LLC interests as limited partnership interests: sec. 469 revisited.
The focus of recent cases has been on application of the "limited partner" rule of Sec. 469(h)(2) and, based on the specific language contained in Temp. Regs. Sec. 1.469-5T, whether an interest in an LLC should be treated as an "interest in a limited partnership as a limited partner." This issue has been addressed in three court cases (Garnett, Thompson, and Gregg), and in each of these cases the court has rejected the IRS's position. In these turbulent economic times, as passthrough losses mount, all practitioners should keep this issue on their radar screen.
Are LLCs Governed by Limited Partnership Rules?
The battle between practitioners and the IRS seems to be outdated and irrelevant at first glance, based on the original form of limited partnerships governed by Temp. Regs. Sec. 1.469-ST(e)(3). The blue book explanation of the Tax Reform Act of 1986 states:
In the case of a limited partnership interest, except to the extent provided by the regulations, it is conclusively presumed that the taxpayer has not materially participated in the activity. In general, under relevant State laws, a limited partnership interest is characterized by limited liability, and in order to maintain limited liability status, a limited partner, as such, cannot be active in the partnerships business. [Staff of the Joint Committee on Taxation, General Explanation of the Tax Reform Act of 1986 (H.R. 3838, 99th Congress, Public Law 99-S14) (JCS-10-87) 236 (May 4, 1987)]
In both Garnett, 132 T.C. No. 19 (2009), and Thompson, No. 06-211 T (Fed. Cl. 7/20/09), the IRS pointed to the language in Temp. Regs. Sec. 1.469-5T(e) as a foundation to its argument: An LLC member must be treated as a limited partner for purposes of the regulations. However, as the Court of Federal Claims stated in Thompson:
This position strikes the court as entirely self-serving and inconsistent. If an LLC member could hold a limited partner's interest under [section] 1.469-5T(e)(3)(i), then, alternatively, that same member could hold a general partner's interest under [section] 1.469-ST(e)(3)(ii).... Defendant loses sight of what the Treasury Secretary drafted [section] 1.469-5T to define--namely what constitutes "material participation" in an activity.
The pertinent question in Thompson and Garnett is, "Are LLC members permitted to take the tests to establish material participation, or is there a non-rebuttable presumption of nonmaterial participation?" The IRS took the position that the mere fact that LLCs are limited liability entities makes their activities presumptively passive. Both the Tax Court and the Federal Circuit disagreed. In both decisions, the courts looked at whether the rationale for treating limited partnership interests as presumptively passive applied to LLCs. They considered two basic issues:
* Degree of management in the entity; and
* Liability exposure from the entity. Limited partnerships are structured with a clear-cut relationship between these two items; because a limited partner in a limited partnership does not have management responsibilities, he or she will be immune from liabilities in the entity.
Compare current LLCs and their treatment of management and liability exposure to the limited partnerships referred to above. These "hybrid" entities make it increasingly difficult to argue that no management control (LLC members can participate in management) is the basis of liability protection (LLC members enjoy limited liability). The core issue is whether an LLC member holds a "limited partnership interest" for purposes of Sec. 469. The discrepancies between the actual state law treatment of these entities led both the Court of Federal Claims and the Tax Court to conclude that LLCs and limited partnerships were not substantially equivalent entities for this purpose and that there was no justification for presuming LLC interests are passive absent a clear provision in the law requiring such treatment.
One case on this topic that has not been given deserved exposure is Gregg, 186 E Supp. 2d 1123 (D. Or. 2000), which deals with issues and arguments regarding passive activity loss treatment for LLC interests similar to those found in Thompson and Garnett. In Gregg, the plaintiff (a member of an LLC) argued that under the laws of the state in which it was organized (Oregon), the member was more akin to a general partner because Oregon law distinguishes limited partner status based on management control of the entity and not liability exposure. The plaintiffs corroborated this argument by stating that none of the LLC members were restricted from control of the business, which was evidenced by the LLC's articles of organization and operating agreement. Accordingly, the LLC members were all general partners, and their losses should not be disallowed.
In Gregg, the court cited the nonexistence of regulations requiring that an LLC member should be treated as a limited partner of a limited partnership and thus rejected the IRS's contention of limited partnership status. Accordingly, the court held that whether Gregg's interest was an interest in a passive activity should be determined under the general test for material participation. The court concluded that Gregg satisfied one of the seven tests (grouping of activities with participation over 500 hours) set forth in Temp. Regs. Secs. 1.469-5T(a)(1)-(7) and did not need to satisfy the higher standard of material participation for limited partners.
In Garnett (issued June 30, 2009), the IRS claimed that, like an interest in a limited partnership, an interest in an LLC or a limited liability partnership (LLP) was presumptively passive under Temp. Regs. Sec. 1.469-5T. As a result, the IRS claimed that the individuals' treatment of losses as nonpassive was incorrect. The IRS argued that the interests in the Garnetts' LLCs and LLPs were equivalent to the interests of a limited partner in a limited partnership because all three types of entities enjoyed limited liability under state law. The Garnetts argued that the mere use of the word "limited" to denote the owner's liability protection as an owner of the LLC or LLP did not make such an interest equivalent to a limited partner interest in a limited partnership. Further, limited partners in limited partnerships have liability protection because they are precluded from participating in management decisions. According to the Garnetts, LLCs and LLPs are fundamentally different from limited partnerships, because LLCs are designed to allow active involvement by LLC members in making management decisions.
The Tax Court decided in favor of the Garnetts. It ruled that because the Garnetts, under the state laws for LLCs and LLPs, could participate in the LLCs and LLPs in which they owned interests, it was improper to presume that they were interests in a passive activity. They should be treated as general partner interests for this purpose, and the general partner exception to Temp. Regs. Sec. 1.4695T(1)(e)(3)(ii) applied. Therefore, whether the interests in the LLCs and LLPs were interests in passive activities should be determined under the general tests for material participation in Temp. Regs. Sec. 1.469-5T(1)(a).
The IRS has shown a willingness to litigate cases like this but has now been rebuffed for similar reasons in the three cases. Barring a state law prohibition (or a specific prohibition in the articles or operating agreement of an LLC) on a member's participation in an LLC's affairs, the courts have held that taxpayers owning interests in LLCs are eligible to have their status determined under the general tests of material participation. Ultimately, the facts and circumstances of each case will dictate whether or not taxpayers' passthrough losses from LLCs are limited by the passive activity loss rules of Sec. 469.
This is an important tax planning opportunity and an idea for proactively managing a client's potential exposure with regard to LLP or LLC activities. Look to state law and inspect each LLP/ LLC's articles and operating agreement, paying careful attention to the specific language about management responsibility and liability protection. This will provide a basis for future deductibility of LLP and LLC losses and to defend the challenges that may arise.
From Craig Cackovic, CPA, and Mark Marquez, CPA, Gregory, Sharer & Stuart, St. Petersburg, FL
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|Title Annotation:||limited liability company|
|Publication:||The Tax Adviser|
|Date:||Dec 1, 2009|
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