Application of the Passive Activity Loss Rules to LLC Members

The IRS has acknowledged that additional guidance is called for in the treatment of LLCs and LLPs for passive activity loss purposes. In light of the widespread popularity of such entities, particularly LLCs, such guidance could not come too soon. This guidance will be particularly pertinent to those who have experienced wide swings in farm and ranch income in recent years.

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...[T]he courts have been in general agreement that the IRS position as stated in the temporary regulations [Temp. Treas. Reg. § 1.469-5T(e)] is not defensible.

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The 2009 case of Garnett v. Commissioner [132 T.C. No. 19 (2009), 2009 U.S. Tax Ct. LEXIS ] involved taxpayers who owned seven limited liability partnerships and two limited liability companies in Iowa, all engaged in farming and agribusiness operations. The LLP agreements provided that each partner would actively participate in the control, management and direction of the LLP's business. [Id.] The LLC operating agreements provided that business was to be conducted by a manager. [Id.] The Tax Court cited to Gregg v. United States [186 F. Supp. 2d 1123 (D. Or. 2000).] and focused on the application of the “general partner” exception and believed that the LLP and LLC members had the right to participate in management, as do general partners, which justified that exception inasmuch as state law did not preclude the members from actively participating in the management and operations of the LLPs and LLCs. Accordingly, the members were entitled to apply all seven of the tests for material participation and were not limited to the three prescribed for limited partners. [Temp. Treas. Reg. § 1.469-5T(e)(2)]

The late July 2009 decision of the United States Court of Federal Claims, Thompson v. United States, [2009-2 U.S.T.C. para. 50,500 (Fed. Cl. 2009), acq. in result only, AOD 2010 FED para. 46,300.] cited approvingly to both Garnett and Gregg v. United States [186 F. Supp. 2d 1123 (D. Or. 2000).] but went beyond those decisions in stating that the temporary regulation [Temp. Treas. Reg. § 1.469-5T(e)(3).] was “. . . simply inapplicable to membership interests in an LLC.” [Thompson v. United States, 2009-2 U.S.T.C. para. 50,500 (Fed. Cl. 2009), acq. in result only, AOD 2010 FED para. 46,300.] That suggests that the current version of the regulations does not limit the losses in question. [See Harl, “The Tax Court and the U.S. Court of Federal Claims Agree: Members of LLCs and LLPs Are Not to be Treated as Limited Partners,” 20 Agric. L. Dig. 2009).]

The Tax Court, in a Tax Court Summary Opinion, in October of 2009
[Hegarty v. Comm'r, T.C. Summary Opinion 2009-153 (involved charter-fishing business which was not deemed to be a passive activity).] held that LLC losses were not limited as determined in Garnett. [In a Tax Court case decided in 2010, the Tax Court again held that LLCs are not necessarily governed by limited partnership passive activity rules. [Newell v. Comm'r, T.C. Memo. 2010-23 (managing member of LLC materially participated under Temp. Treas. Reg. § 1.469-5T(a)(4).)

At New York University's 68th Annual Institute on Federal Taxation in New York on October 21, 2009, Curtis Wilson, IRS Associate Chief Counsel for Passthroughs and Special Industries, was quoted as stating that the issues in Garnett and Thompson “. . . [are] legitimate and . . . IRS intends eventually to respond with guidance.” [CCH, Federal Tax Day, October 22, 2009).]

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LEXIS users can access the complete commentary here. Additional fees may be incurred. (Approx. 6 pages)

For additional insight into the U.S. Tax Court decision in Garnett v. Comm'r, hear a podcast interview on this site with Jeffrey Toberer, counsel for petitioners, discussing  Garnett and the Passive Investment Presumption.

RELATED LINKS:  For  further discussion, see:

 Data in Image LexisNexis Tax Advisor -- Federal Topical " 2D:2.01 (Tax issues related to classification of an entity) 

 Data in Image
LexisNexis Tax Advisor -- Federal Topical " 2D:6.13  (Application of the passive activity rules to partnerships)

 Data in Image
LexisNexis Tax Advisor -- Federal Topical " 1D:26.06. (Application of the passive activity rules to limited partners)