IRS Issues New Proposed Regulations on Passive Activity Losses

The IRS just launched a new online search tool, "Exempt Organizations Select Check,” to help taxpayers more easily find key information about tax-exempt organizations, such as federal tax status and filings.

By using the tool, you can check if the organization:

· Is eligible to receive tax-deductible charitable contributions. This used to be done using IRS Publication 78, which is incorporated in the new tool. Taxpayers can rely on this list in determining deductibility of contributions (just as they did when Publication 78 was a separate electronic publication rather than part of EO Select Check).

· Has its federal tax exemption automatically revoked under the law for not filing a Form 990-series return or notice for three consecutive years. (This is known as the "Auto-Revocation List.”)

· Has filed a Form 990-N (e-Postcard) annual electronic notice. (Most small organizations whose annual gross receipts are normally $50,000 or less are required to electronically submit Form 990-N, unless they choose instead to file a completed Form 990 or Form 990-EZ.)

EO Select Check also offers new search functions. For example, users can now look for organizations eligible to receive deductible contributions by Employer Identification Number (EIN), which was previously not a searchable or sortable field in the electronic Publication 78. And information about organizations eligible to receive deductible contributions is now updated monthly, rather than quarterly.

To access the tool, visit http://apps.irs.gov/app/eos/.

In addition, organizations that have automatically lost their tax exemptions can now be searched by EIN, name, city, state, zip code, country, exemption type, and revocation posting date, rather than only by state. EO Select Check also provides new pop-up help text to assist users in understanding the significance of auto-revocation search results, including the meaning of, and distinctions between, revocation dates and revocation posting dates.

Facts about Charitable Contributions

· Charitable contributions are deductible only if you itemize deductions.

· To be deductible, charitable contributions must be made to qualified organizations.

· Payments to individuals are never deductible.

· If your contribution entitles you to merchandise, goods, or services, including admission to a charity ball, banquet, theatrical performance, or sporting event, you can deduct only the amount that exceeds the fair market value of the benefit received.

· For a contribution of cash, check, or other monetary gift (regardless of the amount), you must keep a bank record or a written communication from the qualified organization containing the organization name, the date of the contribution, and the amount.

IRS Issues New Proposed Regulations on Passive Activity Losses

The passive activity loss (PAL) rules can limit your ability to claim current federal tax deductions for losses thrown off by passive activities. This is because you can generally deduct passive losses only to the extent you have passive income from other sources. If you have little or no passive income, your passive losses are suspended until you have sufficient passive income -- or until you dispose of the loss-producing activities.

However if you materially participate in an activity for the tax year, you are exempt from the PAL limitations for the activity for that year. Therefore, you can deduct the loss from that activity unless another tax rule prevents it.

Question: What about losses incurred by limited partners? The PAL rules often make it difficult for limited partners to meet the material participation standard, while general partners usually have an easier time. So it's better to be classified as a general partner for PAL purposes than a limited partner.

Next Question: Since LLC members have limited liability, must they be classified as limited partners for PAL purposes, which would be unfavorable, when an LLC is treated as a partnership or a sole proprietorship for federal income tax purposes? So far, the IRS has always said yes. However, the courts have repeatedly disagreed with the IRS. In apparent reaction to the losing streak, the IRS recently released taxpayer-friendly proposed regulations. But the rules in the proposed regulations will not take effect until they are issued in final form.

Before addressing the court decisions and the new proposed regulations, we'll first cover some background information on how the rules work.

Material Participation Tests in a Nutshell

IRS regulations prescribe seven tests to determine if a taxpayer can meet the material participation standard with respect to a particular business activity:

1. More-Than-500-Hours Test - You pass this test if you participate in the activity for more than 500 hours during the year.

2. Substantially-All Test - You pass if your participation in the activity during the year constitutes substantially all the participation by all individuals (including those who are not owners of interests in the activity) during that year.

3. More-Than-100-Hours Test - You pass if you participate in the activity for more than 100 hours during the year, and no other individual participates more than you during that year.

4. Significant Participation Activity (SPA) Test - You pass if the activity is a SPA (a term defined by IRS regulations) in which you participate for more than 100 hours during the year, and your total participation in all SPAs during the year exceeds 500 hours.

5. Prior-Year Material Participation Test - You pass if you materially participated in the activity for any five of the 10 immediately preceding years.

6. Personal Service Activity Test - You pass if the activity is a personal service activity, and you materially participated in the activity for any three preceding years.

7. Facts and Circumstances Test - You pass if consideration of relevant facts and circumstances dictate that you materially participate in the activity on a regular, continuous, and substantial basis.

If you can pass one or more of these tests for the tax year in question, you meet the material participation standard for that activity for that year, which means the unfavorable PAL rules are inapplicable to that activity for that year. General partners can take all seven tests in attempting to meet the material participation standard.

Limited Partners Can Only Use Three Tests

When your interest in an activity is owned through a limited partnership interest, the seven material participation tests summarized in the right-hand box are unavailable. Instead, a limited partner can only use the first, fifth, and sixth tests in attempting to meet the material participation standard (the more-than-500-hours test, the prior-year material participation test, and the personal service activity test). These three tests are often much more difficult to pass than the other four.

Courts: LLC Members Are General Partners for PAL Purposes

· In one decision, the Tax Court concluded that a member of a California multi-member LLC was allowed to use all seven of the PAL material participation tests that are available to general partners rather than just the three stricter tests that are available to limited partners (Lee Newell, 132 TC Memo 2010-23).

· In another decision in 2009, the Tax Court said the Iowa LLC statute allowed the taxpayers (a married, joint-filing couple) to actively participate in the Iowa LLCs in question when such active participation would not have been allowed for limited partners under applicable state law. This fact alone made the LLC interests closer to general partner interests than limited partner interests (even though the taxpayers did have limited liability with respect to the LLCs' activities). Therefore, the taxpayers could use all seven of the PAL material participation tests that are available to general partners (Paul D. Garnett, 132 TC 368).

· The Court of Federal Claims agreed with a taxpayer's position that, even though he had limited liability with respect to the Texas LLC in question, he was not a limited partner for PAL purposes because: (1) the LLC was not a limited partnership under applicable Texas law and (2) he functioned as the manager of the business, which would not have been allowed for a limited partner under Texas law. Therefore, the taxpayer could use all seven of the PAL material participation tests that are available to general partners (James R. Thompson, 2009).

· In a Summary Opinion, the Tax Court concluded that the husband and wife in this case should be treated as general partners for PAL purposes with respect to their interests in a Maryland LLC, which they used to operate a money-losing charter fishing business. This decision also stated that the government's argument that limited partner status should apply to LLC members was misplaced, which indicates the Tax Court was getting tired of hearing about the issue (Sean Hegarty, TC Summary Opinion 2009-153, 2009).

Bottom Line for LLC Members

In effect, these decisions all state that LLC interests are general partner interests rather than limited partner interests for purposes of applying the PAL material participation rules. The common thread is the fact that LLC members are allowed to be heavily involved in LLC activities under applicable state LLC laws. In contrast, when a limited partner becomes too involved in a partnership's affairs, his limited partner status may be lost under some state partnership laws. (In some other states, limited partners are allowed to be involved in management without losing their limited partner status.)

According to the courts, this important distinction makes it impossible to conclude that LLC interests are equivalent to limited partner interests for purposes of applying the PAL material participation rules. Therefore, LLC members are general partners for PAL purposes even though LLC members have limited liability similar to what limited partners have.

The New Proposed Regulations

Recently issued, proposed Treasury regulations (1.469-5(e)) state that, for purposes of applying the PAL material participation rules, a limited partner interest is defined as an interest in an entity that is classified as a partnership for federal tax purposes. Also, the owner cannot have rights to manage the entity at any time during the tax year in question under applicable law in the state where the entity is organized and under the entity's governing agreement. The owner of such an interest is treated as a limited partner for purposes of applying the PAL material participation rules. As such, the owner must pass one of the three stricter limited partner tests to meet the material participation standard.

According to the Preamble to the proposed regulations, rights to manage include the right to legally bind the entity. Unfortunately, however, other examples of management rights are not provided.

Because LLC members typically have management rights, the proposed new rules are taxpayer-friendly. Such LLC members would be able to use all seven of the material participation tests. The same would be true for limited partners who have management rights.

Key Point: In stark contrast to the historical IRS position, the degree of limited liability offered by the entity to the owner is irrelevant under the proposed regulations.

Conclusion: While LLC members would be the prime beneficiaries of the liberalized rules in the proposed regulations, limited partners who are allowed under applicable state law to be involved in managing limited partnerships would also benefit. They too would be allowed to use all seven material participation tests in attempting to meet the material participation standard.

However, the new rules in the proposed regulations will not take effect unless and until they are issued in the form of final regulations. Meanwhile, consult your tax adviser for questions about how the PAL rules might affect you.

Note: The Preamble to the proposed regulations states that the proposed new rules would only apply in the context of applying the PAL material participation rules. The proposed new rules would not have any impact on other issues, such as determining the extent to which LLC members are exposed to the self-employment tax.