LLC member not limited partner sec. 469 purposes.

In Gregg, 11/29/00, an Oregon district court treated the taxpayer, the founding member of a limited liability company (LLC), as materially participating in its business for Sec. 469 purposes. The taxpayer claimed ordinary losses originating from the LLC'S activities. The IRS recharacterized the losses as passive and argued that, because the taxpayer's business entity ,afforded him limited liability, his LLC interest was analogous to a limited partnership interest. The court ruled in favor of the taxpayer based on the absence of any regulation asserting that an LLC member should be treated as a limited partner.

Sec. 469

Generally, Sec. 469 imposes a limit on the losses and credits a taxpayer can take for a passive activity. Sec. 469(c) specifies that a passive activity is any activity that involves the conduct of any trade or business and in which the taxpayer does not materially participate. Further, under Sec. 469(h), a taxpayer participates in an activity materially only if he has involvement in the activity's operations on a regular, continuous and substantial basis.

Temp. Regs. Sec. 1.469-5T(a) sets out seven tests for material participation in a particular activity. Generally, a taxpayer must meet one of the seven tests to satisfy the material participation requirement:

1. The individual participates in the activity, for more than 500 hours during such year;

2. The individual's participation in the activity for the tax year is substantially all of the participation in such activity of all individuals (including individuals who are not owners of interests in the activity) for such year;

3. The individual participates in the activity for more than 100 hours during the tax year, and such individual's participation in the activity for the tax year is not less than the participation in the activity of any other individual (including individuals who are not owners of interests in the activity) for such year;

4. The activity is a significant participation activity for the tax year, and the individual's aggregate participation in all significant participation activities during such year exceeds 500 hours;

5. The individual materially participated in the activity for any five tax years during the 10 tax years that immediately precede the tax year;

6. The activity is a personal service activity, and the individual materially participated in the activity for any three tax years preceding the tax year; or

7. Based on all facts and circumstances, the individual participates in the activity on a regular, continuous and substantial basis during such tax year.

If a general partnership carries on an activity, the presumption is that the partners are carrying on the partnership activity directly. A partner then applies the seven tests to determine whether he materially participates. In contrast, if the activity is carried on by a limited partnership, the limited partners are not presumed to be carrying on the partnership activity directly. A limited partner materially participates in the partnership activities only if he meets the first, fifth or sixth tests. Under Temp. Regs. Sec. 1.469-5T(e)(3), a partnership interest is a limited partnership interest if 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.

Gregg

Gregg was the head of a healthcare marketing and consulting firm. In November 1994, he and two other employees formed a new LLC to continue providing such services. The taxpayer was the sole financier of the business venture, while the other two members performed day-to-day operations. For 1994, the LLC had operating losses; the taxpayer deducted the losses on his 1994 return.

The IRS challenged the deduction under Sec. 469. It noted that the LLC generally afforded the taxpayer limited liability with respect to LLC obligations. For this reason, the taxpayer's relationship to the LLC was analogous to that of a limited partner to a limited partnership. Therefore, the Service concluded that the taxpayer should be tested for material participation as a limited partner for purposes of Temp. Regs. Sec. 1.469-5T(e)(3). Under those tests, the taxpayer failed to establish his material participation and the IRS disallowed the losses.

District Court Analysis

The material participation tests for a general partner apply to an LLC member. The district court concluded that the material participation tests for a general partner apply to an LLC member, rejecting the Service's argument that the limited-partner tests should apply. It emphasized three factors that distinguish an LLC and a limited partnership. First, by definition, a limited partnership must have at least one general partner personally liable for the partnership's obligations. The LLC structure does not satisfy this requirement if all members are treated as limited partners. Second, LLC members retain their limited liability regardless of their level of participation in managing the LLC. For Federal tax purposes, a limited partner, by definition, is generally precluded from participating in the partnership's management if he is to retain limited partner status. This contradicts the purpose of using an LLC structure.

Third, the limited-partnership tests cannot apply to all LLC members, because the entity allows active involvement in the management of the business while affording its members limited liability protection. Thus, the differences in the natures of an LLC and a limited partnership justified the application of the tests for general partners to the taxpayer's LLC interest.

The taxpayer proved material participation through his LLC activities. The taxpayer proved his material participation by meeting the sixth test, which applies when an activity is a personal service activity and the taxpayer materially participated in the activity for the three tax years preceding the year at issue. Under Temp. Kegs. Sec. 1.469-5T(d), an activity is a personal service activity if it includes the performance of personal services in the field of health or a trade or business in which capital is not a material income-producing factor. The court determined that the LLC's (and thus the taxpayer's) business was a personal service activity, and allowed the taxpayer to group his prior and current employment to satisfy the sixth test. This determination is significant; for the first time, a court has ruled that similar person al service activities, taking place during different time periods and performed for separate entities, could be grouped together to meet the standard imposed by the sixth test.

The district court rejected the taxpayer's two other arguments supporting his material participation. First, the taxpayer argued that he met the first test because it required spending 500 hours per year performing the activity, which equates to 9.62 hours per week. He showed that he worked an average 14 hours per week in forming the LLC in 1994. The district court disagreed with the argument; while there was no statute, regulation or case law prohibiting annualization, the court reasoned that a literal reading of the statute and regulation did not anticipate or allow proration of the 500-hour requirement, and that such a de minimis standard undermined the Secretary's intent of preventing taxpayers from initiating otherwise passive activities at the end of a tax year and characterizing them as nonpassive.

Second, the taxpayer argued that aggregating his previous employment in the

healthcare field with his participation in his LLC resulted in enough hours to meet the 500-hour "significant participation" requirement of the fourth test. Under Temp. Regs. Sec. 1.469-5T(c)(1), in general, an activity is a significant participation activity only if it (1) is a trade or business activity in which the individual significantly participates for the tax year and (2) would be an activity in which the individual does not materially participate for the tax year if material participation for such year were determined without regard to Temp. Regs. Sec. 1.469-5T(a)(4). Further, Temp. Regs. Sec. 1.469-5T(c)(2) provides that an individual is treated as significantly participating in an activity for a tax year if and only if he participates in the activity for more than 100 hours during such year.

Prior to forming the LLC, the taxpayer worked full time at a healthcare marketing and consulting firm. Because the taxpayer's employment with his former company well exceeded 500 hours (thereby satisfying the first test), the district court did not consider it a "significant" participation activity.

Conclusion

Gregg is significant; for the first time, a court has held that (1) an LLC member should not be treated as a limited partner for purposes of determining material participation under Sec. 469 and (2) a taxpayer can group activities in two entities that existed at different periods of time.

FROM LAWRENCE SMITH, B.B.A., HOLLY BELANGER, J.D., CPA, AND GEENA MERILL, J.D., LL.M., WASHINGTON, DC