Passive activity rules not presumed to apply to LLCs and LLPs.

• Author: Valdez, Veronica
• Position: Limited liability companies, limited liability partnerships

In the Garnett case (132 T.C. No. 19), decided in late June 2009, the Tax Court set precedent for the reporting of losses from LLPs (limited liability partnerships) and LLCs (limited liability companies) by limited liability partners who materially participate in the operations of the businesses in which they are investors.

The taxpayers (Paul and Alicia Garnett) treated the losses from their LLCs, LLPs, and tenancies in common as nonpassive losses and claimed them against income items such as wages and investment income on their 2000, 2001, and 2002 returns. The IRS disallowed certain of these claimed losses on the ground that the petitioners had failed to meet the material participation requirements of Sec. 469, and it assessed the Garnetts over $400,000 in taxes and penalties, leading to this three-year Tax Court battle.

Facts

The Garnetts, business entrepreneurs from Nebraska, were investors in LLPs and LLCs that engaged in agribusiness (poultry, eggs, and hogs). They also owned interests in other business ventures that they characterized as tenancies in common.

The LLP agreements provided that each partner would actively participate in the control, management, and direction of the partnership's business. The agreement also provided that no partner would be liable for the partnership's debts or obligations. The LLPs issued Schedules K-1 to Mr. Garnett identifying him as a limited partner.

The LLC operating agreements provided that the business was to be conducted by a manager, to be elected by the LLC members, who among other responsibilities was to "effectuate ... the regulations and decisions of the Members." Mr. Garnett was not a managing member of the LLCs. The LLC Schedules K-1 identified Mr. Garnett as a "limited liability company member."

Issue

Before this case, the IRS did not distinguish between limited partnerships (LPs) and LLCs and LLPs for purposes of applying the Sec. 469 passive loss rules. Under Sec. 469(h)(2), interests in limited partnerships held as limited partners are presumptively passive. Sec. 469(h)(2) was adopted in 1986, predating the existence of LLPs (which did not come into existence until 1991) and most LLCs (only one state had an LLC statute in 1986). Temporary regulations issued in 1988 (Temp. Regs. Sec. 1.469-5T(e)) also made no explicit reference to LLPs or LLCs. The issue in this case was whether Sec. 469(h)(2) applies to LLP and LLC interests.

Analysis

Sec. 469(a) limits the deductibility of losses...