Who Is a Limited Partner? The IRS Issues Sec. 469 Prop. Regs.

By Holly Belanger, J.D., Orlando, Fla., and Jeanne Sullivan, J.D., LL.M., Washington, D.C.

Editor: Mary Van Leuven, J.D., LL.M.

Partners & Partnerships

Despite its importance in assessing an individual’s tax liability, the determination of whether a person is a “limited partner” for federal income tax purposes is often uncertain. Under Sec. 1402, a limited partner is not subject to the Self-­Employment Contributions Act (SECA) tax on the distributive share of income from trade or business activities of the partnership. In addition, the determination of whether income and loss is subject to the passive activity rules of Sec. 469 can hinge on whether the taxpayer is a limited partner.

The meaning of the term limited partner has evolved separately under each of these statutes. Today, however, there is some support for adopting a single meaning for the term for both Secs. 469 and 1402. In addition, beginning in tax year 2013, net income from an individual’s passive trade or business activities may be subject to an additional 3.8% Medicare contribution tax. As a result, the recently proposed regulations under Sec. 469 that provide for a new definition of limited partner have added significance.


Sec. 469 suspends an individual’s net losses from passive trade or business activities and rental activities (unless the individual qualifies under Sec. 469(c)(7) as a real estate professional). A trade or business activity is passive if the individual does not “materially participate” in the activity. An individual is, except to the extent provided by regulations, presumed not to materially participate with respect to any interest in a limited partnership held as a limited partner under Sec. 469(h)(2). Temp. Regs. Sec. 1.469-5T(a) provides seven tests to determine if a taxpayer materially participates in a trade or business activity, and Temp. Regs. Sec. 1.469-5T(e) restricts a limited partner to only three of the seven tests for purposes of determining material participation (the limited partner tests). As a result, it can be significantly more difficult for a limited partner to be considered to be materially participating in a trade or business activity than it is for other taxpayers.

Temp. Regs. Sec. 1.469-5T(e)(3)(i) treats a partnership interest as a limited partnership interest if (1) the interest is designated a limited partnership interest in the limited partnership agreement or the certificate of limited partnership, without regard to whether the partnership interest holder’s liability for the partnership’s obligations is limited under applicable state law; or (2) the partnership interest holder’s liability for the partnership’s obligations is limited, under the law of the state in which the partnership is organized, to a determinable fixed amount (e.g., the sum of the holder’s capital contributions to the partnership and contractual obligations to make additional capital contributions to the partnership).

A limited partner who is also a general partner in the same partnership is not treated as holding a limited partnership interest in that partnership, if that individual holds the general partnership interest at all times during the partnership’s tax year that ends with or within the individual’s tax year (or the portion of the partnership’s tax year during which the individual directly or indirectly holds the limited partnership interest) (Temp. Regs. Sec. 1.469-5T(e)(3)(ii)).

Case Law

As states developed new forms of business entities, the Sec. 469 regulations’ definition of a limited partnership interest generated considerable controversy. In 1986, when Sec. 469 was enacted, no state authorized LLPs and only one state (Wyoming) permitted LLCs. Moreover, in 1997, the classification of noncorporate business entities (such as LLPs and LLCs) as partnerships for federal tax purposes was made elective. Thus, many nontraditional entities are now classified as partnerships for federal income tax purposes. In addition, many state laws now allow individuals to materially participate in an entity’s business and retain limited liability, including limited partners in some limited partnerships. The Sec. 469 regulations were not updated to take these new types of entities into account. As a result, the courts have been confronted with the issue of how to apply the Sec. 469 regulations to partners and members of LLPs and LLCs, respectively.

The first case to address the question was Gregg, 186 F. Supp. 2d 1123 (D. Or. 2000). In Gregg, the court refused to apply the definition in Temp. Regs. Sec. 1.469-5T(e)(3)(i)(B) to LLC members, concluding that the regulations were obsolete because the LLC rules create a new type of business entity materially different from a limited partnership in that LLC members are permitted to actively participate in managing the business. In the next case, Garnett, 132 T.C. 368 (2009), the Tax Court emphasized that it did not find Temp. Regs. Sec. 1.469-5T(e)(3)(i) invalid but instead concluded that the regulation did not apply to the taxpayers in the case who owned interests in several LLPs and LLCs. The court examined the rights and obligations of the partners and members of the LLPs and LLCs and noted that, under state law, partners or members were not restricted from managing or participating in the entities’ businesses. The court reasoned that it was not appropriate to presume that partners or members of such entities do not materially participate in the business because they have limited liability.

The court went on to note that, to determine whether an individual held a general partnership interest as well as a limited partnership interest (for purposes of Temp. Regs. Sec. 1.469-5T(e)(3)(ii)), it would be necessary to inquire into the nature and extent of the partner’s or member’s authority to act on behalf of the entity. Because this inquiry is “closely akin to factual inquiries appropriately made under the general tests for material participation,” the court concluded it was appropriate to treat interests in an LLP and LLC as general partnership interests for purposes of Sec. 469.

Subsequently, Thompson, 87 Fed. Cl. 728 (2009), used a different rationale to find for the taxpayer. In Thompson, the taxpayer owned 99% of an LLC treated as a partnership directly and 1% through a wholly owned subchapter S corporation. The parties stipulated that, if the taxpayer could use all seven material participation tests, the losses generated by the LLC would be nonpassive, but if the taxpayer were treated as a limited partner, the losses would be passive activity losses. The court concluded that, for Sec. 469(h)(2) and the regulations to apply, the taxpayer must actually be a limited partner in a state-law limited partnership (see also Newell, T.C. Memo. 2010-23; and Hegarty, T.C. Summ. Op. 2009-153). The IRS acquiesced only in the result in Thompson (AOD 2010-02).

The Proposed Regulations

On Nov. 28, 2011, the IRS issued proposed regulations that would change the definition of a limited partner for purposes of Sec. 469(h)(2) (REG-109369-10). The regulations clarify that an interest in an entity such as an LLC or LLP can be a “limited partnership interest” for purposes of Sec. 469 (Prop. Regs. Sec. 1.469-5(e)(3)(i)(A)).

In the proposed regulations, the IRS no longer focuses on determining whether an interest is a limited partnership interest; instead, the focus is on the holder’s right to manage the entity. If the holder of an interest in an entity classified as a partnership for federal income tax purposes under Regs. Sec. 301.7701-3 does not have the right to manage the entity at all times during the entity’s tax year under the law of the jurisdiction in which the entity is organized and under the governing agreement, the holder is considered a limited partner (Prop. Regs. Sec. 1.469-5(e)(3)(i)(B)). However, if an individual holds two types of interests in the entity classified as a partnership, and one of the interests is not treated as a limited partnership interest (e.g., a state-law general partnership interest), the individual would not be treated as holding a limited partnership interest (Prop. Regs. Sec. 1.469-5(e)(3)(ii)).

In addition, the proposed regulations provide that the individual can establish material participation in an activity in which the individual owns an interest as a limited partner and thus avoid having the activity treated as a passive activity. The individual can establish material participation by satisfying one of the three tests specified in Temp. Regs. Sec. 1.469-5T(e) (Prop. Regs. Sec. 1.469-5(e)(2)).


Although it is somewhat unclear, the definition of limited partner in the proposed regulations may apply to many more taxpayers than the definition in the current regulations, as interpreted by the courts. Under the proposed regulations, a member of an entity treated as a partnership for federal tax purposes may be treated as a limited partner if the governing agreement does not address the right to manage, if state law provides that the right to manage is wholly dependent on agreement of the members, or if the member’s rights change in connection with management during the tax year. Moreover, the proposed regulations do not define which powers constitute a right to manage and do not explain whether those powers must be exercised directly or may be exercised indirectly or delegated.

Since the regulations are proposed to be effective when final, at the present time, taxpayers can rely on the current regulations and on the IRS’s acquiescence in Thompson . Treasury and the IRS have requested comments on the proposed regulations. It is hoped the regulations will provide clear and workable rules for members of entities treated as partnerships when they are finalized.


Mary Van Leuven is senior manager, Washington National Tax, at KPMG LLP in Washington, D.C.

For additional information about these items, contact Ms. Van Leuven at 202-533-4750 or mvanleuven@kpmg.com.

Unless otherwise noted, contributors are members of or associated with KPMG LLP.

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