Courts Rule that Active Member of Limited Liability Company Not Subject to Passive Loss Limitations

August 14, 2009 Advisory

On June 30, 2009, the U.S. Tax Court ruled that membership interests in limited liability companies ("LLCs") and Limited Liability Partnerships ("LLPs") will be treated as general partnership interests, and not limited partnership interests, under the passive loss rules of Section 469. See Garnett v. Commissioner, 132 T.C. 19 (2009). This decision will allow LLC and LLP members to more easily avoid the Section 469 passive activity loss rules limiting the deductibility of losses flowing through to members from an LLC or LLP against other sources of income. On July 20, 2009, the U.S. Court of Federal Claims, citing to Garnett, also held that LLC members should be treated as general partners and not as limited partners for purposes of determining such member's active involvement in the LLC's business. See Thompson v. United States, No. 06-211 (Fed. Cl. Jul. 20, 2009).
Background
Section 469(a)(1) prevents taxpayers from deducting losses from certain passive investment activities against other sources of income. In general, the term "passive activity" means a trade or business in which the taxpayer does not materially participate. Section 469(c)(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. Section 469(h)(1). Under temporary regulations promulgated in 1988, but never made final, a taxpayer can show material participation by satisfying any one of the following seven tests: (1) the individual participates in the activity for more than 500 hours during the year, (2) the individual's participation in the activity constitutes substantially all of the participation in such activity of all individuals, (3) the individual participates in the activity for more than 100 hours during the year and such participation is not less than that of any other individual, (4) the activity is a significant participation activity and the individual's participation in all significant participation activities exceeds 500 hours during the year, (5) the individual materially participated in the activity for any five of the last ten years, (6) the activity is a personal service activity and the individual materially participated in the activity for any previous three years, or (7) based on all facts and circumstances, the individual participates in the activity on a regular, continuous, and substantial basis during the year. See Section 1.469-5T(a), Temporary Income Tax Regs., 53 Fed. Reg. 5725-5726 (Feb. 25, 1088).

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