Proposed Change to Definition of "Limited Partnership Interest" for Purposes of Passive Activity Loss Rules Based on Management Rights

On November 25, 2011, the US Internal Revenue Service ("IRS") issued proposed Treasury regulations under the passive activity loss ("PAL") rules which propose to revise the definition of an "interest in a limited partnership as a limited partner". Losses allocated to a limited partner are presumptively subject to the PAL rules, which cannot be used to offset non-passive income, such as interest or dividends. In classifying an interest as a limited or general partnership interest, the Proposed Regulations focus on the holder's ability to manage the entity as opposed to the focus in the current regulations which is the designation as a limited partner or the limited liability of the holder. The Proposed Regulations affect individuals who are partners in partnerships, and are to be effective if and when they are published as final regulations in the Federal Register.

Background

Losses recognized by an individual from a business activity in which the taxpayer does not materially participate are classified as a passive activity losses under the PAL rules. A passive activity loss can only used by the individual taxpayer to offset passive income, and not portfolio income such as interest or dividends. Losses from a limited partner's interest in a limited partnership are presumptively classified as passive losses, except to the extent provided in regulations. The grant of regulatory authority was intended to prevent taxpayers from manipulating the rules by generating passive income through holding limited partnership interests.

Material Participation Requirement for Limited Partners

The ability of a limited partner to claim losses from a limited partnership interest as non-passive losses is more restricted than the ability of a general partner to claim non-passive losses from a general partnership interest. Losses from a general partnership interest can be classified as non-passive losses if the general partner meets any one of seven tests to prove material participation, whereas a limited partner must meet one of only three tests set forth below to be considered to materially participate in the activity of the partnership:

  • Participation in the activity for more than 500 hours during the taxable year.
  • Material participation in the activity for any five of the last 10 taxable years.
  • Material participation in a personal service activity for any three prior taxable years.

Proposed Change to the Definition of Limited Partnership Interest

Under current rules, a limited partnership interest includes (i) any interest that is designated as such in the partnership agreement, without regard to whether liability is limited under state law; or (ii) any other interest in a partnership where the holder's liability is limited under state law to a fixed amount.

The Proposed Regulations provide that an interest in an entity would be treated as an interest in a limited partnership if two conditions are met, the entity must be classified as a partnership for US federal income tax purposes and the holder of the interest must not have rights to manage the entity at all times during the entity's taxable year under the law of the jurisdiction in which the entity was organized and under the governing agreement. The preamble to the Proposed Regulations affirmatively states that rights to manage include the power to bind the entity, but it is not clear if other rights that a member may have would be sufficient for this purpose, such as approval rights or voting control.

If classified as a limited partnership interest, the Proposed Regulations retain the rule of the existing regulations that permits a limited partner to establish material participation in a limited partnership if it satisfies any of the three tests set forth above. In addition, the Proposed Regulations retain the rule that a taxpayer will not be treated as a limited partner for purposes of the PAL rules if it is also a general partner in the partnership at all times during the relevant taxable year when the taxpayer holds the partnership interest.

Purpose of Proposed Change

The legislative history to the PAL rules indicates that the presumption that a limited partner does not materially participate in an activity was based on the fact that under relevant state laws existing at the time, limited liability could be maintained with respect to holding a limited partnership interest only where the limiter partner was not active in the partnership's business. Today, however, many states have adopted a variation of the Revised Uniform limited Partnership Act of 1985, pursuant to which limited partners may participate in the management and control of the partnership without losing their limited liability. Similarly, under the Uniform Limited Liability Act of 1996, LLC members of member-managed LLCs do not lose their limited liability by participating in the management and conduct of the company's business.

The IRS recognizes two key developments that have taken place since the original enactment of the PAL rules: (i) that the original presumptions regarding the limitations on a limited partner's ability to participate in the activities of the partnership are no longer valid today; and (ii) the emergence of LLCs. The Proposed Regulations would clarify the treatment of LLC member interests and eliminate the existing regulations' reliance on limited liability for purposes of determining whether an interest is an interest in a limited partnership as a limited partner by adopting an approach that relies on the individual partner's right to participate in the management of the entity. Thus, under the Proposed Regulations, an LLC member would generally be limited to three of the seven material participation tests, unless the member has sufficient management rights.

Conclusion

The issuance of the Proposed Regulations perhaps signals that the IRS is now willing to concede what various courts and commentators have argued for some time—that the presumption that a partner with limited liability does not materially participate in the activities of the partnership or LLC, is inconsistent with the legislative intent behind the PAL rules and existing business arrangements. Further, the Proposed Regulations' focus on a partner's right to participate in management, instead of its limited liability, is consistent with the approach in defining "limited partner" for purposes of certain other provisions of the Code.

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