Code Section 469 provides that passive activity losses (PALs) cannot be used to offset nonpassive activity income, such as wages, dividends, or profits from nonpassive activities. A taxpayer will incur PALs as to losses from the conduct of a trade or business in which the taxpayer does not materially participate. The IRS provides a list of rules for finding when a taxpayer will be treated as "materially participating" in a business. Treas. Regs. §1.469-5T (a)(1) through (7).
Under Code Section 469(h)(2) and the related Treasury Regulations, a limited partner's interest in a limited partnership is presumptively considered to not have material participation, and thus triggers PAL treatment for partnership losses. Treas. Regs. §1.469-5T(e)(1). Under this rule, only some of the rules referenced above for finding "material participation" can be used to show material participation - not all of the methods described under Treas. Regs. §1.469-5T (a)(1) through (7) are available. For example, the "more than 100 hours of participation" rule of (a)(3) cannot be used by a limited partner to show material participation.
What if the taxpayer owns a member interest in a limited liability company instead of a limited partner interest in a limited partnership? The IRS has sought to equate the two, and thus apply the above presumption of non-material participation status and limited exceptions to that status, to LLC member interests.
However, a recent Tax Court opinion finds that a limited liability company interest should not be treated the same a limited partnership interest for this purpose. This ruling allowed the taxpayer to use the "more than 100 hours of participation" rule to avoid PAL status for its losses.
This is not the first time the IRS has lost on this issue. It had previously lost in both the Tax Court and the Court of Federal Claims. At this point, the IRS would be hard-pressed to continue to assert a position contrary to all 3 of these cases.
Hegarty, TC Summary Opinion 2009-153