Garnett vs. Commissioner - Material Participation
In Garnett v. Commissioner, Dec. 57,875, 132 TC 19 the IRS contended that because the taxpayers had limited liability with respect to their ownership interests in limited liability companies and limited liability partnerships they should be deemed to have a limited partnership interest, and the losses they incurred from these activities should automatically be considered passive losses under Code Sec. 469(h)(2).
The court disagreed with the IRS that simply being a member of an LLC or an LLP and having limited liability automatically makes losses from an LLC or LLP passive. Instead, all of the facts and circumstances of a taxpayer’s participation in the entity must be considered in determining whether the material participation requirements are met.
This is not the only case on this topic that the IRS lost; another is Thompson v United States 87 Fed Cl 728 (July 20, 2009) to which the IRS acquiesced “in result only.”
It should be noted that Code Sec. 469 and related regulations were enacted prior to the existence of LLPs and the widespread availability of LLCs. Recognizing that litigation wasn’t working, the IRS issued Prop. Reg. §1.469-5, which will become effective after being finalized. It clarifies when a member of a partnership or multi-member LLC is a limited partner for determining material participation under the passive activity rules: whether an individual is a limited partner in an LLC depends upon the individual’s right to participate in management of the entity, and not on the extent to which the individual has limited liability. An individual’s interest in an LLC will be treated as a limited partnership interest if:
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For federal tax purposes, the entity is classified as a partnership under the check-the-box regulations, and
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Under state law or the operating agreement of the entity the holder of the interest does not have any rights to manage the entity at any time during the entity’s tax year. (Prop. Reg. 1.469-5(e)(3)(i))
The general partnership exception continues to apply under the proposed regs. That is, an individual is not treated as holding a limited partnership interest in a limited partnership if he or she also holds a general partnership interest at all times during the partnership's tax year ending with or within the individual's tax year. (Prop. Reg. 1.4695(e)(3)(ii)).