TAX COURT FINDS THAT LOSSES FROM LLP OR LLC OR TIC INTERESTS ARE NOT PASSIVE PER SE UNDER IRC SECTION 469(h)(2)07 / 01 / 2009
Garnett v. Commissioner, 132 T.C. No. 19 (June 30, 2009)
The United States Tax Court has held that a taxpayer's interests in a limited liability partnership (LLP), limited liability company (LLC), and tenancies in common (TIC) are not to be treated as interests in a limited partnership as a limited partner, under the rules set forth in I.R.C. Section 469(h)(2).
The taxpayers held an interest in one LLP directly, and held interests in other LLPs, indirectly, through one or more holding company LLCs. The K-1s filed for each LLP identified the holding company LLCs or the husband as a "limited partner." Under the LLP agreements, each partner would actively participate in the control, management, and direction of LLP business, but made clear that no such partner would be liable unless otherwise required by Iowa law.
As for the LLC interests, the taxpayers held interests directly or through one of its holding company LLCs. On K-1s, each LLC identified the relevant holding company LLC or the taxpayer husband as a "limited liability company member." The LLC operating agreements generally established a manager-managed format, whereby a "manager" was to be selected by a majority vote of the LLC members. With at least 2 of the LLCs that were not holding company LLCs, the husband and his wife were not managing members.
As for other business ventures, the taxpayers owned indirectly, through one of their holding company LLCs, interests in two other business entities. The parties stipulated that these were "de facto partnerships" holding title as tenants-in-common among 3 partners. at 6.
The IRS issued a notice of deficiency, claiming that losses reported and flowing through the entity structures were passive, on the ground that the taxpayers had failed to meet the "material participation" tests under Section 469 or on the ground that some of the losses were from rental activities and therefore, passive per se under Section 469(c)(2).
The Tax Court reviewed how material participation is tested under the Regulations by way of seven exclusive tests, set forth in Temp.Regs. 1.469-5T(a), but that there is a special rule for certain limited partnerships under Section 469(h)(2), which treats as presumptively passive losses from certain limited partnerships, and restricting testing to 3 of the 7 regulatory tests. The Tax Court then examined whether the interests in limited partnerships "as a limited partner" captured LLP, LLC, and TIC interests.
The taxpayers relied on Gregg v. United States, 186 F.Supp.2d 1123 (D.Or. 2000), holding that the special rule of Section 469(h)(2) did not apply to a member of an LLC formed under Oregon law. The IRS contends that the Gregg was decided incorrectly, and that the interests in question are not "general partner" interests.
The Tax Court responded by pointing out that Congress did not contemplate LLPs when it enacted Section 469(h)(2) in 1986 (as these were not enacted until 1991), and doubted that Congress even had LLCs in mind since only one state (Wyoming) had an LLC statute. Noting also, that the Temporary Regulations, created in 1988, made no explicit reference to LLPs or LLCs. The Court then reviewed how limited partnerships have 2 classes of partners, general and limited, and how a limited partner, as such, may lose "limited liability" by taking part in the control of the entity, citing to 3 Bromberg & Ribstein, Partnership, treatise). By comparison, it noted that with the LLP, the members (partners) are not restricted from participating in management, and how the LLC is essentially a hybrid of the corporation and partnership forms of business, where LLC members can participate directly in management. at 14
After noting these differences, the IRS took the position that the sole relevant consideration is that the taxpayers enjoyed limited liability with respect to their ownership interests. at 15. As such, the IRS claims that the interests are essentially equivalent to limited partnership interests under the Temporary Regulations.
The Tax Court, however, said that this does not end the matter, since the operative condition under Section 469(h)(2) makes it clear that the tests rely on a finding that the interest in a limited partnership is "as a limited partner." The taxpayers then argued that that is should be read to mean that only limited partnership entities under state law could meet this test. The Tax Court disagreed with the taxpayers' narrow construction, and believes that the IRS had the authority to expand the reach of these rules.
That being said, the Tax Court turned to the "general partner exception" which clearly applies to the situation where a partner in a state law limited partnership possesses both limited and general partnership interests. Regs. 1.469-5T(e)(3)(ii). But, then, by its terms, this exception is NOT expressly confined to such a situtaion. While the IRS appeared to argue that the availability of the "general partner exception" depends on the extent of authority and control, to act for and bind the entity, they claimed that the agreements in question did not give the taxpayers authority to act on behalf of the partnership or LLC entities, nor did they function like they were general partners. Id at 20.
Instead, the Tax Court focused on how members of LLCs and partners in LLPs are not barred by state law from materially participating in the business of the entities, and therefore, it cannot be presumed that they do not "materially participate." Thus, it is necessary to examine the facts and circumstances to ascertain the nature and extent of their participation, using the general tests. Recognizing that the members of LLCs and partners in LLPs are significantly different from the status of general partners in a state law general partnership, it is also a status significantly different from limited partners in state law limited partnerships. Absent explicit regulatory provision, the Tax Court concluded that the legislative purposes of the special rule under 469(h)(2) are more nearly served by treating LLP and LLC interest holders as general partners for this purpose, citing favorably to Gregg. The Court did say that it was not invalidating the temporary regulation; rather simply declining to fill any gap to reflect IRS' litigating position in the case. A similar finding was reached with regard to the TIC interests, rejecting the IRS' position that it is of no consequence that the taxpayers held the interests indirectly through the holding company LLCs.
The Tax Court did note that with one exception, the K-1s issued directly or to holding company LLCs described the interests as something other than general partner (i.e., some saying "limited partner" for the LLPs, and some saying "LLC member"). The IRS made much of these reporting labels, observing that the taxpayers obtained a "tax benefit" by designating their interests in this manner to thereby avoid having to pay self-employment tax. The taxpayers simply noted that there is no place on a K-1 to list "LLP partner" but did not address why they holding company LLCs interest was identified as a "general partner" interest on one K-1, but as a "limited partner" on another. Noting that the IRS does not argue that the reporting on a K-1 is conclusive, or that the taxpayers ought to be collaterally estopped or constrained by any duty of consistency, but also that the IRS did not assert any self-employment tax deficiency, the Tax Court found these alleged inconsistencies far from material. Such did not create a "genuine issue of material fact requiring a trial on application of 469(h)(2), and therefore, the Tax Court granted the taxpayers' motion for partial summary judgment and denied the IRS' motion for partial summary judgment. Id. at 27.
For another example when the labels used by the taxpayer did not prohibit the taxpayer from obtaining summary judgment in a tax case, see Howard's Yellow Cabs v. United States.