T.C. Memo. 2010-23
UNITED STATES TAX COURT
LEE E. AND KATHY H. NEWELL, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 26844-06. Filed February 16, 2010.
Edward I. Kaplan, for petitioners.
Andrew R. Moore, for respondent.
MEMORANDUM OPINION
MARVEL, Judge: Respondent determined deficiencies in
Federal income tax and an addition to tax under section
6651(a)(1)1 as follows:
1
Unless otherwise indicated, all section references are to
the Internal Revenue Code in effect for the years in issue, and
(continued...)
- 2 -
Addition to tax
Year Deficiency1 sec. 6651(a)(1)
1996 $72,145 -0-
1997 846,531 -0-
2001 473,380 $47,338
2002 229,565 -0-
2003 336,821 -0-
1
The years in dispute are 2001, 2002, and 2003. The
deficiencies determined for 1996 and 1997 reflect solely the
disallowance of net operating losses from the years in dispute.
The only issue for decision is whether the managing member
interest of petitioner husband Lee E. Newell (petitioner husband)
in a California limited liability company (L.L.C.) that is
classified as a partnership for Federal income tax purposes is a
limited partnership interest as a limited partner for purposes of
applying the passive activity rules under section 469 and related
regulations.2 We hold that it is not.
Background
The parties submitted this case fully stipulated pursuant to
Rule 122. We incorporate the stipulation of facts into our
findings by this reference. On the date they petitioned this
Court, petitioners resided in California.
1
(...continued)
all Rule references are to the Tax Court Rules of Practice and
Procedure.
2
The parties stipulated that the sec. 6651(a)(1) addition to
tax applies to any deficiency determined for 2001. Because we
conclude that petitioners are not liable for the deficiency
determined for any of the years at issue, petitioners are not
liable for the addition to tax.
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Petitioner husband is an attorney licensed in Florida, but
he does not practice law. His primary business activity involves
the management of real estate investments. He spends more than
50 percent of his time and more than 750 hours annually in real
property trade or business activities.
During 2001, 2002, and 2003 (years at issue) petitioner
husband owned all of the stock in California Custom Millworks,
Inc. (Millworks), an S corporation. Millworks’ business included
manufacturing and installing windows, cabinets, doors, trim, and
other items of carpentry.
During the years at issue petitioner husband actively
engaged in the conduct of the trade or business of Millworks as
follows:
Year Hours
2001 250
2002 300
2003 350
His participation in the trade or business of Millworks was a
significant participation activity as defined by section 1.469-
5T(c), Temporary Income Tax Regs., 53 Fed. Reg. 5726 (Feb. 25,
1988). During the years at issue Millworks incurred losses that
were distributed to petitioner husband and deducted by
petitioners on their Federal income tax returns.3 Respondent
3
In 2005 Millworks filed for bankruptcy “in which all its
assets were disposed, and then liquidated.”
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does not challenge the amount of the losses, which were as
follows:
Year Loss
2001 $458,379
2002 1,270,452
2003 798,431
During the years at issue petitioner husband also owned 33
percent of the member interests in Pasadera Country Club, L.L.C.
(Pasadera). Pasadera was formed in 1999 as an L.L.C. under
California law to engage in the business of owning and operating
a golf course, restaurant, and country club facility. Pasadera
is classified as a partnership for Federal income tax purposes.
At all relevant times petitioner husband was the managing
member of Pasadera4 and was responsible for hiring and firing all
management personnel. As the managing member, he also oversaw
the construction of Pasadera’s 38,000-square-foot clubhouse;
created and administered all membership programs, including
advertising and reviewing and approving membership applications;
and reviewed, approved, and signed all checks for expenses
incurred in the construction and operation of Pasadera. He was
4
The parties stipulated that petitioner husband was the
managing member of Pasadera during the years at issue. The First
Amended and Restated Limited Liability Company Operating
Agreement of Pasadera in effect during the years at issue
(operating agreement) stated that the managing member of Pasadera
was NCDG Golf, L.L.C. (NCDG Golf). Petitioner husband, as
president of NCDG Golf, signed the operating agreement as the
managing member.
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also responsible for annual filings with State and county
agencies and for any liquor license, compliance, or other legal
issues of Pasadera.
Petitioner husband negotiated all construction and permanent
loans for Pasadera and was personally liable for those loans.
As of the date on which the parties submitted the stipulation of
facts, petitioner husband remained personally liable for
Pasadera’s outstanding loan obligations. If Pasadera experienced
an operational cash shortfall, he, along with two other members
of Pasadera, provided funding to cover the shortfall.
Petitioner husband actively engaged in the conduct of the
trade or business of Pasadera as follows:
Year Hours
2001 450
2002 400
2003 400
Pasadera incurred losses in each of the years at issue.
Petitioner husband’s distributive shares of the losses, the
amounts of which respondent does not dispute, were as follows:
Year Loss
2001 $1,882,125
2002 2,104,000
2003 2,034,394
Petitioners deducted the losses on their 2001-03 joint Federal
income tax returns.
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Respondent examined petitioners’ 2001-03 income tax returns
and determined that the losses from both Millworks and Pasadera
had been incurred in a passive activity under section 469 and
that the Millworks and Pasadera losses petitioners claimed in
each of the years at issue “are suspended and not currently
deductible” under section 469(a)(1). Respondent issued to
petitioners a notice of deficiency reflecting the determinations.
As a further consequence of respondent’s disallowance of the
passive activity losses for the years at issue, respondent
disallowed petitioners’ claimed net operating loss carrybacks to
1996 and 1997 in the notice of deficiency. Petitioners timely
petitioned this Court.
Discussion
A. Passive Activity Losses in General
Generally, losses incurred in a trade or business are
deductible by a taxpayer under section 165(c)(1). However, the
deduction of a passive activity loss5 is suspended, i.e., the
loss is not deductible in the year incurred, but it may be
carried forward to the next taxable year. Sec. 469(a)(1), (b).
A passive activity is any activity that involves the conduct
of a trade or business in which the taxpayer does not materially
5
Sec. 469(d)(1) defines a passive activity loss as the
amount by which the aggregate losses from all passive activities
for the taxable year exceed the aggregate income from all passive
activities for the year.
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participate. Sec. 469(c)(1). A taxpayer materially participates
in an activity if the taxpayer is involved in the operations of
the activity on a regular, continuous, and substantial basis.
Sec. 469(h)(1).
When it enacted section 469, Congress authorized the
Secretary to prescribe regulations that specify what constitutes
material participation for purposes of section 469. Sec.
469(l)(1). Pursuant to that grant of authority, in 1988 the
Secretary promulgated temporary regulations under section 469
that apply to the years at issue. Secs. 1.469-1T through 1.469-
11T, Temporary Income Tax Regs., 53 Fed. Reg. 5686 (Feb. 25,
1988).6
The temporary regulations promulgated under section 469
provide seven tests for determining whether an individual shall
be treated as materially participating in an activity.7 Sec.
6
Sec. 7805(e)(2), which was enacted in 1988, provides: “Any
temporary regulation shall expire within 3 years after the date
of issuance of such regulation.” It applies to any temporary
regulation issued after Nov. 20, 1988. Technical and
Miscellaneous Revenue Act of 1988, Pub. L. 100-647, sec. 6232(b),
102 Stat. 3735. The sec. 469 temporary regulations were issued
on Feb. 19, 1988, before the effective date of sec. 7805(e).
7
The seven tests in the temporary regulations are as
follows:
(1) The individual participates in the activity
for more than 500 hours during such year;
(2) The individual’s participation in the activity
for the taxable year constitutes substantially all of
(continued...)
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1.469-5T(a), Temporary Income Tax Regs., 53 Fed. Reg. 5725 (Feb.
25, 1988). The parties agree that the only material
participation test under the temporary regulations applicable to
7
(...continued)
the participation in such activity of all individuals
(including individuals who are not owners of interests
in the activity) for such year;
(3) The individual participates in the activity
for more than 100 hours during the taxable year, and
such individual’s participation in the activity for the
taxable year is not less than the participation in the
activity of any other individual (including individuals
who are not owners of interests in the activity) for
such year;
(4) The activity is a significant participation
activity (within the meaning of paragraph (c) of this
section) for the taxable year, and the individual’s
aggregate participation in all significant
participation activities during such year exceeds 500
hours;
(5) The individual materially participated in the
activity (determined without regard to this paragraph
(a)(5)) for any five taxable years (whether or not
consecutive) during the ten taxable years that
immediately precede the taxable year;
(6) The activity is a personal service activity
(within the meaning of paragraph (d) of this section),
and the individual materially participated in the
activity for any three taxable years (whether or not
consecutive) preceding the taxable year; or
(7) Based on all of the facts and circumstances
(taking into account the rules in paragraph (b) of this
section), the individual participates in the activity
on a regular, continuous, and substantial basis during
such year.
Sec. 1.469-5T(a), Temporary Income Tax Regs., 53 Fed. Reg. 5725
(Feb. 25, 1988).
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petitioner husband’s Millworks and Pasadera activities is the
significant participation activity test under section 1.469-
5T(a)(4), Temporary Income Tax Regs., 53 Fed. Reg. 5726 (Feb. 25,
1988). Under that test (1) the activity must be a significant
participation activity for the taxable year, and (2) the
individual’s aggregate participation in all significant
participation activities during the year must exceed 500 hours.
Id. An activity is a significant participation activity only if
(1) the activity is a trade or business, (2) the individual
participates in the activity for more than 100 hours during the
year, and (3) the individual cannot establish material
participation under any of the other material participation tests
in the regulations. Sec. 1.469-5T(c), Temporary Income Tax
Regs., supra.
B. The Parties’ Arguments
The parties agree that petitioner husband’s participation in
Millworks and Pasadera satisfies the significant participation
activity test of section 1.469-5T(a)(4), Temporary Income Tax
Regs., supra. Despite this agreement, respondent argues that
section 469(h)(2) requires petitioner husband’s interest in
Pasadera, a California L.L.C., to be treated as an interest with
respect to which he does not materially participate. Respondent
contends that under section 469(h)(2), which sets forth a special
rule for “interests in a limited partnership as a limited
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partner”, and section 1.469-5T(e), Temporary Income Tax Regs., 53
Fed. Reg. 5726 (Feb. 25, 1988), petitioner husband’s member
interest in Pasadera is treated as a limited partnership interest
as defined under section 1.469-5T(e)(3)(i)(B), Temporary Income
Tax Regs., 53 Fed. Reg. 5726 (Feb. 25, 1988), and is subject to
the restriction contained in section 1.469-5T(e)(1), Temporary
Income Tax Regs., 53 Fed. Reg. 5726 (Feb. 25, 1988).
Respondent’s argument assumes that petitioner husband held a
limited partnership interest in Pasadera as a limited partner.
C. Special Rule for Limited Partnership Interests
Section 469(h)(2) provides: “Interests in limited
partnerships.--Except as provided in regulations, no interest in
a limited partnership as a limited partner shall be treated as an
interest with respect to which a taxpayer materially
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participates.”8 Section 1.469-5T(e), Temporary Income Tax Regs.,
supra,9 provides:
(e) Treatment of limited partners--(1) General
rule. Except as otherwise provided in this paragraph
(e), an individual shall not be treated as materially
participating in any activity of a limited partnership
for purposes of applying section 469 and the
regulations thereunder to--
(i) The individual’s share of any income, gain,
loss, deduction, or credit from such activity that is
attributable to a limited partnership interest in the
partnership; and
(ii) Any gain or loss from such activity
recognized upon a sale or exchange of such an interest.
* * * * * * *
(3) Limited partnership interest--(i) In general.
* * * for purposes of section 469(h)(2) and this
paragraph (e), a partnership interest shall be treated
as a limited partnership interest if–-
8
The temporary regulations under sec. 469 provide that an
individual is not subject to sec. 469(h)(2) if: (1) The
individual participates in the activity for more than 500 hours
during the year; (2) the individual materially participated in
the activity for any 5 taxable years (whether or not consecutive)
during the 10 taxable years that immediately precede the taxable
year; or (3) the activity is a personal service activity, which
is an activity in the fields of health, law, engineering,
architecture, accounting, actuarial science, performing arts,
consulting, or any other trade or business in which capital is
not a material income-producing factor, and the individual
materially participated in the activity for any 3 taxable years
(whether or not consecutive) preceding the taxable year. Sec.
1.469-5T(e)(2), (a)(1), (5), (6), (d), Temporary Income Tax
Regs., 53 Fed. Reg. 5725-5726 (Feb. 25, 1988). None of the
exceptions applies in this case.
9
Petitioners do not challenge the validity of sec. 1.469-5T,
Temporary Income Tax Regs., 53 Fed. Reg. 5725 (Feb. 25, 1988).
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(A) Such interest is designated a limited
partnership interest in the limited partnership
agreement or the certificate of limited partnership,
without regard to whether the liability of the holder
of such interest for obligations of the partnership is
limited under the applicable State law; or
(B) The liability of the holder of such interest
for obligations of the partnership is limited under the
law of the State in which the partnership is organized,
to a determinable fixed amount (for example, the sum of
the holder’s capital contributions to the partnership
and contractual obligations to make additional capital
contributions to the partnership).
By its terms section 469(h)(2) applies only if the taxpayer
has an interest in a limited partnership as a limited partner.
See Garnett v. Commissioner, 132 T.C. __ (2009). In Garnett we
held that an interest in an Iowa L.L.C. was not an “interest in a
limited partnership as a limited partner” within the meaning of
section 469(h)(2) or the regulations thereunder. Id. at __, __
(slip op. at 22-23, 27). In so doing we recognized that Congress
enacted section 469(h)(2) to address the statutory constraints on
a limited partner’s ability to participate in the partnership’s
business and that a member of an Iowa L.L.C. was not similarly
constrained. Id. at __ (slip op. at 21-23). Because a member of
an Iowa L.L.C., unlike a limited partner, was not prohibited by
State law from participating in the partnership’s business and
more closely resembled a general partner, we concluded that a
member of an Iowa L.L.C. came within the general partner
exception of section 1.469-5T(e)(3)(ii), Temporary Income Tax
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Regs., supra. Consequently, we held that the special rules of
section 469(h)(2) did not apply to an interest in an Iowa L.L.C.
We turn then to petitioner husband’s interest in Pasadera.
Pasadera was formed as an L.L.C. under California law. Under
California law, a member of an L.L.C. may participate in the
management of the L.L.C. Cal. Corp. Code sec. 17150 (West
2006).10 Moreover, under Pasadera’s operating agreement, the
managing member has the right to participate in the management of
the L.L.C.11 Petitioner husband was permitted to participate in
the management of Pasadera by California law, and he was required
to do so by the operating agreement. In contrast, under
California law, a limited partner in a California limited
partnership will lose his limited liability if he
participates in managing the limited partnership. See Cal. Corp.
Code sec. 15507(a) (West 2006).
Respondent concedes that petitioner husband substantially
participated in managing Pasadera as its managing member.
Respondent argues, however, that petitioner husband’s interest in
Pasadera was a limited partnership interest as that term is
10
In addition, no member of an L.L.C. is personally liable
for any debt, obligation, or liability of the L.L.C. solely by
reason of being a member thereof. Cal. Corp. Code sec. 17101(a)
(West 2006).
11
Although petitioner husband was personally liable for some
loans of Pasadera, those obligations, as respondent points out,
do not alter the fact that petitioner husband’s liability as a
member of Pasadera was limited to a determinable fixed amount.
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defined in section 1.469-5T(e)(3)(i)(B), Temporary Income Tax
Regs., supra, and consequently, section 469(h)(2) applies to his
interest. In support of his argument, respondent notes, and
petitioners do not dispute, that Pasadera is treated as a
partnership for Federal tax purposes under section 301.7701-3(a)
and (b), Proced. & Admin. Regs., and that petitioner husband
enjoys limited liability under California law.
We reject respondent’s argument. Respondent’s argument
fails to recognize that in order for section 469(h)(2) to apply
at all, petitioner husband must have held an ownership interest
in a limited partnership as a limited partner. See Garnett v.
Commissioner, supra; Gregg v. United States, 186 F. Supp. 2d 1123
(D. Or. 2000). Petitioner husband did not. As we emphasized in
Garnett, an L.L.C. is a hybrid form of business entity that
shares some of the characteristics of a partnership and some of
the characteristics of a corporation. Garnett v. Commissioner,
supra at __ (slip op. at 14); see also 1 Bromberg & Ribstein,
Partnership, sec. 1.01(b)(4) (1996). Members of a California
L.L.C. can participate directly in management, but they also
enjoy limited liability for company debts and liabilities under
California law.12 If we analogize a California L.L.C. to a
limited partnership, the members of a California L.L.C. more
12
Nevertheless, petitioner husband obligated himself
personally for Pasadera’s outstanding loan obligations.
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closely resemble general partners than limited partners. This is
particularly true with respect to petitioner husband, who was the
managing member of Pasadera. In that capacity he managed the
day-to-day operations of Pasadera, functioning just as a general
partner would function in a limited partnership.
In Garnett v. Commissioner, supra, we did not decide whether
an interest in an Iowa L.L.C. could be treated as an interest in
a limited partnership for purposes of section 469 and the
temporary regulations.13 Instead, we focused our analysis on
whether a member in an L.L.C. holds his membership interest “as a
limited partner”. Specifically, we examined whether a member in
13
In Thompson v. United States, 87 Fed. Cl. 728, 734 (2009),
which was decided after we issued our Opinion in Garnett v.
Commissioner, 132 T.C. ___ (2009), the U.S. Court of Federal
Claims examined sec. 1.469-5T(e)(3), Temporary Income Tax Regs.,
53 Fed. Reg. 5726 (Feb. 25, 1988), and concluded that sec. 1.469-
5T(e)(3)(i)(B), Temporary Income Tax Regs., supra, “literally
requires that the ownership interest be in a business entity that
is, in fact, a partnership under state law--not merely taxed as
such under the Code.” Because the cited portion of the
regulation was unambiguous, the Court of Federal Claims concluded
that it had to enforce the regulation’s plain meaning. Thompson
v. United States, supra at 734. Moreover, because sec. 469(h)(2)
refers to an interest in a partnership “as a limited partner”,
the Court of Federal Claims concluded that “the taxpayer must
actually be a limited partner” for the prohibition of sec.
469(h)(2) to apply. Id. The Court of Federal Claims held that
(1) once sec. 1.469-5T(e)(3), Temporary Income Tax Regs., supra,
“is read in context and with due regard to its text, structure,
and purpose, it becomes abundantly clear that it is simply
inapplicable to a membership interest in an LLC”, and (2) even if
the regulation could apply to the taxpayer, the taxpayer’s
interest “would best be categorized as a general partner’s
interest under §1.469-5T(e)(3)(ii)”. Id. at 738 (citing Garnett
v. Commissioner, supra at __ (slip op. at 23), with approval).
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an L.L.C. qualifies for the general partner exception set forth
in section 1.469-5T(e)(3)(ii), Temporary Income Tax Regs., supra.
Section 1.469-5T(e)(1), Temporary Income Tax Regs., supra,
sets forth the general rule that a limited partner shall not be
treated as materially participating in any activity of a limited
partnership for purposes of applying section 469 and the
regulations thereunder. However, section 1.469-5T(e)(3)(ii),
Temporary Income Tax Regs., supra, provides:
(ii) Limited partner holding general partner
interest.--A partnership interest of an individual
shall not be treated as a limited partnership interest
for the individual’s taxable year if the individual is
a general partner in the partnership at all times
during the partnership’s taxable year ending with or
within the individual’s taxable year (or the portion of
the partnership’s taxable year during which the
individual (directly or indirectly) owns such limited
partnership interest).
As we pointed out in Garnett v. Commissioner, 132 T.C. at __
(slip op. at 18), the general partner exception of section 1.469-
5T(e)(3)(ii), Temporary Income Tax Regs., supra, is not expressly
confined to the situation where a limited partner also holds a
general partnership interest. The exception provides that an
individual who is a general partner is not restricted from
claiming that he materially participated in the partnership.
After examining the legislative history of section 469 and taking
into account the lack of any prohibition regarding participation
in management under State law, we concluded that the general
partner exception was broad enough to cover the activity of a
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taxpayer who holds an interest in an L.L.C. and is authorized by
State law to participate in managing the L.L.C. Garnett v.
Commissioner, supra at __ (slip op. at 20-23). We held that the
taxpayers who were members of an Iowa L.L.C. held their
membership interests in the L.L.C. as “general partners” within
the meaning of the temporary regulations. Id.
The same reasoning applies to a membership interest in a
California L.L.C. And, because the membership interest at issue
here is held by the managing member, the reasoning is even more
compelling. Unlike the taxpayers in Garnett, whose exact roles
in the management of the L.L.C.s were not fleshed out, the
parties stipulated that petitioner husband was the L.L.C.’s
managing member and, as such, he actively and substantially
participated in its management during 2001-03. In addition to
the authority conferred by California law to participate in the
L.L.C.’s management, petitioner husband was expressly authorized
by the operating agreement to act on the L.L.C.’s behalf and to
manage the L.L.C.’s operations. In fact, the parties stipulated
that petitioner husband handled the day-to-day operations of
Pasadera, including hiring and firing employees, negotiating loan
agreements and other contracts, overseeing construction,
administering membership programs, and reviewing, approving, and
signing all checks. As the managing member of the L.L.C.,
petitioner husband functioned as the substantial equivalent of a
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general partner in a limited partnership. See id. at __ (slip
op. at 22).
In view of the above and consistent with Garnett, we
conclude that petitioner husband comes within the general partner
exception of section 1.469-5T(e)(3)(ii), Temporary Income Tax
Regs., supra, and consequently did not hold his managing member
interest in Pasadera, a California L.L.C., as a limited partner.
Because section 469(h)(2) does not apply to petitioner husband’s
membership interest in Pasadera and because respondent concedes
that petitioner husband otherwise met the requirements of the
significant participation activity test under section 1.469-
5T(a)(4), Temporary Income Tax Regs., supra, petitioner husband’s
Pasadera activity was a significant participation activity for
the years at issue, and his aggregate participation in all
significant participation activities (Millworks and Pasadera) in
each of the years at issue exceeded 500 hours. Thus, under the
significant participation test of section 1.469-5T(a)(4),
Temporary Income Tax Regs., supra, petitioner husband is treated
as materially participating in Millworks and Pasadera during the
years 2001-03. We hold therefore that petitioners properly
deducted their Millworks and Pasadera losses for 2001-03.
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To reflect the foregoing,
Decision will be entered
for petitioners.