A limited liability company (LLC) member's interest in his LLC was not a limited partnership interest for purposes of applying the more stringent test for material participation under the passive activity rules because the IRS lacks the authority to apply that rule to anyone who is not, strictly speaking, a limited partner. Accordingly, material participation of an LLC member is evaluated using the more generous criteria that normally applies to anyone who is not a limited partner. This decision by the Court of Federal Claims follows within days the Tax Court's similar decision against the IRS in P.D. Garnett, 132 TC No. 19, Dec. 57,875 (TAXDAY, 2009/07/01, J.1).

CCH Comment. This decision by the US Court of Federal Claims is quite taxpayer-friendly. Like the Garnett decision, it includes interests in limited liability partnerships (LLPs) within its sweep, but unlike Garnett , it does not leave the door open for the IRS to amend its regulations to address the treatment of LLC and LLP members with respect to the more stringent material participation criteria.

Background. Code Sec. 469(h)(2) provides that, except as provided by regulations, no interest in a limited partnership as a limited partner is to be treated as an interest with respect to which a taxpayer materially participates. Legislative history indicates that Congress implemented this rule in recognition of the state rules governing limited partnerships under which a limited partnership interest loses its limited liability protection if the owner participates in managing the partnership. The thinking was that it was safe to assume that limited partners do not materially participate in the partnerships. Temporary Reg. §1.469-5T(e)(3) loosens this absolute rule by allowing limited partners to prove material participation, albeit without the benefit of the full range of criteria normally available to a taxpayer. It also provides an exception for taxpayers who also have a general partnership interest. Since this regulation was issued in 1988, LLPs and LLCs have become common. Like limited partner interests, LLP and LLC interests have limited liability, but unlike limited partner interests, they do not preclude the owner from participating in partnership management.

Court's reasoning. The Court of Federal Claims took a literal view of the language in Code Sec. 469(h)(2), and held that the more stringent material participation rule applies solely to those who held interests in a limited partnership as a limited partners. Hence, the IRS has no authority to apply the more stringent material participation test to one who holds an LLC or LLP interest. The court rejected the IRS's view that limited liability was the main test of whether the more stringent rule applies and, instead, focused on the involvement of the taxpayer in management. The court reasoned tha,t in light of the legislative history suggesting limited partners were singled out due to the state rules against participation in management, there was no reason to extend the rule to LLC and LLP interests, which were not so limited.

Garnett compared. According to the Tax Court, Temporary Reg. §1.469-5T(e)(3) requires the pigeonholing of LLC and LLP interests into either general partner or limited liability partner status, neither of which is a clear fit for LLC or LLP interests. The court noted a complete lack of guidance in the regulation on how to define general and limited liability partners. The Tax Court decided to "pigeonhole" the LLC and LLP interests as general partner interests so that they fall under the general partner exception to the more stringent standards. The court noted that it was declining to "fill any gap" in the regulations to reflect the IRS's litigating position in the case.

CCH Comment. Although both the Tax Court and the Court of Federal Claims arrived at the same conclusion, the Tax Court is kinder to the IRS. In recognition of the fact that LLCs and LLPs are generally taxed as partnerships, the Tax Court avoided applying a literal reading of "limited partner." In light of the fact that the IRS applied the limited partner rule to LLC and LLP interests without amending its regulation, the Tax Court appears to have concluded that it woul give the taxpayer the benefit of the doubt in applying it. However, the Court of Federal Claims said that the IRS cannot apply the regulation to LLC and LLP interests, ever. If these decisions are upheld on appeal, it will be interesting to see which court's reasoning ultimately prevails. In any case, at the very least the IRS will likely have to rethink its current position that any participation in the LLC or LLP will result in application of the more stringent material participation test.

J.R. Thompson, FedCl, 2009-2 USTC ¶50,501