LLCs, Passive Activity Losses and Section 1411

At last, after a number of years of uncertainty, recent decisions and proposed regulations issued by the Internal Revenue Service have finally resolved how the passive activity loss rules of IRC § 469 apply to LLCs.

More significantly, they have done so in a way which significantly benefits LLC members and assumes increased importance because of the enactment of  IRC § 1411 and the new 3.8% Medicare Tax which applies to net investment income.

The Passive Activity Loss Rules

Since 1986, § 469 and the enactment of the “passive activity loss” rules have significantly limited the ability of taxpayers to utilize losses arising from “passive activities” to offset other taxable income. 

Section 469, of course, was a response to the tax shelter splurge of the 1980s and effectively killed “trafficking” in losses to shelter income.

Under IRC § 469, losses from passive activities cannot offset income from salaries, interest, dividends, gains from the sale of stock or other capital assets, or net income from a business in which the taxpayer actively participates.  Rather, such disallowed losses are carried forward and deducted in the future when passive income exists or when the taxpayer disposes of the passive activity that generated the passive activity losses.  [IRC § 469].

Material Participation Exception

As an exception to this general rule, the passive activity loss rule does not apply where an investor materially participates or is deemed to materially participate in an activity on a regular, continuous and substantial basis.  [IRC § 469(h)(1)].

In determining whether an owner meets the “material participation” test, general partners of a general partnership, S corporation shareholders, and certain other investors who are not limited partners may use seven (7) alternative mechanical tests set forth in temporary regulations to establish material participation in an activity.  [Temp. Reg. § 1.469-5T(a)].

Specifically, such investors may satisfy the material participation requirements for the taxable year by demonstrating any of the following:

1. The investor participated in the activity for more than 500 hours during that year.  [Temp. Reg. § 1.469-5T(a)(1)].
2. The investor’s participation in the activity for the taxable year constituted substantially all of the participation of all individuals in the activity for that year -- including those individuals who are not owners of interests in the activity.  [Temp. Reg. § 1.469-5T(a)(2)].
3. The investor participated in the activity for more than 100 hours during the year, and the investor’s participation was not less than any other person’s participation in the activity that year.  [Temp. Reg. § 1.469-5T(a)(3)].
4. The activity is a significant participation activity, [A significant participation activity is an activity that is a trade or business activity in which the individual significantly participates -- participates for more than 100 hours -- for the taxable year but does not materially participate for such year -- determined without regard to this material participation test.  Temp. Reg. § 1.469-5T(c)], and the investor’s aggregate participation in all significant participation activities during that year exceeded 500 hours.  [Temp. Reg. § 1.469-5T(a)(4)].
5. The investor materially participated for any five taxable years during the ten taxable years immediately preceding the current taxable year.  [Temp. Reg. § 1.469-5T(a)(5)].
6. The activity is a personal service activity.  For these purposes, an activity constitutes a personal service activity if such activity involves “the performance of personal services in the fields of health, law, engineering, architecture, actuarial science, performing arts or consulting; or any other trade or business in which capital is not a material income-producing factor.”  Temp. Reg. § 1.469-5T(d) and the investor materially participated for any three taxable years preceding the taxable year.  [Temp. Reg. § 1.469-5T(a)(6)]. or
7. Based on all the facts and circumstances -- after taking into account certain limitations -- the investor participated in the activity on a regular, continuous, and substantial basis during that year.  [Temp. Reg. § 1.469-5T(a)(7)].

The “Limited Partner” Presumption

However, if a taxpayer holds an “interest in a limited partnership as a limited partner,” § 469(h)(2) presumes the taxpayer did not materially participate in the activity of the partnership.  Thus, the activity is a per se passive activity.  I.R.C. § 469(h)(2) (“Except as provided in regulations, no interest in a limited partnership as a limited partner shall be treated as an interest with respect to which a taxpayer materially participates.”)

An investor holding a limited partnership interest can overcome this passive activity presumption in one of two ways:

1. If the investor is also a general partner in the partnership, the passive activity presumption does not apply.
2. If the investor satisfies test (1), (5) or (6) of the material participation standard described above, the investor can overcome the passive activity presumption. 

As a consequence of the presumption, limited partners cannot use the often more lenient participation tests.

Members of LLCs Limited Partners?

The question arose as to how these rules apply to LLCs.  The IRS consistently took the position that holders of LLC interests held such interests as limited partners.  Fortunately for taxpayers, this position was rejected in a series of cases.  Gregg  v. United States, 186 F. Supp. 2d 1123 (D. Or. 2000); Thompson v. United States, 87 Fed. Cl. 728 (2009); Newell v. Commissioner, 99 T.C.M. (CCH) 1107, 2010 T.C.M. (RIA) § 10,023; Garnett v. Commissioner, 132 T.C. 368 (2009);Hegarty v. Commissioner, No. 3730-07S, T.C. Summ. Op. 2009-153, 2009 WL 3188789 (T.C. Oct. 6, 2009). 

Rather than focusing on limited liability, which was the crux of the government’s position, the courts focused on whether the relevant member in the LLC could participate in the management of the business.  This argument was first successfully urged in the Gregg case and it was subsequently expanded upon in the subsequent decisions.

After this series of defeats, on November 28, 2011, the Service issued proposed regulations to provide guidance on whether the passive activity presumption applies to LLC members.  [Prop. Reg. § 1.469-5(e)(3)(i)].

Specifically, the proposed regulations provide that an interest in an entity constitutes an interest in a limited partnership as a limited partner if two requirements are met:

1. The entity is classified as a partnership for federal income tax purposes and
2. The interest holder does not “have rights to manage the entity at all times during the entity’s taxable years under the law of the jurisdiction in which the entity is organized under the governing agreement.”  [Prop. Reg. § 1.469-5(e)(iii).

According to the preamble of the Regulations, the right to manage the entity also “includes [the power to bind the entity].”  Thus, if those requirements are met, an interest holder would not be subject to the “limited partner” passive activity presumption under the proposed regulations. 

The proposed regulations thus abandon the current regulations’ reliance on limited liability and instead focus upon the issue of control.

Note, however, this suggests that in drafting LLC operating agreements, if avoiding the passive activity loss rules is important, it will be important to consider the impact of appointing managers and thus stripping non-member managers of control and authority to bind.  This could conceivably convert an otherwise qualifying member back into a “limited partner” for purposes of the proposed regulations.

Passive Activities, Material Participation and Section 1411

The foregoing is all well and good but, to some degree, would likely provoke a large yawn if there were no other consequences.  However, what would have formerly been a matter of only passing interest with the enactment of new IRC § 1411 is now of great interest. 

The reason for this is that to the extent that an owner of an entity taxed as a partnership or S corporation has gain attributable to that entity, if that interest is attributable to a non-passive activity, the resulting gain escapes the § 1411 3.8% additional surcharge tax.

This can be, of course, of extreme importance, particularly in the real estate industry. 

Thus, it can be seen that the recent cases and proposed regulations would permit LLC members to achieve a better tax than limited partners.

Impact on Self-Employment Tax

The interesting question next arises, what is the interface between these and self-employment tax on members of an LLC?

One potential negative is the risk that a member in an LLC would now be subject to self-employment tax on that member’s distributive share of net earnings from self-employment. 

Because, however, the definition of limited partner and the characterization of self-employment tax  is not congruent with the definition used for purposes of passive activity losses, it is quite possible for a member of an LLC to “materially participate” in the business of an LLC for purposes of passive activity loss rules and § 1411, yet potentially maintain “limited partner” characterization for self-employment tax rules. 

For instance, consider an LLC member who has no personal liability for LLC obligations or management authority in the LLC and who works in the LLC business more than 100 hours -- but less than 500 hours -- during the taxable year.  According to Thompson and Gregg, that member may qualify as a general partner under the passive activity loss rules.  Thus, the member may deduct any losses attributable to the LLC immediately as non-passive losses.  Later, if that same LLC becomes profitable, the member would not be subject to any self-employment tax on the member’s distributive share of LLC income pursuant to the proposed self-employment tax regulations (assuming that the member continues to work less than 500 hours during the taxable year and the LLC is not a service partnership).

On the other hand, a limited partner would not fare as well.  If the investor in the example above were a limited partner in a limited partnership -- instead of an LLC member, -- the investor would still not be subject to self-employment tax on the member’s distributive share of the partnership’s income under the proposed regulations.  But -- unlike an LLC member -- as a limited partner, the investor would not be able to immediately deduct any losses attributable to the partnership as non-passive losses under the recent case law.  Instead, the investor’s ability to deduct such losses would be limited under the passive activity loss rules.

This whole issue is further complicated by the recent decision in Renkemeyer,  Campbell and Weaver, LLP v. Commissioner, 136 T.C. 137 (2011).  In a somewhat poorly articulated case, the court seems to adopt an approach of a general “participation” test to determine whether an owner is a “limited partner” to qualify for the limited exclusion from self-employment tax.

Although the facts are complex in Renkemeyer, one can look at it for proposition that where the partner has an independent trade or business on a more or less regular, continuous activity, the courts will be open to a recharacterization of distributions to that partner as giving rise to income subject to self-employment. 

In sum, if the IRS chooses to pursue the logic of the Renkemeyer case in regulations under IRC § 1411, it may be able to close what otherwise is a potential hole in the overlap between 1411 and the 1402.  But apparently, the IRS has concluded that it may lack this authority under IRC § 1411.[1]  If so, Congress may need to revisit the area.  In the interim, a significant planning opportunity exists for taxpayers that will produce much work for lawyers and accountants and complex structures for business.