Earlier this year, in Revenue Ruling 2008-12, the IRS ruled that the interest expense of a partnership engaged in trading activities for the account of its owners is characterized as investment interest expense of limited partners for those who do not materially participate in the business. While most expenses of partners in limited partnerships that conduct business activities are treated as "passive" if the partner does not materially participate, Regs. Section 1.469-1T(e)(6) provides that an activity of trading personal property for the account of owners of interests in the activity is NOT a passive activity (without regard to whether such activity is a trade or business activity), and thus passive loss treatment is not appropriate.
In Revenue Ruling 2008-38, the IRS has followed up on the earlier ruling and has indicated that the investment interest expense is business expense under Code Section 62(a)(1), and is not an itemized deduction. An accompanying Notice indicated that the expense is reported on Schedule E. The IRS guidance is useful for taxpayers. By characterizing the interest expense relating to the trading activities of the partnership as not being an itemized deduction under Section 63(d), it is effectively deductible for individual taxpayers even if they do not itemize their deductions. However, since investment interest deductions are not subject to the phase-out of itemized deductions under Code Sections 67 and 68 (unlike many other itemized deductions), the characterization of the deductions as itemized deductions will often not be a big deal to many taxpayers who otherwise itemize.
The IRS also indicated that any investment interest expense of the trading partnership that relates not to its trading activities but to its investment property is an itemized deduction. If a partnership has both types of interest expense, the taxpayer must allocate the individual's net investment income between the two categories of investment interest expense using a reasonable method of allocation. The Ruling provides an example of a reasonable method - allocate to each category based on the relative amounts of interest expense directly attributable to the two types of activities. Since this may unduly skew the bulk of the interest expense to investment activities (and thus making the deduction an itemized deduction to that extent) when the bulk of the indebtedness relates to investment activity and not trading activity, another reasonable method of allocation may be desired. While the Ruling provides no further guidance on what is reasonable, perhaps allocations based on relative amounts of gross income derived by the two types of activities, or the relative amounts of gross assets involved in each of the activities, may also pass muster as reasonable methods of allocation, and should be considered by taxpayers if they provide more favorable results.