Who is a limited partner? The IRS issues sec. 469 prop. regs.

• Author: Van Leuven, Mary

Despite its importance in assessing an individual's tax liability, the determination of whether a person is a "limited partner" for federal income tax purposes is often uncertain. Under Sec. 1402, a limited partner is not subject to the Self-Employment Contributions Act (SECA) tax on the distributive share of income from trade or business activities of the partnership. In addition, the determination of whether income and loss is subject to the passive activity rules of Sec. 469 can hinge on whether the taxpayer is a limited partner.

The meaning of the term limited partner has evolved separately under each of these statutes. Today, however, there is some support for adopting a single meaning for the term for both Secs. 469 and 1402. In addition, beginning in tax year 2013, net income from an individual's passive trade or business activities may be subject to an additional 3.8% Medicare contribution tax. As a result, the recently proposed regulations under Sec. 469 that provide for a new definition of limited partner have added significance.

Background

Sec. 469 suspends an individual's net losses from passive trade or business activities and rental activities (unless the individual qualifies under Sec. 469(c) (7) as a real estate professional). A trade or business activity is passive if the individual does not "materially participate" in the activity. An individual is, except to the extent provided by regulations, presumed not to materially participate with respect to any interest in a limited partnership held as a limited partner under Sec. 469(h)(2). Temp. Regs. Sec. 1.469-5T(a) provides seven tests to determine if a taxpayer materially participates in a trade or business activity, and Temp. Regs. Sec. 1.469-ST(e) restricts a limited partner to only three of the seven tests for purposes of determining material participation (the limited partner tests). As a result, it can be significantly more difficult for a limited partner to be considered to be materially participating in a trade or business activity than it is for other taxpayers.

Temp. Regs. Sec. 1.469-5T(e)(3)(i) treats a partnership interest as a limited partnership interest if (1) the interest is designated a limited partnership interest in the limited partnership agreement or the certificate of limited partnership, without regard to whether the partnership interest holder's liability for the partnership's obligations is limited under applicable state law; or (2) the partnership...