IRS Proposes Relaxing Rules on Material Participation by Limited Partners, LLC Members

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The Internal Revenue Service on Friday issued proposed regulations (REG-109369-10)  that would change the treatment of limited partners and LLC members under the passive activity rules, which can restrict the deduction of real estate and other passive activity losses. If such partners have rights to manage the partnership under local law, the regulations would remove the presumption that their losses are passive.

Under Sec. 469(h)(2), losses from a limited partner’s interest in a limited partnership are presumptively treated as passive losses.  This treatment was originally put into the Code at a time when state laws (following the Uniform Limited Partnership Act of 1916) generally forbade limited partners from participating in the control of the partnership.  The result of this treatment is that flow-through losses to limited partners can normally only be deducted against other items of passive income, or when the activity is disposed of.

The IRS notes that under the Revised Uniform Limited Partnership Act of 1985, many states have adopted laws that allow limited partners to participate in the management and control of the partnership without losing their limited liability, and therefore, the original presumption that all limited partners are by definition passive, can now be a misnomer. In addition, under state LLC laws, LLC members do not lose their limited liability by participating in the management and conduct of the LLC’s business.

With these proposed regulations, the IRS is changing its position on this issue and redefining when a partner’s interest will be treated as a limited partnership interest for purposes of the passive activity rules. Under the proposed regulations, an interest in an entity will be treated as an interest in a limited partnership under Sec. 469(h)(2) if:

  1. The entity is classified as a partnership for federal tax purposes; and
  2. The holder of the interest does not have rights to manage the entity at all times during the entity’s tax year under the law of the jurisdiction in which the entity was organized and under the entity’s governing agreement. Rights to manage include the power to bind the entity.
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