Garnett Vs. IRS

[AuditorTurnedGood]

I just saw this decision come out on the Tax Court site. Looks like the Court dealt a blow the Service, stating that Limited Liability Partners and LLC Members can't be automatically determined to be non-material participants without looking at facts and circumstances. Could have some big effects for our passive activity clients.

http://www.ustaxcourt.gov/InOpHistoric/Garnett.TC.WPD.pdf

[Snaggletooth]

Gist of the Decision

Hi ATG - This is a 24-page rendering of the decision, plus in stilted lawyerese.

Can you give us the gist of what happened in 50 words or so? Of course this request reveals me as the lazy idiot that I probably am...

[erchess]

The taxpayer received a notice of deficiency for I think two returns due to the disallowance of losses from LLPs and LLCs and I believe other issues that are not spelled out in this ruling.

While the case was still being argued in internal IRS channels the Service and the taxpayers jointly requested that the Tax Court issue a Summary Judgment on only one question, which is whether the IRS can simply declare that all Limited Partners and LLC Members do not materially participate and therefore have passive activities. The court said, "No this is a facts and circumstances issue because the code section on which the IRS was relying does not apply to LLPs and LLCs."

The case now goes back to internal IRS Channels and I have no idea whether it will be in Court again. Either way the ruling had gone I believe that the case would have continued.

[JoshinNC]

the good

side of this is that we MAY now be able to deduct losses from LLC's where the taxpayer does not meet the material participation rules. The bad side is that the Service may now be able to argue that all LLC members, if they participate 1 hour per year, are liable for SE tax on their net profit.

This ruling, while only a summary judgment on one issue in the case, may have both good and bad (very bad in my opinion) effects for LLC members. I may have to rethink completely how I advise clients going forward regarding formation of entities and the payment of SE tax.

I don't know how to do one of those poll thingies but maybe one of you guys can start one on "what percentage, if any, of an active LLC member's income is subject to SE".

[Davc]

Hi ATG - This is a 24-page rendering of the decision, plus in stilted lawyerese.

Can you give us the gist of what happened in 50 words or so? Of course this request reveals me as the lazy idiot that I probably am...

Here:

Couple Did Not Have Limited Partnership Interests in LLCs, LLPs
The Tax Court has held that a couple's interests in several limited liability companies and partnerships do not qualify as limited partnership interests and are not subject to the rule in section 469(h)(2) that presumes certain losses from limited partnership interests are passive.
Paul and Alicia Garnett owned interests in several limited liability companies and partnerships and tenancies-in-common that engaged in agricultural business operations. The Garnetts had direct interests in one LLP and one LLC and indirect interests in several other LLPS and LLCs. They were listed as limited partners in the LLP ventures and as limited liability company members as to the LLCs. The Garnetts also had similar arrangements for interests they held in two tenancies-in-common.
The IRS disallowed certain losses the Garnetts claimed related to their interests in the LLPs and LLCs, saying they failed to meet the participation requirements of section 469.
The Garnetts argued that the special rule in section 469(h)(2) treating certain limited partnerships losses as passive did not apply to their situation because none of the entities was a limited partnership and because the Garnetts were general, rather than limited, partners. The Service argued that the Garnetts' interests qualified as limited partnership interests and did not qualify as general partner interests as that term is generally understood.
The court first considered whether section 469(h)(2) is applicable to LLCs and LLPs, which were either new or nonexistent business entities when section 469 was enacted. The court rejected the government's argument that enjoyment of limited liability qualifies one's interest as a limited partnership interest. Instead, the court said, one must take into account whether the interest in a limited partnership is that of a limited partner. The court also rejected the Garnetts' proposed definition of a limited partner, saying a strict and literal meaning would be counter to Congress's intent to treat substantially equivalent entities and interests therein as limited partnerships and interests held by limited partners.
In determining whether the general partner exception applied to the Garnetts' business entities, the court said an inquiry into the nature and extent of a partner's authority to act on behalf of an entity would blur the special rule “in a manner that is at odds with the statutory framework and legislative intent.” Statutory constraints on a limited partner's participation justified a presumption that the partner would not materially participate. Such a presumption, however, cannot be extended to LLCs and LLPs, the court said. The court said an inquiry under section 469 to determine whether the Garnetts materially participated would probably occur at some point in the case, declining to fill in the gaps caused by “pigeonholing” ownership interests as either general or limited partner interests. The court then found that the Garnetts' ownership interests in the LLPs and LLCs fell under the general partner exception and did not qualify as limited partnership interests.
As to the tenancies-in-common, the court held that the Garnetts' interests therein were not limited partnership interests as neither the IRS nor the Garnetts attempted to categorize the interests as such.
Finally, the court found that the inconsistencies in how the Garnetts' interests were listed on their Schedules K-1 were not material and did not require further fact-finding.

[Snaggletooth]

Hats off

Thanks for encapsulating the decision, Davc. It may appear to be a long post, but tremendously condensed from the full version.

I'll also take the time to thank you for many times you have posted in the past. Your answers are always to-the-point, relevant, and correct (as far as I know). There have been a couple times you corrected me from the disbursement of errant information, and I was relieved that you had done so.

Hats off to a very helpful and knowledgeable source. Keep those cards and letters coming.

[Davc]

It was plagiarized from BNA.