Limited Partners and Material Participation: A Tax Planning Opportunity

Editors: Mindy Tyson Cozewith, CPA, M.Tax., and Sean Fox, MPA

LLCs & LLPs

On November 25, 2011, the IRS issued proposed regulations (REG-109369-10) that seek to redefine the term “limited partner” for purposes of the passive activity rules of Sec. 469. The proposed regulations generally seek to ensure that members of LLCs and partners of LLPs, other than managing members or managing partners, are treated as limited partners. They also suggest that the IRS may have abandoned its effort to achieve a similar result through litigation under the existing regulations. Accordingly, until the IRS finalizes the new regulations, taxpayers holding interests in LLCs and LLPs may want to revisit whether their losses may qualify as active rather than passive.

Previous Treatment of Losses from an Interest in a Limited Partnership

If a taxpayer does not materially participate in a trade or business, Sec. 469 treats the losses or credits from it as passive. As a result, they may generally only be used against passive income or upon the disposition of the activity. Limited partners in limited partnerships have an additional hurdle to prove that they are “materially participating.” Sec. 469(h)(2) provides that “no interest in a limited partnership as a limited partner shall be treated as an interest with respect to which a taxpayer materially participates,” except as otherwise provided by regulations.

The existing regulations allow even a limited partner to qualify by participating for more than 500 hours, but they prohibit limited partners from qualifying under several other tests that are available to sole proprietors or partners other than “limited partners.” Those alternative tests include the ability to aggregate several partnerships and the ability to qualify under some circumstances with as little as 100 hours or more (see Temp. Regs. Sec. 1.469-5T).

For taxpayers who cannot qualify under the 500-hour test, but might qualify under the more liberal test applicable to nonlimited partners, this may be a good time to review whether they “fail” the definition of a limited partner—and thus qualify for the more liberal tests—under the current regulations and the cases interpreting them.

Challenges to the Material Participation Rules

Within the past 10 years, several cases were decided rejecting the IRS position that members of LLCs were limited partners for purposes of Sec. 469.

Gregg: In Gregg, 186 F. Supp. 2d 1123 (D. Or. 2000), the taxpayer was a member of an LLC. The court stated that, because the regulations were silent as to the treatment of LLC members, the limited partner exception in Sec. 469(h)(2) could not be applied to require the higher standard of participation that applied to limited partners. The court looked to state law to determine the nature of Gregg’s partnership interest and concluded that state law in Oregon distinguished limited partner status from general partner status based on a taxpayer’s control rather than his liability. Since the taxpayer could control the partnership, the court treated him as a general partner. Apparently, even the new proposed regulations accept the premise of focusing on control rather than limited liability under state law.

Garnett: In Garnett, 132 T.C. 368 (2009), the taxpayers held LLP and LLC interests through ownership in other LLCs and treated the losses as losses from a general partnership. The Tax Court noted that partners in LLPs or LLCs were not automatically constrained from participating in management and therefore should not be presumed to lack material participation. Accordingly, the Tax Court ruled that the taxpayers’ interests were the equivalent of general partnership interests, not limited partnership interests.

Thompson: In Thompson, 87 Fed. Cl. 728 (2009), the taxpayer owned 99% of an LLC directly and the remaining 1% through a wholly owned S corporation. The court ruled that the taxpayer’s interest would best be categorized as a general partnership interest under Temp. Regs. Sec. 1.469-5T(e)(3)(ii). Additionally, the court ruled that the taxpayer did not have to prove material participation under one of the seven Temp. Regs. Sec. 1.469-5T(a) tests because the IRS had stipulated that, if the taxpayer did not hold a limited partnership interest under Temp. Regs. Sec. 1.469-5T(e)(3), he could prove material participation. The IRS issued Action on Decision 2010-02, acquiescing to the result only.

Newell: Following the precedent that was set in Garnett, the Tax Court in Newell, T.C. Memo. 2010-23, ruled that the taxpayer, an LLC member, functioned as a general partner and therefore qualified for the general partner exception under Temp. Regs. Sec. 1.469-5T(e)(3)(ii).

Effect on Current LLCs and Limited Partnerships

Since the proposed regulations do not become effective until the date they are finalized, the current law and guidance from the court cases discussed above remain in effect and should be considered. Of course, taxpayers should seek the guidance of a qualified tax adviser.

EditorNotes

Mindy Tyson Cozewith is a director, Washington National Tax in Atlanta, and Sean Fox is a director, Washington National Tax in Washington, DC, for McGladrey & Pullen LLP.

For additional information about these items, contact Ms. Cozewith at (404) 751-9089 or mindy.cozewith@mcgladrey.com.

Unless otherwise noted, contributors are members of or associated with McGladrey & Pullen LLP.