In Garnett v. Commissioner, the U.S. Tax Court reversed a longstanding IRS practice of applying the Limited Partner (LP) passive loss deduction limitation to owners of Limited Liability Partnerships (LLPs) and Limited Liability Companies (LLCs). The Tax Court ruled that LLP and LLC owners that are legally permitted to actively engage in management, and are found to have exercised their management rights, are not subject to the presumption that they are passive investors. Therefore, these taxpayers are not required to wait for the LLP or LLC to distribute profits before they may deduct losses related to the entities.

Although the Tax Court opinion does not mention L3Cs, they are subject to the applicable statutes and regulations and thus fall within the court’s reasoning.

The taxpayers in Garnett owned interests in LLPs and LLCs formed in Iowa. The Iowa organizing statutes for LLPs and LLCs are similar to those in many other states and allow owners to participate in the organizations’ management. This stands in contrast to LP organizing statutes that prohibit limited partners from participating in management, and treat those that do as general partners.

Internal Revenue Code Section 469(h)(2) contains a presumption that limited partners cannot deduct partnership losses from other income because they are passive investors. Passive investors generally may only deduct losses from income earned from their investment. Therefore, most limited partners cannot deduct LP losses until the LP pays them a return on their ownership interest. In Garnett, the IRS argued that the presumption in section 469(h)(2) also applies to owners of LLP and LLC interests because the rule stems from the fact that the owner has limited liability for the business’s debts and liabilities.

The Tax Court rejected the IRS’s argument that the taxpayers’ limitation on liability automatically subjected them to the presumption in Section 469(h)(2). The Court found that LPs differ substantially from LLPs and LLCs because owners of LLPs and LLCs are permitted to participate in management, and are typically governed by the general partnership provisions of authorizing legislation. Similarly, upon reviewing the legislative history relating to the presumption, the Tax Court found that it was intended to apply to limited partners that are not legally authorized to participate in a partnership’s management.

Finally, the court noted that the Section 469(h)(2) presumption has a general partner exception for limited partners that possess dual limited and general partnership interests. Therefore, the legislation acknowledges that some limited partners with limited liability also possess general partnership management interests, and excludes those limited partners from the presumption.

In this circumstance, Iowa law permits owners of LLPs and LLCs to actively engage in management. The Tax Court noted that the question of whether a taxpayer actually exercises this management right depends on the facts and circumstances of each case. The Garnett taxpayers argued – and the IRS agreed – that they exercised their management rights relating to all of the entities. Unfortunately the opinion does not provide much detail about the nature of the Garnett taxpayers’ management activities. However, the Tax Court directs us to the general tests for “material participation” under Section 469 and the related regulations. In essence, these sections provide that a taxpayer that is regularly, continually, and substantially engaged in management may avoid the presumption.

Cecily Jackson is a Los Angeles attorney specializing in tax-exempt organizations and small business law.