10.11 Partners and Members of LLCs and LLPs

As a general partner, your share of partnership income or loss during the partnership year ending within your tax year is passive or nonpassive, depending on whether you materially participated under any of the seven IRS tests(10.6) in the partnership activities during the year. Limited partners have a reduced ability to show material participation as discussed below. On Schedule K-1 of Form 1065, the partnership will identify each activity it conducts and specify the income, loss, deductions, and credits from each activity.

Planning Reminder

Publicly Traded Partnerships (PTPs)

A PTP is a partnership whose interests are traded on established securities exchanges or are readily tradable in secondary markets. PTPs that are not treated as corporations for tax purposes are subject to special rules that allow losses to be used only to offset income from the same PTP. See the instructions to Form 8582.

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Not treated as passive income are payments for services and certain guaranteed payments made in liquidation of a retiring or deceased partner’s interest unless attributed to unrealized receivables and goodwill at a time the partner was passive.

Gain or loss on the disposition of a partnership interest may be attributed to different trade, investment, or rental activities of the partnership. The allocation is made according to a complicated formula included in IRS regulations.

Payments to a retired partner.

Gain or loss is treated as passive only to the extent that it would be treated as such at the start of the liquidation of the partner’s interest.

Limited partners.

Under IRS regulations, a limited partner has only a limited opportunity to establish material participation. A limited partner may use only three of the seven tests to establish material participation and thereby avoid passive treatment for the partnership income or loss:

The IRS in late 2011 released proposed regulations that revise its definition of a limited partner for purposes of applying the above material participation rules. Older regulations treated a partner other than a general partner as a limited partner if his or her liability was limited under state law. The new proposed regulations recognize that the reliance on limited liability is outdated given the emergence of LLCs and state law changes that allow limited partners to participate in management of the partnership without losing limited liability, similar to general partners and LLC members.

The proposed regulations, which were not yet finalized when this book went to press and may be changed in response to public comments, focus on a partner’s right to participate in management rather than on limited liability. As proposed, a taxpayer’s interest in an entity that is classified as a partnership is treated as a limited partnership interest if the taxpayer does not have rights to manage the partnership under the governing agreement and under the law of the jurisdiction in which the partnership was organized. A taxpayer who is treated as a limited partner under this definition would have to establish material participation under Test 1, 5, or 6 as noted above. A taxpayer who has management rights and who is not treated as a limited partner would be able to establish material participation under any of the seven material participation tests described in 10.6.

To determine material participation in rental real estate activities under the special rules for real estate professionals, a limited partner must meet Test 1, Test 5, or Test 6 (10.6), but see the de minimis exception at 10.3.

A limited partner is not considered to be an “active participant” and thus does not qualify for the $25,000 rental loss allowance (10.2).

LLC and LLP members.

The Tax Court and the Court of Federal Claims rejected IRS attempts to treat LLC and LLP members as limited partners under the older regulations that focused on limited liability. These court decisions allowed an LLC or LLP member to apply any of the IRS’s seven tests for material participation (10.6).

The IRS acquiesced after the result in the Court of Federal Claims case and announced that it would no longer litigate similar cases.