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Nonpassive losses: new case treats losses from LLPs, LLCs as nonpassive.

In Garnett v. Commissioner, 132 TC No. 19, June 30, 2009, the Tax Court held that the taxpayers did not own their interest in LLPs and LLCs as limited partners. Therefore, the losses from these interest were not presumptively passive under IRC Sec. 469(h)(2).



For 2000-02, Paul and Alicia Garnett owned interests in seven LLPs and two LLCs that conducted agribusiness operations--primarily the production of poultry, eggs and hogs. The couple also owned interests in two other businesses that they characterized as tenancies in common. They owned most of those interests indirectly through five separate LLCs.

The IRS determined tax deficiencies of $361,468 and $72,294 or accuracy-related penalties for these tax years. The deficiencies arose primarily from the IRS' disallowance of losses from these interests claimed by the Garnetts. The IRS disallowed these losses under Sec. 469(a) as passive activity losses on the ground that the couple did not materially participate in the business entities' activities.

Statutory Provision

Sec. 469(h)(2) reads: "interests in Limited Partnerships--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." Observation. Thus, under this provision, losses from an interest in a limited partnership as a limited partner are treated as presumptively passive.

Legislative History

The 1986 Senate Finance Committee Report (No. 99-313 at 731-732, 1986-3 CB Vol.3) pertinently states the following:

"Under the bill, the Secretary of the Treasury is empowered to provide through regulations that limited partnership interests in certain circumstances will not be treated (other than through the application of the general facts and circumstances test regarding material participation) as interests in passive activities ... "The exercise of such authority might also be appropriate where taxpayers sought to avoid limited partnership status with respect to substantially equivalent entities."' (Emphasis added.)

The Conference Committee Report did not change this language.

Pertinent Regulation

Regs. Sec. 1.469-5T(eX3)(i) relevantly provides the following: "In general ... 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

"(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 ... ."

Court's Framing of Issue and Rationale

When Congress enacted Sec. 469(h)(2) in 1986, it did not have LLPs specifically in mind, since LLPs did not come into existence until 1991. Similarly, it is doubtful that Congress had LLCs in mind, since only one state, Wyoming, had an LLC statute in 1986. 'The temporary regulations, promulgated in 1988, make no explicit reference to LLPs or LLCs. The question is whether Sec. 469(h)(2) nevertheless applies to them.

The court found that, with "appropriate regard" for the legislative purpose of Sec. 469(h)(2), the Garnetts held their ownership interest in the LLPs and LLCs as general partners within the meaning of Temp. Regs, Sec. 1.469-5T(e)(3).

"The need to pigeonhole the ownership interests as either general partner interests or limited partner interests arises in the first instance from the fiction of treating an LLP or an LLC as a 'limited partnership" under Regs. Sec. 1.469-5T(e)(3)(i). Inasmuch as classifying an LLP or LLC interest as a limited partnership interest entails a departure from conventional concepts of limited partnerships, it similarly entails, we believe, a departure from conventional concepts of general partners and limited partners. In the final analysis, and absent explicit regulatory provision, we conclude that the legislative purposes of the special rule of Sec. 469(h)(2) are more nearly served by treating LLP and LLC members as general partners for this purpose."

Court's Conclusion

'We conclude and hold that petitioners' ownership interests in the LLPs and LLCs are excepted from classification as 'limited partnership interests' under the temporary regulations by operation of the general partner exception. "Accordingly, petitioners" ownership interests in the LLPs and the LLCs are not subject to the special rule of Sec. 469(h)(2)."


The court additionally found interests in tenancies in common that were held by the taxpayers were not interests in limited partnerships and, therefore, they also were not subject to the Sec. 469(h)(2) rule.

by Stuart R. Josephs, CPA

Stuart R. Josephs, CPA has a San Diego-based Tax Assistance Practice that specializes in assisting practitioners in resolving their clients' tax questions and problems. Josephs, chair of the Federal Subcommittee of CalCPA's Committee on Taxation, can be reached at [619] 469-6999 or
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Title Annotation:Fed Tax
Author:Josephs, Stuart R.
Publication:California CPA
Date:Aug 1, 2009
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