as presumptively passive did not extend to LLP or LLC interests because there were no statutory constraints on the partners’ or members’ participation in their LLPs or LLCs under state law and it therefore could not be presumed that an LLP partner or LLC member did not materially participate. The appropriate way to determine if the interest was passive, according to the Tax Court, was to apply the general tests for material participation in Sec. 469. Therefore, the Tax Court concluded that “the legislative purposes of the special rule of Sec. 469(h) (2) are more nearly served by treating L.L.P. and L.L.C. members as general partners” and not treating the members’ income and losses as presumptively passive.
Reflections
In a decision released shortly after Garnett, the Court of Federal Claims ruled on the same issue with respect to an interest in an LLC (Thompson, No. 06-211-T (Fed. Cl. 7/20/09)). It also held that an LLC interest should not be treated as a limited partnership interest for purposes of Temp. Regs. Sec. 1.469-5T(e)(3) and that the determination of whether an LLC interest should be treated as passive should be made by applying the general tests for material participation in Sec. 469.
Like the Tax Court, the Court of Federal Claims found that the presumptively passive treatment that applied to a limited partnership interest should not be extended to an LLC interest because of the differences between the entities regarding the participation of members or partners. However, contrary to the Tax Court, the Court of Federal Claims also found that an LLC interest could not be subject to Temp. Regs. Sec. 1.469-5T(e)(3)(i)(B) because an LLC was not organized as a partnership under state law and a member of an LLC was not a limited partner as is literally required under the regulation.
Garnett, 132 T.C. No. 19 (2009)
