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Posted 11/28/11
Long-Awaited Regulations On LLC Member Material Participation Released By IRS
The IRS has issued proposed regulations revising its approach to testing material participation by LLC members for purposes of the passive loss limitations. Under the previous temporary regulations, the IRS had restricted LLC members' ability to use all seven material participation tests by treating them presumptively as "limited partners" because of their limited liability. Under the temporary regulations, limited partners can only prove material participation under three of the seven tests. Under the passive loss rules, if a taxpayer cannot prove material participation in a business activity, passive losses can only offset passive income and may not be used against other income on the return.
In the last three years, the IRS lost four court cases on this issue with the courts finding that LLC members are more like general partners because of their ability to participate in the management of the business. In response to those cases, the proposed regulations eliminate the current regulations' reliance on limited liability as the determining factor and instead adopt an approach that examines an LLC member's right to participate in management of the entity. If the LLC member has the right to manage the entity "at all times during the entity's taxable year" under state law and under the entity's governing agreement, then the LLC member will not be treated as strictly a passive investor.
Real Estate Professionals
Real estate professionals are exempted from automatic treatment as passive investors if they meet certain requirements. Under the proposed rules, if a real estate professional elects to treat all interests in rental real estate as a single activity, then the taxpayer will be treated as a limited partner if the taxpayer holds any of the interests as a limited partner. If a taxpayer is treated as a limited partner, the taxpayer may not use all seven material participation tests, but instead may only use one of three tests allowed under the previous regulations.
Click here for the text of the Proposed Regulations.