Newly Proposed IRS Regulations Intend to Clarify Definition of Limited Partner for Purposes of Material Participation


A question that often comes up in the course of our work is whether a taxpayer is materially participating in a trade or business.  Material participation is an important concept because the tax treatment of income or losses from a trade or business will be classified as passive or non-passive accordingly.  If a taxpayer does not materially participate in a trade or business, the activity is treated as passive.  Additionally, by statutory definition, all rental activities, even those in which the taxpayer materially participates, are generally treated as passive activities.  Material participation is defined as involvement in the operations of the activity that is regular, continuous and substantial, per IRC §416(h)(1).  There are seven tests that determine whether someone should be treated as materially participating.  In order to be considered materially participating, a taxpayer would need to meet one of these seven tests.

Limited partners are generally treated as not materially participating in partnership activities and therefore flow-through income and losses are treated as passive. Currently, a partnership interest is considered to be a limited partnership interest if the partnership agreement indicates it is limited or if the liability of the partner is limited for obligations of the partnership according to the  state laws in the state in which the partnership is formed.

The seven material participation tests are:

  1. Individual participates in the activity for more than 500 hours during the year
  2. Individual’s participation in the activity for the year constitutes substantially all of the participation of all individuals involved in the activity for the year
  3. Individual participates in the activity for more than 100 hours during the year, and such participation is not less than anyone else’s participation, including non-owners
  4. Activity is a significant participation activity (more than 100 hours), and the individual’s aggregate participation in all significant activities exceeds 500 hours
  5. Individual materially participates in the activity for any 5 out of the previous 10 taxable years preceding the taxable year
  6. Activity is a personal service activity (health, law, engineering, accounting, etc.) and individual materially participated in the activity for any 3 taxable years preceding the taxable year
  7. Based on all of the facts and circumstances, the individual participates in the activity on a regular, continuous and substantial basis during the year

The IRS has issued proposed regulations to modify the definition of a “limited partner” as it relates to a taxpayer being treated as materially participating.  If the holder of the interest in a partnership does not have management rights during the entire tax year, the proposed regulations detail that an interest in the entity would be treated as a limited partnership interest.  One exception to the rule is if an individual has both a limited and a general partner interest.  In this case, they would be treated as a general partner. Under the proposed regulations, it will become easier for individuals to meet the material participation tests. Fewer partnership interests will be treated as limited interests for passive loss purposes and as a result, taxpayers will be able to report the income or losses as non-passive.


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