Proposed passive activity loss regulations ease the definition of limited partnership interest, and extend it to LLC interests

IRS has issued proposed regulations that would provide a new definition of limited partnership interest for purposes of Code Sec. 469(h)(2), which treats limited partnership interests as passive interests for passive activity loss (PAL) purposes except as regulations provide otherwise.

Observation: Under the new definition, more partnership interests could escape treatment as passive interests.

At the same time, the proposed regulations would make it clear that an interest in a limited liability company (LLC) could be treated as a limited partnership interest for PAL purposes.

Observation: But LLC interests also would benefit from the eased definition. The LLC change apparently is being made in response to court cases holding that LLC interest were not limited partnership interests for purposes of Code Sec. 469(h)(2).

Background.  Under the Code Sec. 469 passive activity rules, passive activity losses cannot offset nonpassive activity income, such as wages, dividends, or profits from nonpassive activities. Passive activities include the conduct of trade or business activities in which the taxpayer doesn’t materially participate and, generally, rental activities without regard to whether the taxpayer materially participates in them.

Under Code Sec. 469(h)(1), a taxpayer materially participates in an activity only if he is involved in the activity’s operations on a regular, continuous, and substantial basis, which generally requires him to meet one of seven tests carried in Reg. § 1.469-5T(a).  

Under Reg. § 1.469-5T(a)(4), one of these seven tests, (1) the activity must be a significant participation activity for the tax year, and (2) the individual’s aggregate participation in all significant participation activities during the year must exceed 500 hours.  An activity is a significant participation activity only if (a) the activity is a trade or business, (b) the individual participates in the activity for more than 100 hours during the year, and (c) the individual cannot establish material participation under any of the other material participation tests in the regulations.

Under Code Sec. 469(h)(2), a limited partner’s interest in a limited partnership isn’t treated as an interest in an activity in which the taxpayer materially participates, except to the extent provided in the regulations.  Thus, Code Sec. 469(h)(2) treats losses from an “interest in a limited partnership as a limited partner” as presumptively passive.   Reg. § 1.469-5T(e)(2) provides that a limited partner clears the material participation hurdle only if he meets one of three tests (instead of the generally applicable one of seven tests) in Reg. § 1.469-5T(a).  The more-than-500-hour test for significant participation activities in Reg. § 1.469-5T(a)(4) is not one of these three tests.

Reg. § 1.469-5T(e)(3)(i) provides that a partnership interest is treated 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 liability of the holder of the interest for obligations of the partnership is limited under the applicable state law; or
  2. the liability of the holder of the interest for obligations of the partnership is limited under the law of the state in which the partnership is organized to a fixed amount.  For example, state law could limit the liability of the partner to the sum of the partner’s capital contributions to the partnership and contractual obligations to make additional capital contributions to the partnership.

 

However, under Reg. § 1.469-5T(e)(3)(ii), a partnership interest isn’t treated as a limited partnership interest for the individual’s tax year if he is a general partner as well as a limited partner in the partnership during its tax year ending with or within the individual’s tax year.

Several cases have held that an interest in an LLC is not a limited partnership interest for purposes of Code Sec. 469(h)(2).

New definition.  Under the proposed regulations, subject to an exception noted below, an interest in an entity would be treated as an interest in a limited partnership under Code Sec. 469(h)(2) if:

  1. the entity in which the interest is held is classified as a partnership for Federal income tax purposes under Reg. § 301.7701-3; and
  2. the holder of the interest does not have rights to manage the entity at all times during the entity’s tax year under the law of the jurisdiction in which the entity was organized and under the governing agreement.

Under the exception, an individual would not be treated as holding an interest in a limited partnership as a limited partner for his tax year if he also holds an interest in the partnership that is not an interest in a limited partnership as a limited partner, such as a state-law general partnership interest, at all times during the entity’s tax year ending with or within his tax year (or the portion of the entity’s tax year during which he directly or indirectly owns the interest).

Reason behind changed definition.  The preamble notes that Congress enacted Code Sec. 469(h)(2) to address the limitations on a limited partner’s ability to participate in the control of the partnership’s business.  Under the Uniform Limited Partnership Act of 1916, limited partners could lose their limited liability protection if they participated in the control of the partnership.

The temporary regulations had been drafted with these constraints in mind. Today, many states have adopted a variation of the Revised Uniform Limited Partnership Act of 1985 (RULPA).  Under RULPA, limited partners may participate in the management and control of the partnership without losing their limited liability. As a consequence, limited partners under RULPA are now more akin to general partners and LLC members with respect to their rights in the management of the entity. Under the Uniform Limited Liability Company Act of 1996, LLC members of member-managed LLCs do not lose their limited liability by participating in the management and conduct of the company’s business.

Recognizing that the original presumptions regarding the limitations on a limited partner’s participation in the activities of the entity are no longer valid today, and also recognizing the emergence of LLCs, the proposed regulations eliminate the temporary regulations’ reliance on limited liability for purposes of determining whether an interest is an interest in a limited partnership as a limited partner under Code Sec. 469(h)(2). Instead, the proposed regulations would adopt an approach that relies on the individual partner’s right to participate in the management of the entity.

Observation: Thus, under the proposed regulations, it seems likely that fewer partnerships interests will be treated as limited partnership interests for PAL purposes as compared to the temporary regulations. Thus, more individuals holding partnership interests will have an easier time meeting the material participation test than under the temporary regulations.

Effective date. The regulations would apply to tax years beginning on or after the date they are finalized.

 

© 2011 Douglas Rutherford, CPA.  All Rights Reserved.  Douglas Rutherford is a nationally recognized CPA practicing in the real estate industry. He is the founder of Rutherford, CPA & Associates, and the President and CEO of RentalSoftware.com. He is also the developer of the national leading real estate investment analysis software, the  Cash Flow Analyzer ® & Flipper’s ® software products. Doug earned his Masters of Taxation degree from Georgia State University, Atlanta, GA.  Visit RealEstateAnalysisSoftwareBlog.com for more information and resources for successful real estate investing.