IRS Loses in Second Venue this Summer on Theory that LLC Interests Automatically are Treated as Limited Partnership Interests under §469(c)(1)(B)

The IRS, fresh from the loss in the Garnett case, attempted before the Court of Federal Claims to obtain support for its view that an LLC membership interest automatically is treated, for purposes of the passive loss rules, as a limited partnership interest due to the owner having limited liability. In the case of Thompson v. United States, the government again attempted to argue that Temporary Reg. §1.469-5T(e)(3) mandates that result.

James Thompson did not challenge the validity of the regulation, but rather argued that it was not applicable to him. Temporary Reg. §1.469-5T(e)(3)(i)(B) does hold that an interest that is not otherwise a limited partnership interest will be treated as one if the “liability of the holder of such interest for obligations of the partnership is limited, under the law of the State in which the partnership is organized.” The IRS views that as being an open and shut resolution of the matter, at least unless the taxpayer challenges the validity of the underlying regulation.

In Garnett, the Tax Court argued that the IRS view failed to take into account the clause following at (iii) that notes that if a person who is otherwise a limited partner holds a general partnership interest, then the person will not be subject to §469(c)(1)’s automatic passive classification. The Court of Claims initially goes a different route to arrive at a very similar result. It finds the regulation simply inapplicable to an LLC, arguing that the word “partnership” found in Temporary Reg. §1.469-5T(e)(3)(i)(B) looks to the state law definitions and not the “assumed” entity type under the check the box regulations. As an LLC is not, for state law purposes, a partnership the sentence is simply inapplicable (there is partnership organized under any state law).

However, the Court of Claims does not stop there—it notes an issue with trying to treat an LLC as a limited partnership. The Court notes that a limited partnership requires both limited and general partners, and so quizzes the IRS about just who is the “general partner” in this supposed limited partnership. The Court also pointed out that under the law for the state of Texas, where this entity was based, a limited partner in a true limited partnership under Texas law would have lost that status had the partner been participating in management to the extent that James Thompson did.

The Court commented that the IRS was in error in viewing the key feature of a limited partnership for purposes of §469 was whether liabilities are limited—rather, the court noted, that Congress was mainly concerned with investors who had no real role in an entity that attempted to claim losses.

It’s important not to read the results this case, or the Garnett case, too broadly. The cases do not hold that every LLC member is automatically treated as not subject to the passive loss rules. Rather they simply hold that we have to test involvement in the same way that we otherwise test whether an individual has enough involvement with the activity for it to be treated as not passive.

As well, the Court’s view about the key differences between an LLC and a limited partnership may create issues if carried over into another place where the Internal Revenue Code mentions limited partnerships–§1402(a)(13)’s exclusion of income from a partnership from self-employment tax for limited partners. Many practitioners would not find a strict state law definitional reading of that provision to be one whose results their clients would be happy with.

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