Ted and John are friends from the same town. Each is successful in his professional career (Ted as a dentist, John as an insurance salesman). Ted decides to invest in and do some part-time work at a chicken farm in town, and John, thinking that that sounds like a good way to make a little extra money, invests in and does parttime work at an ostrich farm across the road from Ted’s chicken farm. Each, along with a handful of other investors, works about 400 hours a year on his respective farm.

After the recent downturn in the economy, Ted and John both have losses in their respective farming businesses. Each wants to deduct their respective losses in their farming businesses against the ordinary income from their primary careers. It turns out, however, that Ted can deduct his losses while John cannot. Why? Ted’s farm is owned by a limited liability company (“LLC”) in which Ted is a member, whereas John’s farm is owned by a limited partnership (“LP”) in which John is a limited partner. This small difference determines whether the losses from their respective farms are a “passive activity loss.”

Real Estate Bubbles and the Background of Passive Activity Loss

You may remember the 1980s real estate bubble (yes, there have been others besides the current one), which was brought on in a large part by people’s investment in real estate not for the purposes of making money, but for creating losses that they could use to offset their other (ordinary) income. In 1986, the tax code was significantly revamped and completely rewritten in part to address this problem, and the result was the passive activity loss rules.

Ordinary losses that you incur in business can be used to offset your personal income. However, “passive activity losses” may only be used to offset income from passive activities. For example, if you have losses of $15,000 from your side business investment (be it an ostrich farm, chicken farm, or rental real estate), you cannot use those losses to offset your regular income (as a dentist, insurance salesman or other trade or business) unless you qualify under the passive activity loss rules.

So What is Material Participation?

The primary question in determining whether a loss is or is not a passive activity loss is whether the taxpayer “materially participates” in the loss-producing activity. If the taxpayer materially participates, then the loss is not a “passive activity loss.” In general, there are seven tests a taxpayer can meet in order to establish that they are “materially participating.” However, the material participation rules created a special exception for “limited partners.” Limited partners can only qualify under three of these seven tests, thereby creating a higher hurdle for limited partners to establish that their losses are from non-passive activity.

These seven tests are briefly:

  • The taxpayer participates in the activity for more than 500 hours during such year;
  • The taxpayer’s participation in the activity for the taxable year constitutes substantially all of the participation in such activity of all individuals (including individuals who are not owners of interests in the activity) for such year;
  • The taxpayer participates in the activity for more than 100 hours during the taxable year, and such individual’s participation in the activity for the taxable year is not less than the participation in the activity of any other individual (including individuals who are not owners of interests in the activity) for such year;
  • The activity is a significant participation activity for the taxable year, and the taxpayer’s aggregate participation in all significant participation activities during such year exceeds 500 hours;
  • The taxpayer materially participated in the activity for any five taxable years (whether or not consecutive) during the 10 taxable years that immediately precede the taxable year;
  • The activity is a personal service activity and the taxpayer materially participated in the activity for any three taxable years (whether or not consecutive) preceding the taxable year; or
  • Based on all of the facts and circumstances, the taxpayer participates in the activity on a regular, continuous, and substantial basis during such year.

Until recently, the IRS took the position that members of LLCs and partners of limited liability partnerships (“LLPs”) were “limited partners” for purposes of the material participation rules in the same way that LP limited partners were treated. The problem is that the rules are not clear on how LLCs and LLPs were to be treated. LLCs and LLPs hardly existed at all in 1986, and generally they were not contemplated by Congress and the IRS when the material participation rules were first created. Since no subsequent regulation or guidance was provided, it was unclear to what extent the special limited partnership rules applied to LLCs or LLPs.

Two recent cases, Thompson v. U.S. (July 20, 2009), in the federal claims court, and Garnett v. Commissioner in the United States Tax Court (June 30, 2009), came down clearly for the proposition that LLC members and LLP partners can qualify under any of the seven tests rather than the three tests available to LP limited partners. Since Ted and John only meet the standard under the third test (which third test is permitted for qualification by LLC members and not permitted for LP limited partners), the type of entity ownership determines whether Ted and John can deduct their respective losses.

But … Does This Create a Problem for Ted’s Self-Employment Tax?

Thompson and Garnett make life easier for Ted in that he can deduct his side-business losses against his ordinary income (whereas John cannot), but they create a side problem for Ted that may be greater than his benefit: he may now owe self-employment tax on his LLC membership income. The self-employment tax sections of the Internal Revenue Code exclude “limited partnership” income from self-employment taxation to the extent that such income is not a guaranteed payment for services.

While Thompson and Garnett do not directly address the issue of self-employment tax, it appears arguable that the IRS will take the position that members of LLCs and partners of LLPs are not “limited partners” and, therefore, cannot use this exclusion to avoid self-employment tax. Ted would be ill-advised to try and argue out of one side of his mouth that he is a limited partner for self-employment taxation, while arguing out of the other side of his mouth that he is not a limited partner for passive activity loss purposes.

The Special Matter of Rental Real Estate

Since the 1986 revision to the Internal Revenue Code was largely created to close the real estate tax loophole, rental real estate activities were given their own special passive activity loss rules. Although not identical, the real estate provisions do contain a similar limited partnership restriction: if a taxpayer has a limited partnership interest in a piece of rental real estate and has chosen to aggregate it with other rental real property interests, the IRS will treat all interests as limited partnership interests.

Although neither Thompson nor Garnett specifically addresses the rental real estate context, it appears that the same reasoning would apply in that context as well. To the extent that an LLC member or LLP partner is concerned that the special limited partnership rules restrict his or her ability to treat losses as non-passive, the taxpayer is recommended to visit with professionals to discuss the implications of this new legal development.