Small Business Taxes & Management

Special Report

Taxpayers Beat IRS on Losses From LLPs and LLCs


Small Business Taxes & ManagementTM--Copyright 2009, A/N Group, Inc.


In order to close the loopholes associated with taxpayers taking large losses from S corporations and partnerships, in 1986 Congress enacted laws that restrict the deduction of pass-through losses from these entities. One of the restrictions is that a partner (or shareholder) must materially participate in the activity. Material participation is defined generally as regular, continuous, and substantial involvement in the business operations. You can show material participation by passing one of seven tests in the IRS regulations (1.469-5T)(see below for the tests). For most taxpayers who operate their own business, passing the first test is easy--participation of more than 500 hours in the activity during the year. But things get more complicated for some taxpayers. The law requires that, except as specifically provided, no interest in a limited partnership as a limited partner shall be treated as an interest with respect to which a taxpayer materially participates. A limited partner can still show material participation but must pass one of three tests--(1) participation of more than 500 hours during the year; (2) material participation in the activity for any 5 taxable years during the immediately preceding 10-year period; or (3) based on all the facts and circumstances, the individual participates in the activity on a regular, continuous, and substantial basis during the year.

In Paul D. Garnett and Alicia Garnett (132 T.C. No. 19) the taxpayers owned interests in seven limited liability partnerships (LLPs) (these are different than a limited partnership) and two limited liability companies (LLCs) that were engaged in agribusiness operations, primarily the production of poultry, eggs, and hogs. The taxpayers owned most of these interest indirectly through one or another of five separate LLC holding companies.

The LLP agreements generally provided that each partner would actively participate in the control, management, and direction of the partnership's business. The LLP agreements also generally provided that no partner would be liable for the partnership's debts or obligations. The LLC operating agreements generally provided that business was to be conducted by a manager with exclusive authority to act for the company. The manager was to be selected by majority vote of the LLC's members and had the responsibility, among others, to "effectuate * * * the regulations and decision of the Members". The taxpayers were not managing members of the two LLCs that were not holding LLCs. The taxpayers also owned indirectly, through one of the holding LLCs, interests in two other business entities holding title as tenants in common, but de facto partnerships under state law.

In a limited partnership general partners typically have management power and personal liability while limited partners lack management powers and enjoy immunity from liability for debts of the partnership. A fundamental concept of limited partnerships is that a limited partner may lose limited liability by taking part in control of the partnership. An LLP is a general partnership that by making a filing or registration with the state has obtained a form of limited liability for its general partners. Consequently, members of an LLP are not statutorily restricted from participating in management. An LLC is "essentially a hybrid of the corporate and partnership forms of business." LLC members can participate directly in management but have limited liability for the company's debts and liabilities.

Acknowledging that differences exist among limited partnerships, LLPs, and LLCs, the IRS contended that under the temporary regulations the differences are irrelevant. The IRS contended that the sole relevant consideration is that the taxpayers enjoyed limited liability with respect to their ownership interests. Because of this limited liability, the IRS contended, each LLP and LLC interest in question is a limited partnership interest under the temporary regulations.

The Court noted the Code and regulations provide no general definition of "limited partner". While the taxpayers suggested that the Court should interpret the term literally to mean nothing more nor less than a limited partner in a limited partnership, the Court declined to do so. The Court also examined the "limited partner holding general partner interest exception" to account for situations where a limited partner is also a general partner. The Court noted that both the taxpayer and the IRS agreed that the taxpayers were not precluded from participating in the management and operations of the LLPs and LLCs and the IRS did not dispute that the taxpayers were given at least some role in management, but the IRS contended that the circumstances did not suffice to classify the taxpayers as general partners because the partnership agreements did not give them the authority to take action on behalf of the partners. The IRS suggested the Court make threshold factual inquiries into the nature and extent of the taxpayers' authority to act on behalf of the LLPs and LLCs. The Court noted these inquiries seem closely akin to the inquiries to be made under the tests for material participation.

The Court noted that, 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 the IRS suggested, 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.

The Court said it did not believe that this rationale properly extends to interests in LLPs and LLCs. As previously discussed, members of LLPs and LLCs, 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, the Court said, pursuant to the general tests for material participation under Section 469 and the regulations thereunder.

The Court concluded that the taxpayers held their ownership interests in the LLPs and the LLCs as "general partners" within the meaning of the temporary regulations. The Court recognized the status in these entities differs significantly from the status of general partners in State law limited partnerships, but it also recognized that their status differs significantly from that of limited partners in State law limited partnerships. 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 section 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, a departure from conventional concepts of general partners and limited partners. In the final analysis, and absent explicit regulatory provision, the Court concluded that the legislative purposes of the special rule of Section 469(h)(2) are more nearly served by treating LLP and LLC members as general partners for this purpose.

What does this mean to you? First, even though the taxpayers won their position, they were not automatically allowed to deduct losses from the LLPs and LLCs. They still had to show they materially participated in the LLPs and LLCs, but they could do so using the standard tests and the IRS could not presume that they did not materially participate as would be the case if they were limited partners in a limited partnership. That's important because having to rebut a presumption is more difficult. The material participation test has not changed. Second, some taxpayers who were in similar situations and did not take the losses but who could pass the material participation test may want to file amended returns. Talk to your tax advisor about the facts in your particular situation. Third, this may not be the final word. The IRS could appeal the case or go to court on another case in which they have a stronger position. In addition, there are other options available to the government.

Remember, just because you're the sole shareholder of an S corporation or sole member of an LLC, you still must be able to show material participation. You're considered to be materially participating in an activity for the taxpayer year only if:

  1. You participate in the activity for more than 500 hours during such year;
  2. Your participation in the activity for the taxable year constitutes 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. You participate in the activity for more than 100 hours during the taxable year, and your participation in the activity for the taxable 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 (within the meaning of paragraph (c) of this section) for the taxable year, and your aggregate participation in all significant participation activities during such year exceeds 500 hours;
  5. You materially participated in the activity (determined without regard to this paragraph (a)(5)) for any five taxable years (whether or not consecutive) during the ten taxable years that immediately precede the taxable year;
  6. The activity is a personal service activity (within the meaning of paragraph (d) of this section), and you materially participated in the activity for any three taxable years (whether or not consecutive) preceding the taxable year; or
  7. Based on all of the facts and circumstances (taking into account the rules in paragraph (b) of this section), you participate in the activity on a regular, continuous, and substantial basis during such year.

Fortunately, most small business owners will easily pass the first test. But you could have problems if you own multiple businesses and aren't active in the ones with losses. You may have options. Again, talk to your advisor.


Copyright 2009 by A/N Group, Inc. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is distributed with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional should be sought. The information is not necessarily a complete summary of all materials on the subject. Copyright is not claimed on material from U.S. Government sources.--ISSN 1089-1536

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--Last Update 07/14/09