Limited partners and material participation: a tax planning opportunity.

• Author: Johnson, Michael

On November 25, 2011, the IRS issued proposed regulations (REG-109369-10) that seek to redefine the term "limited partner" for purposes of the passive activity rules of Sec. 469. The proposed regulations generally seek to ensure that members of LLCs and partners of LLPs, other than managing members or managing partners, are treated as limited partners. They also suggest that the IRS may have abandoned its effort to achieve a similar result through litigation under the existing regulations. Accordingly, until the IRS finalizes the new regulations, taxpayers holding interests in LLCs and LLPs may want to revisit whether their losses may qualify as active rather than passive.

Previous treatment of losses from an interest in a limited partnership

If a taxpayer does not materially participate in a trade or business, Sec. 469 treats the losses or credits from it as passive. As a result, they may generally only be used against passive income or upon the disposition of the activity. Limited partners in limited partnerships have an additional hurdle to prove that they are "materially participating." Sec. 469(h)(2) provides that "no interest in a limited partnership as a limited partner shall be treated as an interest with respect to which a taxpayer materially participates," except as otherwise provided by regulations.

The existing regulations allow even a limited partner to qualify by participating for more than 500 hours, but they prohibit limited partners from qualifying under several other tests that are avail able to sole proprietors or partners other than "limited partners." Those alternative tests include the ability to aggregate several partnerships and the ability to qualify under some circumstances with as little as 100 hours or more (see Temp. Regs. Sec. 1.469-5T).

For taxpayers who cannot qualify under the 500-hour test, but might qualify under the more liberal test applicable to nonlimited partners, this may be a good time to review whether they "fail" the definition of a limited partner--and thus qualify for the more liberal tests--under the current regulations and the cases interpreting them.

Challenges to the Material Participation Rules

Within the past 10 years, several cases were decided rejecting the IRS position that members of LLCs were limited partners for purposes of Sec. 469.

Gregg: In Gregg, 186 F. Supp. 2d 1123 (D. Or. 2000), the taxpayer was a member of an LLC. The court stated that, because the regulations were silent as...