The Tax court shot down an IRS bid to treat as "per se" passive losses from limited liability companies or limited liability limited partnerships. Nebraskans Paul and Alicia Garnett invested in LLCs and LLLPs that operated farming businesses in Iowa. The Garnetts claimed that they "materially participated" in the entities and deducted losses shown on the K-1s from the LLCs and LLLPs. The IRS assessed about $360,000 in deficiencies from these losses from 2000 to 2002, saying that the losses were passive no matter what. "Passive" losses are allowed only to the extent of "passive" income, or when the activity is sold.
The IRS applied Sec. 469(h)(2), which says: 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.
The taxpayers argued that LLCs and LLLPs are not "limited partners" under these rules, and they are therefore subject to the regular "material participation" rules for determining whether a loss is passive. The Tax Court looked at the state law rules governing these entities to sort it out. The court found that Iowa law gives allows powers to LLC members and LLLP owners beyond those allowed traditional limited partners. They also said limited liability wasn't enough to make an owner a "limited partner" under Sec. 469(h)(2):
Thus, while limited liability was one characteristic of limited partners that Congress considered in the enactment of section 469(h)(2), it clearly was not, as respondent suggests, the sole or even determinative consideration. To the contrary, the more direct and germane consideration was the legislative belief that statutory constraints on a limited partner's ability to participate in the partnership's business justified a presumption that a limited partner generally does not materially participate and made further factual inquiry into the matter unnecessary.
We do not believe that this rationale properly extends to interests in L.L.P.s and L.L.C.s. As previously discussed, members of L.L.P.s and L.L.C.s, unlike limited partners in State law limited partnerships, are not barred by State law from materially participating in the entities' business. Accordingly, it cannot be presumed that they do not materially participate. Rather, it is necessary to examine the facts and circumstances to ascertain the nature and extent of their participation. That factual inquiry is appropriately made, we believe, pursuant to the general tests for material participation under section 469 and the regulations thereunder.
When Sec. 469(h) was written, LLCs and LLLPs barely existed. The differences between these new entities and the old limited partnerships are profound, and it is common for LLC and LLLP members to work full time in roles analogous to general partners in limited partnerships. The new entities just aren't comparable to limited partnerships.
Yesterday's ruling doesn't close the case; it was a "summary judgment" motion on the 469(h)(2) issue. The IRS might still challenge the losses under the normal "material participation" standards.
Cite: Garnett, 132 T.C. No. 19.
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