Two Courts Say That LLC and LLP Members Are Not Per-Se “Passive” Limited Partners

The passive loss rules can have a substantial impact on farmers and ranchers as well as investors in farm and ranch land.  Until 1987, it was not uncommon for non-farm investors to purchase agricultural land and incur losses which the investor would then use to offset against the investor’s wage or other income.  However, the passive loss rules, enacted in 1986, reduce the possibility of offsetting passive losses against active income.   The effect of the rules is that deductions from passive trade or business activities, to the extent the deductions exceed income from all passive activities may not be deducted against other income.

The proper characterization of the loss depends on whether the taxpayer is materially participating in the business.   But, I.R.C. §469(h)(2) creates a per-se rule of non-material participation for limited partner interests in a limited partnership unless the Treasury specifies differently in regulations.  The statute was written before practically all state LLC statutes were enacted and before the advent of LLPs, and the Treasury has never issued regulations to detail how the statue is to apply to these new types of business forms.

The issue of how losses incurred by taxpayers that are members of LLCs (and LLPs) are to be treated under the passive loss rules has surfaced in four recent court opinions three by the U.S. Tax Court (one a full opinion, one a memorandum opinion and one a summary opinion) and one by the U.S. Court of Federal Claims).  In the cases, IRS stood by its long-held position that the per-se rule of non-material participation applies to ownership interests in LLCs because of the limited liability feature of the entity.