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Superior Court Finds LLC Fees Unconstitutional

July 20, 2009
By Phillip L. Jelsma

In Garnett v. Commissioner 132 T.C. No. 19 (2009), the Tax Court concluded that an interest in a limited liability company (“LLC”) was not automatically treated as a limited partnership for purposes of the passive loss rules. The decision suggests that LLC interests can be treated as either active or passive activities depending on whether or not the member of the LLC materially participates in the LLC’s activities.

The taxpayer held an interest in two LLC’s where they were neither the majority owner nor the manager. At issue was whether the LLCs were automatically characterized as passive activities. I.R.C. Section 469 generally limits the deductibility of losses from passive activities to passive income. A passive activity is a trade or business in which the taxpayer does not materially participate. The IRS regulations provide seven tests for material participation, only two of which apply to limited partnership interests. Before the Tax Court was a question of whether LLC interests were presumptively the same as limited partners’ limited partnership interests, therefore, the taxpayers would be restricted to two tests for material participation instead of the seven tests which apply to general partnership interests.

In concluding that LLC interests were not presumptively the same as limited partnership interests, the Tax Court noted under the Congressional Committee Reports to section 469 that limited partnerships were presumptively passive since a limited partner generally is precluded from participating in a partnership business if he is to retain his limited liability status. However, the Tax Court concluded that the rationale does not extend to LLCs since unlike limited partnerships, members are not precluded by state law by materially participating in the business of the LLC. Accordingly, the court held that the taxpayers held their interests as general partners for purposes of the passive activity rules. In reaching this conclusion, the Tax Court was careful to not invalidate the temporary regulations on this point.

This is an important case of first impression. Previously, the United States District Court in Oregon, Gregg v. United States 186 F. 2d 123 (D. Or. 2000) held that members of an Oregon LLC were not automatically characterized as limited partners for purposes of the passive loss aggregative rules. If you would like more information on the Garrett case, please contact Phil Jelsma at 858.367.7675 or pjelsma@cgs3.com.