Tax policy issues related to partnerships and pass-through entities are both political and economic as the predominant form of investment and business entity is now the limited liability company (LLC).  Tax practice issues tend to track and respond to business and investment needs so as to allow the flexibility offered by the partnership tax rules while continuing to address perceived abuses.  The rules regarding deductibility of "passive losses" by members of LLCs and limited partnerships affects both.  

     The stakes are the requirements of proving "material participation" for purposes of escaping the passive activity limitation on deduction of partnership losses.  Section 469(h)(2), as implemented by Treasury and IRS, provides that no interest in a LP 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 LP, the taxpayer is able to show material participation by meeting one of seven tests. 

     Regs. §1.469-5T(e)(3)(i) provides that a partnership interest is treated as an interest in an LP if (A) it is 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 such interest for obligations of the partnership is limited under the applicable state law; or (B) 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, to a determinable fixed amount (for example, the sum of the holder's capital contributions to the partnership and contractual obligations to make additional capital contributions to the partnership).  Regs. §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).

     Historically, participation in management and daily activities of an LP was sufficient to strip a limited partner of the limited liability protection from business obligations that the partner would otherwise enjoy.  Periodic revisions to the Uniform Partnership Act during the 1900s gradually softened that rule until the Uniform Limited Partnership Act of 2001 (ULPA 2001) eliminated it so that limited partners retained limited liability against business obligations regardless of the partners' level of participation.  A prefatory note to §303 of ULPA 2001 stated that, "[a]lthough this [nonparticipation requirement] is subject to a lengthy list of safe harbors in a world with [limited liability entities], the rule is an anachronism."

    Today, eighteen states and the District of Columbia have adopted ULPA 2001.  The remaining states, except for Louisiana, have at least adopted a prior version (with or without modification), which did not go so far as to eliminate the participation standard entirely, but afforded much more flexibility to participate without losing liability protection than an earlier version.  Thus, in today's business environment, the non-participation requirement for retention of limited liability protection is either wholly eliminated or substantially weakened in almost every state.  

    Prop. Regs. §1.469-5(e) would also eliminate reliance on state law limited liability and adopt an approach based on a member's (or partner's) ability to participate in management of the entity.  Specifically, Prop. Regs. §1.469-5T(e) (REG-109369-10) would provide that an interest in an entity will be treated as an interest in a LP in determining whether material participation may be established by meeting any one of three (versus any one of seven) tests if (A) the entity in which the interest is held is classified as a partnership for federal income tax purposes and (B) 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. The question then becomes what does the right "to manage" mean? 

     Generally, in a member-managed LLC, the members holding voting interests essentially manage the business of the LLC because they have authority to act on its behalf to the extent the membership agreement does not specify otherwise.  In a manager-managed LLC, the members elect manager(s) who have the authority to manage and operate the LLC; the members of a manager-managed LLC could choose to manage the LLC themselves or grant managerial authority to a third party. 

    At least one commentator has traced the development of limited liability entities and concluded that §469(h)(2) should be repealed in light of today's business environment.  (Gutting, "Keeping Pace with the Times: Exploring the Meaning of Limited Partner for Purposes of the Internal Revenue Code," 60 U. Kan. L. Rev. 89 (2011).)  Should this be a part of meaningful tax reform?  The proposed regulations would be consistent with the Tax Court's interpretation of the purpose of §469(h)(2), but some questions would still remain.  Should members of a manager-managed LLC for which the members have chosen third party management be treated as having management rights?  If not, should the members right to delegate management authority to a third party constitute the right "to manage" for this purpose?