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Recently, I’ve had a number of questions and referrals from other practitioners regarding the application of the material participation rules to limited partnership interests and trusts (and about documentation of material participation) and I'm seeing these issues come up more frequently in my practice.

Generally, for an activity to be considered nonpassive, the taxpayer must meet one of the seven “material participation” tests found in Temp. Treas. Reg. §1.469-5T(a). (Yes, this regulation is still temporary despite its original adoption in February, 1988). It is not the nature of the activity that determines whether there is “material participation”. Rather, it is the degree of involvement of the taxpayer in the activity within the particular tax year (and each year is tested individually). Asking the client the right due diligence questions regarding material participation is essential in properly characterizing the income as passive or nonpassive. This takes on greater importance for higher-income clients in light of the net investment income tax (which applies to passive income). Material participation is not elective; either the taxpayer meets one of the seven tests and is treated as a material participant or they do not meet any of the seven tests and will not be treated as a material participant.

Material Participation and Limited Partnership Interests

Special material participation rules apply to limited partnerships. First, under current guidance, a partnership interest is a limited partnership interest if either:[1]

• There is a partnership agreement or certificate that specifically designates the interest as a limited partnership interest (regardless how applicable state law may actually limit the holder’s actual liability), or
• State law limits the limited partner’s liability by a determinable fixed amount.

Second, while limited partnership income is generally regarded as passive, the income may be considered nonpassive for a limited partner who can establish material participation. 

Third, the limited partner does not have all seven material participation tests at his or her disposal to establish material participation in connection with the limited partnership interest.  Only three of the seven tests found in Temp. Treas. Reg. §1.469-5T(a) are available to the limited partner for this purpose.[2] These are:

• The “more than 500 hours” test (Temp. Treas. Reg. §1.469-5T(a)(1))
• The “five years of material participation” test (Temp. Treas. Reg. §1.469-5T(a)(5))
• The “personal service activity” test (Temp. Treas. Reg. §1.469-5T(a))

In addition, the limited partner is considered to own their interest directly even if it is indirectly owned through another entity^[3]

The “General Partner” Exception

A limited partnership interest is not treated as a limited partnership interest for the period of time during the tax year in which the holder of that interest was also a general partner.[4]

The Tax Court has applied this “general partner exception” to LLP and LLC interests.[5]  Since the Tax Court treats LLP partners and LLC members as general partners, such partners and members have all seven tests found in Temp. Treas. Reg. §1.469-5T(a) available to them to establish material participation (and are therefore not limited to the three tests mentioned earlier for limited partners).  The Tax Court has applied these general partner standards in at least three cases.[6]

New Proposed Regulations

In part, the Tax Court’s broader application of the general partner exception to LLPs and LLCs reflects the fact that current IRS guidance in the area pre-dates the advent of modern types of limited-liability entities such as the LLP and LLC and is in need of updating. The IRS has responded by drafting proposed regulations that will address these newer types of entities now available under the laws of most states.

Under the proposed rules, an interest in a partnership, LLC, LLP or other entity will be characterized as a limited partnership interest if:[7]

• The entity is classified as a partnership for federal tax purposes, and
• Applicable state law and the entity’s governing documents do not provide the interest owner with management rights at any time during the tax year.

These proposed regulations were issued in November, 2011 and remain proposed.  It appears the IRS is waiting to see how the Tax Court addresses further litigation in this area before refining and finalizing the new rules.

Trusts and Material Participation

Determining whether a trust has materially participated in an activity has become a much more important issue in light of the net investment income tax that is retained and not distributed by the trust (and while individual taxpayers have the benefit of relatively high income thresholds before the NIIT applies to passive income, that threshold for a trust is only $12,300 for 2015).

Generally, for a grantor trust, the trust’s level of participation is determined by the degree of involvement of the grantor.[8] For estates and other types of trust arrangements, the level of participation of the fiduciary or trustee (acting in the capacity of fiduciary or trustee) in the activity is determinative.[9]

Last year, the Tax Court held that the participation of trustees and employees of trust-administered businesses, at least under the facts present in the case, could be taken into account in determining whether the trust met the material participation requirement.[10] (Incidentally, the Tax Court also held in this case that a trust could qualify as a real estate professional, despite the use of the word “individual” in Treas. Reg. §1.469-9(b)(4), the operative regulation on this point).

Documenting Material Participation

In addressing audits and controversies for clients referred to me that involve material participation a frequent problem is the lack of documentation regarding material participation (or documentation of the lack of material participation for those who want to establish the income is, in fact, passive and not nonpassive). Regulatory guidance indicates that the taxpayer can establish the extent of participation in an activity by “any reasonable means.”[11] Ideally, the client should be advised to maintain a contemporaneous journal or log (or even an appointment book or calendar) that provides a reasonable description of the actions taken that form participation in the activity and the number of hours expended per day. Generally, in Tax Court, an initial determination by the IRS regarding material participation is presumed correct, and the burden of proof is on the taxpayer to establish the IRS is incorrect. However, the burden of proof on a factual issue, such as material participation, may be shifted to the IRS if the taxpayer:[12]

• Provides credible evidence on the issue
• Complies with Code substantiation requirements
• Maintains the records the Code requires, and
• Cooperates with reasonable IRS requests for further information

Accordingly, appropriate record keeping in this area by the taxpayer is critical if the taxpayer is going to prevail in an audit or controversy situation.

Overview and Further Reference

The IRS Audit Tax Guide regarding passive activities provides a good overview of the material participation rules. It also touches on the activity grouping rules which is a highly underutilized planning tool associated with the material participation rules.