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Recent Developments in Material Participation for LLCs and LLPs

Recent Developments in Material Participation for LLCs and LLPs. Presented by: Jim Browne Strasburger & Price LLP Tel: 214.651.4420 Email: jim.browne@strasburger.com December 1, 2010. Objectives. Understand what is a passive activity loss and how material participation affects such losses

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Recent Developments in Material Participation for LLCs and LLPs

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  1. Recent Developments in Material Participation for LLCs and LLPs Presented by: Jim BrowneStrasburger & Price LLPTel: 214.651.4420Email: jim.browne@strasburger.com December 1, 2010

  2. Objectives • Understand what is a passive activity loss and how material participation affects such losses • Understand the general 7 factor test for material participation by individuals and the special 3 factor test applied to limited partners • Understand the case law interpreting the limited partner test as applied to LLC/LLP members • Understand current status of the law affecting material participation of LP/LLC/LLP/LLLP members • Understand likely future IRS guidance

  3. Agenda • Overview of passive activity loss rules • Material participation for LLCs and LLPs • Statute and regulations • Case law • IRS response • Planning considerations • Current law • Future IRS guidance

  4. Material Participationfor LLCs and LLPs Overview of Passive Activity Loss (PAL) Rules

  5. Overview of PAL Rules • Background • Prior to 1986, tax shelters were pervasive • Passive business investments (real estate, farming, cattle, etc.) generated losses to offset income from other sources • §465 at-risk rules (1981) had not stopped the problem • Created the impression that “Only the little people pay taxes.” • Objective of PAL rules • Prevent losses from passive business activities from currently offsetting portfolio income or active business income (wages, etc.)

  6. Overview of PAL Rules • §469 disallows any “passive activity loss” and any “passive activity credit” • Passive activity loss is excess of losses from all passive activities over the income from all passive activities • Passive activity credit is the excess of credits from all passive activities over the tax liability from all passive activities • Excess losses/credits carry forward to following year • Suspended losses/credits are generally allowed (become non-passive) upon a taxable disposition of the entire activity to an unrelated party, or upon death

  7. Overview of PAL Rules • Persons affected • Individual, estate, or trust (other than a grantor trust) • Closely held C corporation • Personal service corporation • Partnerships (including LLCs) and S corporations • Not directly subject to PAL rules, but partners are subject to the rules on their allocable shares of the company’s tax items • Special rules for publicly traded partnerships

  8. Overview of PAL Rules • Passive activity defined • A trade or business activity in which the taxpayer does not materially participate • Trading securities, etc. for owners is not a passive activity • R&D and startup activities are considered a business activity • A rental activity (regardless of material participation) • Exception for real estate professionals • Excludes any working interest in any oil and gas property that the taxpayer holds directly or though a non-limited liability entity (regardless of material participation)

  9. Material Participationfor LLCs and LLPs Material Participation

  10. Material Participation • General rule: An individual (T) materially participates if T satisfies any one of the following tests: [Reg. §1.469-5T(a)] (1) T participates for >500 hours (2) T’s participation is substantially all participation of all persons (3) T participates for >100 hours and ≥ any other person (4) Activity is a significant participation activity (SPA) (>100, but <500 hours) and T’s participation in all SPAs is >500 hours (5) T materially participated in any 5 of last 10 years (6) Activity is a personal service activity and T materially participated for any 3 prior years (7) Facts and circumstances: T participates on regular, continuous, and substantial basis for >100 hours

  11. Material Participation • Limited partner rule [§469(h)(2)] • Senate Report: “In order to maintain limited liability status, a limited partner generally is precluded from materially participating in the business activity of the partnership … [and] limited partnerships commonly are used as vehicles for marketing tax [shelters].” • Statute: “Except as provided in regulations, no interest in a limited partnership as a limited partner shall be treated as an interest with respect to which a taxpayer materially participates.” • Legislative history grants authority to extend regulations to “substantially equivalent entities”

  12. Material Participation • Limited partner rule (con’t) • The premise of the limited partner rule is questionable • Limited partners who participate in control don’t necessarily lose limited liability (e.g., no creditor knowledge/reliance, or participation in control as an employee or agent or in other permitted capacities) • 2001 version of the uniform limited partnership act eliminated the limitation on control rights of limited partners • Should §469(h)(2) be repealed? • What harm would come if limited partners were subject to the same objective tests for material participation as others?

  13. Material Participation • Regulations re limited partner rule [Reg. §1.469-5T(e)] • General rule: no material participation by LPs • T is not treated as materially participating in any activity of a limited partnership for purposes of applying §469 to T’s share of tax items attributable to a limited partnership interest in the partnership • A “limited partnership interest” is any partnership interest: • Designated as such in the limited partnership agreement; or • As to which the holder’s liability is limited to a determinable fixed amount under state law • Focus of regulation is on limited liability; no mention of ability to participate in control of the business

  14. Material Participation • Regulations re limited partner rule (con’t) • Exception 1 – general partner interest • T’s partnership interest will not be treated as a limited partnership interest if T is a general partner in the partnership at all times during the year • “General partner” is not defined in the regulations • Theory seems to be that if T has unlimited liability as a general partner, any limited liability associated with T’s limited partnership interest is meaningless • Under this theory, if T holds a general partner interest through a single member LLC, T should not be viewed as a general partner, but the regulations do not specifically address this

  15. Material Participation • Regulations re limited partner rule (con’t) • Exception 2 - 3 factor test (1) T participates for >500 hours (2) T’s participation is substantially all participation of all persons (3) T participates for >100 hours and ≥ any other person (4) Activity is a significant participation activity (SPA) and T’s participation in all SPAs is >500 hours (5) T materially participated in any 5 of last 10 years (6) Activity is a personal service activity and T materially participated for any 3 prior years (7) Facts and circumstances: T participates on regular, continuous, and substantial basis for >100 hours

  16. Material Participation • Summary of limited partner rule • General rule: no material participation by a limited partner • Exception 1: limited partner that is also a general partner • Exception 2: limited partner that meets 3 factor test

  17. Material Participation • Evolution of limited liability entities • Traditional limited partnership (LP) • Limited partners have limited liability, but participation in control of the partnership business can compromise limited liability • General partner has unlimited liability • Limited liability company (LLC) • Limited liability for members regardless of exercise of control rights • No person with unlimited liability • Non-managing members may have no control rights

  18. Material Participation • Evolution of limited liability entities (con’t) • Limited liability partnership (LLP) • General partnership that registers as an LLP • Some states (e.g., DE) provide no liability for partnership obligations (equivalent to a member managed LLC) • Other states (e.g., TX) provide no liability for partnership obligations other than negligence etc. under partner’s control • Limited liability limited partnership (LLLP) • Limited partnership that registers as a LLLP • Impact is on liability of the general partners

  19. Material Participation • Application of limited partner rule to LLC/LLP* • No specific guidance in statute, legislative history, or regulations • IRS initial position: • LLC/LLP is a partnership for tax purposes • Member has limited liability and is therefore a limited partner • LLC/LLP members are not general partners (they do not have unlimited liability) • Therefore the LLC/LLP member is subject to the 3 factor test *This presentation assumes that the LLC/LLP is classified as a partnership for federal income tax purposes

  20. Material Participation • Gregg v U.S. (D. Ore. 2000) • Facts: T retired as CEO of closely held health care company (Ethix Corp.) in Nov. 1994 and formed an LLC to start a comparable health care business. He participated for ~100 hours during 1994. Two other members were former Ethix employees, who worked ~40 hours per week. • Loss incurred for 1994 and T deducted his share as a business loss • IRS disallowed T’s loss, and assessed penalties • T can win only under SPA test (test 4), which is not available to limited partners

  21. Material Participation • Gregg v U.S. (D. Ore. 2000) (con’t) • Holding: summary judgment for T • Limited partner test does not apply to LLC members • LLCs are designed to permit active participation by members without loss of limited liability; therefore, 7 factor test applies • Material participation: T met the first test • 500 hour test cannot be pro-rated for 1994 • But Ethix and LLC activities can be treated as a single activity, and on a combined basis T meets the 500 hour test (Test 1) • Limited partner status was not relevant to the outcome

  22. Material Participation • Garnett v. Comm’r (Tax Ct. 2009) • Facts: • T owned, directly and indirectly, minority interests (generally <15%) in multiple LLPs, LLCs, and TICs (all taxed as partnerships) engaged in farming and rental real estate • T’s control rights: • LLPs provided for active participation and limited liability for all partners • LLCs were manager managed, and T was not a manager of any operating LLC • T had management authority for one of the two TICs • IRS disallowed certain of the losses from the entities

  23. Material Participation • Garnett v. Comm’r (Tax Ct. 2009) (con’t) • Holding: summary judgment for T • Limited partner rule appliesto LLC/LLP member interests because LLC/LLP is treated as a partnership for tax purposes and Congress intended to give IRS to prescribe rules for “other similar entities” • Implicitly rejects reasoning in Gregg • But court concluded that a LLC/LLP member interest is a general partner interest under the regulations • Court specifically stated it was not invalidating the regulations

  24. Material Participation • Garnett v. Comm’r (Tax Ct. 2009) (con’t) • Surprisingly, IRS argued that general partner status depends on extent of control rights possessed and exercised • No support for this argument in the regulations; focus of regulations is exclusively on limited liability • The court felt that such an inquiry duplicated the 7 factor test • Court’s holding that an LLC member is a general partner is unconvincing; contrived effort to avoid invalidating regs • Unclear why IRS didn’t appeal as to the entities in which T did not possess and exercise control rights • Possibly because T would fail to meet any of the 7 tests anyway

  25. Material Participation • Thompson v. U.S. (Ct. Cl. 2009) • Facts: • T owned, directly and through an S corporation, 100% of an LLC that conducted an air charter service. T was the sole manager of the LLC • T and IRS stipulated that T met the material participation test if, but only if, T’s member interest in the LLC is not a limited partnership interest • Probably test 2 (sole participant)

  26. Material Participation • Thompson v. U.S. (Ct. Cl. 2009) (con’t) • Holding: summary judgment for T • Limited partner rule does not apply • The LLC is not a limited partnership, and T is not a limited partner • The LLC is not substantially equivalent to a limited partnership • And T’s interest constitutes a general partner interest • Limited liability is not the defining attribute of a limited partnership interest; rather Congress focused on participation in the activity • IRS conceded that if the LLC were a limited partnership, T would be a general partner • Effectively agrees with both Gregg and Garnett

  27. Material Participation • Hegarty v. Comm’r (Tax Ct. Sum. Op. 2009) • Facts: • Ts (H&W) operated a charter fishing business through an LLC • Ts participated for >100 hours and were the only persons that participated in the activity • Holding: IRS disallowance of Ts’ losses is rejected • Under Garnett, Ts are considered general partners and can use the 7 factor test • Ts materially participated in the activity under test 2 (sole participant)

  28. Material Participation • Newell v. Comm’r (T.C. Memo 2010) • Facts: • T, a real estate professional, owned all of the stock of an S corporation (M) engaged in the millwork business, and a 33% managing member interest in an LLC (P) that operated a golf club • T worked in each business for >100 hours, but <500 hours • T assumed liability for certain P debts • IRS claims losses of both M and P were passive activity losses • T did not meet the significant participation activity test (test 4) with respect to P because that test is not available to a limited partner

  29. Material Participation • Newell v. Comm’r (T.C. Memo 2010) (con’t) • Holding: decision for T • Garnett followed • T is a general partner in P and can rely on the 7 factor test • T’s case is even stronger than in Garnett because T established that he was the managing member in P and was actively involved in day-to-day operations • T’s assumption of certain P liabilities did not affect the analysis • T satisfies the significant participation activities test (test 4) with respect to P

  30. Material Participation • Summary of case law • Two ways for LLC/LLP member to win • Limited partner rule does not apply to an LLC member • Tax Court rejects this argument, but it is accepted in the Ct. Fed. Cl. • LLC/LLP interest is a general partner interest • Extends even to non-manager LLC/LLP interests (?) • No way to lose • IRS litigating position rejected in every case • Regulations’ focus on limited liability as the hallmark of limited partner status rejected in every case

  31. Material Participation • IRS response • Thompson case: acquiesce in result only [AOD 2010-02, Mar. 2010] • Probably chose Thompson case to signal disagreement with holding that the regulations don’t apply to LLC members • IRS apparently will apply 7 factor test to LLC/LLP members • 2009-2010 priority guidance plan adds item for partnership §469 material participation • IRS comments: • limited liability isn't the key in determining limited partner status; limitations on control rights is the key • Even for a true limited partner, there may be no substantive limitation on control rights

  32. Material Participationfor LLCs and LLPs Planning Considerations

  33. Planning Considerations • Current law • LLC/LLP members are effectively exempt from limited partner rule and can apply the 7 factor test • It appears that even a non-managing member can apply the 7 factor test; but can T satisfy the any of the tests? • Status of limited partner in an LLLP unclear • Designation as a limited partner implies limited partner status (3 factor test) • But ability to participate in control without loss of limited liability implies general partner status (7 factor test)

  34. Planning Considerations • Implications for self-employment taxes (SET) • §1402(a)(13) excludes from SET the distributive share “of a limited partner, as such, other than guaranteed payments … for services” • Originally enacted to prevent taxpayers from accruing social security benefits via passive investments in partnerships • Now operates as a taxpayer favorable shield from SET • Does the holding in Garnett -- that an LLC member is classified as a general partner for PAL purposes -- imply that an LLC member should also be classified as a general partner for SET purposes?

  35. Planning Considerations • Implications for SET (con’t) • IRS unlikely to argue that an LLC member is per se a general partner for SET purposes • Undermines the original statutory purpose of §1402(a)(13) • Proposed regulations acknowledge that LLC members should be classified in the same manner as limited partners • Proposed regulations contemplate dual status partners; PAL rules do not • New Medicare tax (§1411; eff. 2013) eliminates the benefit of §1402(a)(13) for high income taxpayers in passive activities • Any remaining gaps in SET likely to be dealt with through legislation (proposed §1402(m))

  36. Planning Considerations • Future IRS guidance • Option 1: Full exemption for LLC/LLP/LLLP members • Limited partner is any partner in an entity classified as a partnership for tax purposes who has both (a) limited liability and (b) “limited control rights” • Limited control rights = T may not participate in control of the entity’s business without potentially compromising T’s limited liability under the statute governing formation and operation of the entity • LLC/LLP/LLLP members would have the same status as S corporation shareholders • Eliminate “designated as a limited partnership interest” test, or make it a presumption • Eliminate the general partner exception?

  37. Planning Considerations • Future IRS guidance (con’t) • Control rights in separate capacity • T is not treated as having limited control rights if T possesses the authority to participate in control of the entity in a capacity other than as a partner without subjecting T to unlimited liability, and T actively exercises that authority • E.g., T actively controls the partnership as an employee or agent of the partnership, or as an officer of an S corporation GP or as a manager of an LLC GP • Active = >100 hours? • Theory is that T is not the type of pure passive limited partner that Congress targeted

  38. Planning Considerations • Future IRS guidance (con’t) • Option 2: Partial exemption for LLC/LLLP members • Limited control rights means either • T may not participate in control of the entity’s business without potentially compromising T’s limited liability under the state statute governing formation and operation of the entity or • T lacks authority to participate in the control of the business (regardless of impact on limited liability) • Non-managing members of manager-managed LLC and limited partners of LLLPs would generally be treated as limited partners • Exception for possession and active exercise of control rights in a separate capacity would apply • Perpetuates preference for S corporation shareholders (who are not limited partners regardless of limitations on control rights)

  39. Planning Considerations • Future IRS guidance (con’t) • Option 3: eliminate the limited partner rule • Apply the 7 factor test to limited partners • Rationale: • Concern of §469(h)(2) is sufficiently addressed in 7 factor test • Changes in state laws affecting limited partners and development of alternative limited liability entities have effectively eliminated the premise for subjecting limited partners to special limitations on material participation • Harmonizes treatment of all limited liability investors

  40. Material Participationfor LLCs and LLPs Summary

  41. Summary • Passive activity losses cannot offset portfolio income or active business income • A passive activity generally defined as a business in which T does not materially participate • Special rules for rental activities and working interests • There are two tests for material participation • General rule for individuals = 7 factor test • Limited partners = 3 factor test • The IRS’s position that a limited partnership interest is defined by limited liability has been rejected

  42. Summary • Current law • LLC/LLP members can use the general 7 factor test • Status of LLLP limited partners is unclear • Other limited partners generally must use the 3 factor test • Future IRS guidance • IRS should eliminate the limited partner rule, but unlikely • Limited partner will likely be defined as having both limited liability and limited control rights • Will non-managing members be deemed to lack control rights? • Will control rights in other capacities be counted?

  43. Disclaimers • This document is not intended to provide advice on any specific legal matter or factual situation, and should not be relied upon without consultation with qualified professional advisors. • Any tax advice contained in this document was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties that may be imposed under applicable tax laws, or (ii) promoting, marketing, or recommending to another party any transaction or tax-related matter.

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