Keeping Pace with the Times: Exploring the Meaning of Limited Partner for Purposes of the Internal Revenue Code

Abstract

This article explores the use of the term “limited partner” within the passive loss rules of Internal Revenue Code (Code) section 469 and the corresponding Treasury Regulations in light of the always changing business environment. The passive loss rules of Code section 469 turn on whether a taxpayer materially participated in the loss generating activity. The preferential nature of several Code provisions turns on whether a person is a limited partner, the majority of these references being codified within the Code prior to the creation of many new types of entities, including the Limited Liability Company (LLC), the Limited Liability Partnership (LLP), and the Limited Liability Limited Partnership (LLLP) (collectively referred to as a Limited Liability Entities). The term was placed in to the Code when the only entities taxed as partnerships were general partnerships and limited partnerships. At such time, a limited partner was essentially prohibited from participating if the limited partner wanted to maintain his limited liability status. However, this article asserts that in today’s business environment, a trend is developing where the distinctions between an individual’s ability to participate in Limited Liability Entities and maintain limited liability has become blurred. Under the special rule of Code section 469(h)(2), if a taxpayer is a limited partner, deducting certain losses is subject to more stringent rules. For almost twenty years, the Internal Revenue Service (the Service) has been asserting in audits that an interest in Limited Liability Entities should be treated as a limited partner for applying Code section 469. In late 2009, however, the United States Tax Court held that an LLC member and an LLP partner were not limited partners for purposes of the passive loss rules. Shortly thereafter, the United States Court of Federal Claims reaffirmed that for purposes of the passive losses rules LLC members were not limited partners. The Court of Federal Claims, nevertheless, did not address the application of Code section 469(h)(2) to an LLP. Accordingly, it is still unclear whether under Code section 469(h)(2) a partner in an LLP and/or an LLLP is considered a limited partner. Essentially, this has led to the belief by scholars and practitioners that the issue is resolved concerning an LLC. Yet, in December 2010, the Service commented that it would issue guidance in this area. Furthermore, both the United States Tax Court and the United States Court of Federal Claims hinted that the Service could amend the Treasury Regulations to explicitly include Limited Liability Entities as being subject to the more stringent rule of Code section 469(h)(2). This article proposes that the Service should not amend the regulation, but, instead Congress should revoke Code section 469(h)(2), as in today’s business world there has been a change of circumstances, and the Code must advance to keep pace with the times.