By Susan Reaman

The Federal Court of Claims in Thompson v. U.S., 104 AFTR 2d 2009-XXXX, 07/20/2009 granted the Taxpayer summary judgment in deciding that its LLC member interest was not a limited partner interest for purposes of the passive activity rules under IRS Code § 469 and the regulations therunder.  This case follows another recent taxpayer favorable case Tax Court opinion in Paul D. Garnett, et ux. v. Commissioner, 132 T.C. No. 19.

In Thompson the Taxpayer structured his business activity in the form of a limited liability company (“LLC”) under State law that treated LLCs as hybrid entities that are neither partnerships nor corporations. The taxpayer held directly a 99% member interest in LLC and indirectly the remaining 1% through a Subchapter S corporation.

Because LLC did not elect to be treated as a corporation for federal tax purposes, by default the Code treated it as a partnership, see Treas. Reg. § 301.7701-3 (b)(1)(i). The Taxpayer claimed losses of the LLC on its individual income tax return.  The IRS denied the losses because it concluded that the taxpayer did not materially participate in the business of the LLC.

Generally, under Treas. Reg. § 1.469-5T(a). an individual may establish his material participation for a given taxable year by demonstrating any of the following:

(1) The individual participate[d] in the activity for more than 500 hours during such year;

(2) The individual's participation in the activity for the taxable year constitute[d] substantially all of the participation in such activity of all individuals ... for such year;

(3) The individual participate[d] in the activity for more than 100 hours during the taxable year, and such individual's participation in the activity for the taxable year [was] not less than the participation in the activity of any other individual ... for such year;

(4)  The activity was a significant participation activity ... for the taxable year, and the individual's aggregate participation in all significant participation activities during such year exceeded 500 hours;

(5) The individual materially participated in the activity ... for any five taxable years ... during the ten taxable years that immediately precede[d] the taxable year;

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

(7) Based on all of the facts and circumstances ..., the individual participated in the activity on a regular, continuous, and substantial basis during such year.

The Code treats limited partners differently because it presumes that they do not materially participate in their limited partnerships. Section 469(h)(2) provides that 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. In fact, under the Treasury Regulations implementing § 469, if a taxpayer holds a limited partnership interest, only three of the seven tests described above—(1), (5), and (6)—are available to measure the taxpayer's material participation in the partnership.

Except as provided in paragraph (e)(3)(ii) of this section, Treas. Reg.§ 1.469-5T(e)(3)(i)(B) provides that a partnership interest shall be treated as a limited partnership interest if 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.

Treas. Reg. § 1.469-5T(e)(3)(ii) provides that a partnership interest of an individual shall not be treated as a limited partnership interest for the individual's taxable year if the individual is a general partner in the partnership at all times during the partnership's taxable year ending with or within the individual's taxable year (or the portion of the partnership's taxable year during which the individual (directly or indirectly) owns such limited partnership interest).

The government argued that it was proper for the IRS to treat taxpayers’ interest in LLC as a limited partnership interest under Treasury Regulation § 1.469-5T(e)(3)(i)(B) because the taxpayer elected to have LLC taxed as a partnership for income tax purposes and because plaintiff's liability is limited under the laws of the state in which was organized.

However, the court in agreeing with the taxpayer, concluded the IRS’s own regulations literally requires that the ownership interest be in a business entity that is, in fact, a partnership under state law—not merely taxed as such under the Code. In addition, the Court raised the possibility that the taxpayer could also prevail under the general partner exception from treatment as a limited partner given the high degree of control taxpayer exerted over business operations as its sole manager.

The court ultimately concluded that the terms—“material participation” and “passive activity”—indicate that Congress was primarily concerned with the taxpayer's level of involvement in the activity in question and not the extent to which liability is limited.

The IRS raised the same argument in Garnett, in which the petitioners owned interests in both LLCs and limited liability partnerships (“LLPs”).

The Tax Court held that 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. It cannot be presumed that they do not materially participate, but rather, it is necessary to examine the facts and circumstances to ascertain the nature and extent of their participation.

For more information, please contact Susan Reaman at (202) 585-8327 or sreaman@nixonpeabody.com.