Tax Court to IRS: LLC members are not limited partners

The IRS has continued to litigate – and lose – cases in which it argues that members of a limited liability company should be treated in the same manner as a limited partner when applying the passive activity loss rules.

The latest case to test this theory is Newell v. Commissioner, TC Memo 2010-33 (Feb. 16, 2010).

Lee Newell's primary business involves the management of real estate investments. He spends more than 50 percent of his time and more than 750 hours annually in real property trade or business activities.

In the years at issue in the case, Newell owned a 33 percent member interest in Pasadera Country Club, L.L.C., an LLC formed in California. Newell is the managing member of the LLC.

Pasadera incurred losses that Newell deducted on his tax return. The IRS agreed that Newell spent more than 400 hours annually in the activities of Pasadera and at least 250 hours annually in another business activity. However, the IRS contended that the losses should be suspended under the passive activity loss rules because Newell did not "materially participate" in the activity.

1. Both the IRS and Newell agreed that temporary regulations issued in 1988 provide seven tests for determining whether an individual materially participates in an activity.Participation in the activity for more than 500 hours during the year.
2. Participation that constitutes substantially all of the participation in the activity of all individuals, including non-owners.
3. Participation in the activity for more than 100 hours during the year, with that participation exceeding any other individual’s participation during the year.
4. Participation in “significant participation activities” for an aggregate of more than 500 hours during the year.
5. Material participation in any five years during the preceding 10 tax years.
6. Material participation in any three preceding years, if the activity is a personal service activity.
7. Participation on a regular, continuous and substantial basis during the year, taking into account all the relevant facts and circumstances.

Both the IRS and Newell agreed that the fourth test was the significant test in this case. They also agreed that an activity is a “significant participation activity” only if:

• The activity is a trade or business;
• The individual participates in the activity more than 100 hours during the year; and
• The individual cannot establish material participation under any of the other six tests.

Finally, the IRS agreed that, although Newell met the test as described, that test is not available to limited partners. And the IRS has consistently argued that members of LLCs should be treated as limited partners.

For the second time in the last year, the Tax Court has rejected the IRS's view. In Garnett v. Commissioner, 132 TC No. 19 (June 30, 2009), the Tax Court held that an interest in an Iowa LLC was not the equivalent of a limited partnership interest. Now, the court in Newell reached the same conclusion for a California LLC. The U.S. Court of Federal Claims reached a similar conclusion with respect to a Texas LLC in Thompson v. United States, 87 Fed. Cl. 728 (July 20, 2009).

It seems clear that the Tax Court believes that members of LLCs who materially participate in the business activity should treat the LLC as an active, not a passive, activity. The IRS has acquiesced to the result in Thompson and has said it will stop litigating these cases pending the issuance of new guidance.

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