Two cases decided three weeks apart have made it very clear that LLC membership interests are not limited partnership interests under the passive activity loss rules of IRC Section 469. This determination is important because if an LLC interest is treated as a limited partnership interest the member would be limited in his or her ability to claim material participation in the business operations. Material participation is critical to ordinary loss treatment for tax purposes. Ordinary loss treatment is better than passive activity loss treatment because the latter can only offset passive activity income.
In Garnett v Commissioner, 2009 U.S. Tax Court LEXIS 18, 132 T.C. 19 (June 30, 2009) the Tax Court ruled that the LLP and LLC interests of the petitioners (it just so happens they entities in question were Iowa LLPs and LLCs) were entitled to be treated as general partnership interests and not subject to the special rule of IRC Section 469(h)(2). Instead, the seven factor test of Temp. Reg. Sec. 1.469-5T(a) would be used to determine whether the taxpayer materially participated in the business operations.
The Federal Court of Claims went further in Thompson v. US, No: 06-211 T (July 20, 2009). Garnett was unwilling to simply conclude that LLCs are not partnerships therefore LLC interests are not limited partnership interests. Instead, the opinion relies on the general partnership exception found in the regulations to hold an LLC interest to be a general partnership interest. Thompson shared no such reluctance. The IRS regulations say that "a partnership interest shall be treated as a limited partnership interest if...[t]he 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. Sec. 1.469-5T(e)(3)(i)(B) (emphasis added by the court). The court was compelled to enforce the "plain meaning" of the regulation. An LLC is not a limited partnership. Therefore an LLC interest could not be a limited partnership interest. QED.
The Thompson opinion goes on for six more pages with a rather anticlimactic discussion about whether limited liability or participation in management was more important to the determination of limited partnership status. Didn't the court just conclude that it didn't matter?
-Marc Ward
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