In response to several losses in court, the IRS is redefining a limited partnership interest under the passive loss rules. The IRS has issued proposed regulations that will allow limited partners and LLC members to be considered to have material participation in a limited partnership, thus allowing the partner to recognize passive losses under Section 469 of the Internal Revenue Code.
Currently, Section 469(h)(2) presumptively treats losses from interests in limited partnerships as passive and provides that no interest in a limited partnership as a limited partner shall be treated as an interest in which the taxpayer materially participates. When this was originally put into the Internal Revenue Code, state laws generally did not allow limited partners to participate in the control of the partnership. Since then, many states have adopted laws allowing limited partners to participate in the management and control of partnerships, including LLCs, and keep their limited liability status.
Under the proposed regulations, an interest in an entity will be treated as an interest in a limited partnership under Section 469(h)(2) if:
- The entity in which the interest is held is classified as a partnership for federal tax purposes, and
- The holder of the interest does not have rights to manage the entity at all times during the entity’s taxable year under the law of the state in which the entity was organized and under the partnership/operating agreement
The proposed rule is only to be used for the purposes of the passive activity rules and not for any other area that makes a distinction between general and limited partners.
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