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By Lisa M. Starczewski, Esq.
Valley Forge, PA
For several years, the application of the passive loss rules to LLCs has been the subject of debate and litigation. Recently proposed regulations clarify these rules, but leave some unanswered questions.
Section 469(h)(2) essentially creates a presumption that losses from interests in limited partnerships are passive. This section, as implemented by regulations, provides that no interest in a limited partnership is treated as an interest with respect to which a taxpayer "materially participates" unless the taxpayer establishes material participation by satisfying one of three tests. If an interest is not an interest in a limited partnership, the taxpayer is able to show material participation by meeting one of seven tests.
Under the current temporary regulations, a partnership interest is treated as a limited partnership interest (and, therefore, is subject to the presumption against material participation) if: (1) the interest is either designated as 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 the interest for obligations of the partnership is limited under applicable state law; or (2) the liability of the holder of the 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.1 However, even if the interest is characterized as a limited partnership interest under this rule, the so-called "general partner exception" applies 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 portion of the partnership's taxable year during which the individual directly or indirectly owns the limited partnership interest).2 If the general partner exception applies, all seven tests are available to a taxpayer to establish material participation.
The IRS has attempted, over the years, to take the position that an LLC interest is a limited partnership interest for purposes of the passive loss rules. The courts, however, have generally refused to impose the presumption of passivity on the holders of LLC (as well as LLP) interests.3 After a few years of wrangling with the courts and losing, the IRS seems to have capitulated (at least in part) by issuing proposed regulations clarifying the circumstances under which an LLC member will be treated as a limited partner for purposes of the §469(h)(2) passivity presumption.
In November 2011, the IRS issued proposed regulations4 that, once finalized, would amend the definition of a limited partnership interest, as set forth under the current temporary regulations, to eliminate the current reliance on state law limited liability and, instead, adopt an approach based on an LLC member's ability to participate in management of the entity.
The proposed regulations provide that an interest in an entity will be treated as an interest in a limited partnership for purposes of the passivity presumption if: (1) the entity in which the interest is held is classified as a partnership for Federal income tax purposes; and (2) the holder of the interest does not have rights to manage the entity at all times during the entity's taxable year under the law of the jurisdiction in which the entity was organized and under the governing agreement.5
Query how this new definition will be interpreted? What does the right "to manage" mean in the context of an LLC? The second prong of the definition includes language that literally appears to characterize an interest as a limited partnership interest if the holder does not have the right to manage under state law and under the governing agreement. State law generally allows LLC members to manage while maintaining limited liability. Is the state law right to manage sufficient to satisfy the second prong of the definition? The use of the conjunctive in the proposed regulations implies that an LLC member will be treated as a limited partner unless the LLC member lacks management rights under both state law and the governing agreement. Will the IRS look specifically at each LLC member to determine that particular member's right to manage under the LLC agreement?
At a Bloomberg/BNA tax luncheon held on January 10, 2012, Michala Irons, one of the principal IRS authors of the proposed regulations (speaking on her own behalf) suggested that, under the second prong of the new definition of "limited partnership interest," a taxpayer may avoid characterization as a limited partner if he or she meets only one part of the two-part test.6 In other words, if an LLC member has the right to manage under either state law or the governing agreement, the member is not treated as a limited partner. Ms. Irons noted, however, that this interpretation may need to be clarified in the final regulations.
If Ms. Irons' statement, in fact, reflects the IRS's position, it would be rare for an LLC member to be classified as a limited partner under the new definition. For example, even if the governing agreement specifically states that a particular LLC member has no management authority, does a general right to manage under state law trump that provision for purposes of the new regulations? Further, how does an "either/or" test apply in the context of an operating agreement that gives only certain members management rights? For example, what if the LLC is a manager-managed LLC (in contrast to a member-managed LLC)? Do only the managers meet the regulatory test, or do all members meet it because, technically, under state law they have the right to manage without losing their limited liability?
An "either/or" test may make sense if the governing agreement is silent with respect to management rights. It may, however, be more confusing to apply in the context of an agreement that limits or eliminates certain members' rights to manage. Perhaps the regulations should include a provision stating that a taxpayer is a limited partner if the taxpayer has a general right to manage under state law but the operating agreement specifically precludes or limits the right. Alternatively, the IRS could provide in the regulations that, in a manager-managed LLC, only the managers will be treated as having the right to manage for purposes of the passive loss rules.
The IRS also may need to clarify the meaning of a "right to manage." Is the IRS looking for specific types of management rights to avoid characterization as a limited partner? Will the IRS require day-to-day management, or is a right to approve certain specified transactions (for example, a sale or a loan) sufficient? It remains to be seen whether the final regulations will clarify these issues. However, in any event, the proposed regulations are a welcome change to the application of the passive loss rules to LLCs.
For more information, in the Tax Management Portfolios, see Shaviro, 549 T.M., Passive Loss Rules, and in Tax Practice Series, see ¶2980, Passive Loss Rules.
1 Regs. §1.469-5T(e)(3)(i).
2 Regs. §1.469-5T(e)(3)(ii).
3 See, e.g., Newell v. Comr., T.C. Memo 2010-23 (member of LLC not subject to §469(h)(2); member was not limited partner under state law); Thompson v. U.S., 87 Fed. Cl. 728 (2009), acq. in result only, 2010-14 I.R.B. 515; Garnett v. Comr., 132 T.C. 368 (2009) (presumption of passivity does not apply to interests in LLPs and LLCs, even though partner or member enjoys limited liability under state law); Gregg v. U.S., 186 F. Supp. 1123 (D. Or. 2000) (LLC member can establish material participation under any one of seven tests of Regs. §1.469-5T(a); LLCs specifically created to allow active involvement with limited liability).
4 See Prop. Regs. §1.469-5(e), REG-109369-10, 76 Fed. Reg. 72875 (11/28/11), applicable for tax years beginning on or after date on which final regulations are published in the Federal Register.
5 Prop. Regs. 1.469-5(e)(3)(i).
6 "Test for Limited Partners under New Rules Looks at `Right to Manage,' IRS Official Says," 6 BNA Daily Tax Rep. G-4 (1/11/12).
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