This is considered by many a very important decision by the Tax Court and was addressed several days ago in the Wall Street Journal (here). I was not very fond of WSJ's explanation. I invite you to compare and contrast this analysis with what the article stated.
The Garnett’s Entity Holdings
The Court decides here ‘what the law actually says,’ and not ‘did the taxpayer comply with the law,’ the facts, therefore, are somewhat irrelevant. A brief explanation, however, to set the background is helpful.
The taxpayers, the Garnetts, owned interests in several partnerships. GFF stands for Garnett Family Farms. Through their various GFF, LLC entities, the taxpayers owned interests in 6 LLPs, 1 LLC, and 2 entities considered Tenants-In-Common. They directly owned interests in 1 LLP and 1 LLC. A diagram is worth more than a thousand words here.
On their 2000 through 2002 tax returns, the Garnetts reported income and losses that flowed through to them from their interests in the LLPs and LLCs. The IRS asserts that the Garnetts hold their interests as “limited partners” and are therefore subject to the limitations imposed by section 469(h)(2).
Passive Activity Rules and Seven Material Participation Tests
Section 469(a) disallows losses associated with passive activities. A passive activity is defined – in sec. 469(c) – as a trade or business in which the taxpayer does not materially participate. Section 469(h)(1) states, taxpayers who are involved in an activity on a “regular, continuous, and substantial” basis are treated as materially participating. Section 469(h)(2) provides an exception for interest in limited partnerships. Under 469(h)(2) a taxpayer whose interest is held in a limited partnership is not treated as materially participating except as provided by the regulations.
The regulations, sec. 1.469-5T(a), set out seven ways in which a taxpayer can show material participation. In the case of 469(h)(2) limited partnership interests, however, only three of the seven can be used to determine material participation. Those three are (1), (5), and (6). Sec. 1.469-5T(e)(2). Consequently, it is more difficult to establish material participation if the taxpayer’s interest is considered a 469(h)(2) interest. The seven tests are as follows:
(1) The individual participates in the activity for more than 500 hours during such year;
(2) The individual's participation in the activity for the taxable year constitutes substantially all of the participation in such activity of all individuals (including individuals who are not owners of interests in the activity) for such year;
(3) The individual participates in the activity for more than 100 hours during the taxable year, and such individual's participation in the activity for the taxable year is not less than the participation in the activity of any other individual (including individuals who are not owners of interests in the activity) for such year;
(4) The activity is a significant participation activity (within the meaning of paragraph (c) of this section) for the taxable year, and the individual's aggregate participation in all significant participation activities during such year exceeds 500 hours;
(5) The individual materially participated in the activity (determined without regard to this paragraph (a)(5)) for any five taxable years (whether or not consecutive) during the ten taxable years that immediately precede the taxable year;
(6) The activity is a personal service activity (within the meaning of paragraph (d) of this section), and the individual materially participated in the activity for any three taxable years (whether or not consecutive) preceding the taxable year; or
(7) Based on all of the facts and circumstances (taking into account the rules in paragraph (b) of this section), the individual participates in the activity on a regular, continuous, and substantial basis during such year.
The really important test is (4). This is where most taxpayers can satisfy the material participation test. This test allows taxpayers to aggregate significant participation activities. A significant participation activity is a trade or business activity where the taxpayer participates for more than 100 hours during the year. By aggregating significant participation activities the 500 hour threshold for test (4) becomes much easier to reach.
Tax Court Holds an LLC/LLP Interest is not Covered by Section 469(h)(2)
The Tax Court points out that aside from one State, LLCs and LLPs were not even in existence at the time Congress passed 469(h)(2). It is therefore unlikely Congress contemplated these entity types when the legislation was drafted.
As justification for 469(h)(2) the legislative history takes particular note, that a limited partner necessarily voids his or her liability protection by materially participating in the partnership’s business. As a result, there is a presumption that the limited partner is passive. The legislative history also states the “Secretary would have regulatory authority to treat ‘substantially equivalent entities’ as limited partnerships for purposes of section 469(h)(2).”
The Tax Court contrasts the legal characteristics of limited partnerships with limited liability partnerships and limited liability corporations; one difference appears determinative. An LLC member or an LLP partner maintain their liability protection even though he or she materially participates in the partnership’s business. Thus, the presumption mentioned earlier seems misplaced when applied to LLC and LLP interests.
What Really Changes
In an earlier decision, Gregg v. United States, 186 F. Supp. 2d 1123 (D. Or. 2000), the Oregon District Court came to the same conclusion as the Tax Court. The difference being that decision was authority for taxpayers in the 9th Circuit, while the Tax Court’s decision here applies to all taxpayers.
My research in this area revealed that most secondary sources already indicated a lack of statutory support for the IRS’s position in this case. Consequently, I think most tax return preparers already used all seven tests to determine material participation for LLC members.
The Garnett’s case is just getting started. They still have to prove they materially participated in each of their eleven entities, although now it will be a little easier. In addition, as was before this case, they have to satisfy the at-risk rules of section 465 and the partnership basis rules of section 704 to deduct losses.
The Tax Court, at the request of the Service, ignored the indirect ownerships when interpreting 469(h)(2). Question for the readers – assuming there are any – which entity do the Garnett’s apply the material participation tests to? The GFF entities or the second tier?