Free Response to Motion - District Court of Federal Claims - federal

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THE UNITED STATES COURT OF FEDERAL CLAIMS No. 06-211 T (Judge Victor J. Wolski) _______________________________________________ JAMES R. THOMPSON, Plaintiff, v. THE UNITED STATES Defendant. ______________________________________________ DEFENDANT'S BRIEF IN OPPOSITION TO PLAINTIFF'S MOTION FOR PARTIAL SUMMARY JUDGMENT AND IN SUPPORT OF ITS CROSS MOTION FOR PARTIAL SUMMARY JUDGMENT ______________________________________________

EILEEN J. O'CONNOR Assistant Attorney General DAVID GUSTAFSON STEVEN FRAHM JEFFREY R. MALO Attorneys Justice Department (Tax) Court of Federal Claims Section P.O. Box 26 Ben Franklin Post Office Washington, D.C. 20044 (202) 305-7539 (202) 514-9440 (facsimile)

2518008.1

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Table of Contents Table of Contents............................................................................................................ ii Table of Authorities ....................................................................................................... iv Cases .......................................................................................................................... iv Statutes....................................................................................................................... iv State Law............................................................................................................ iv Federal Law Internal Revenue Code (26 U.S.C.)............................................... v Miscellaneous ............................................................................................................. v Treasury Regulations .......................................................................................... v Temporary Treasury Regulations ....................................................................... v Legislative History .............................................................................................. v Administrative History ........................................................................................ v Uniform Laws..................................................................................................... vi Table of Exhibits........................................................................................................... vii DEFENDANT'S BRIEF IN OPPOSITION TO PLAINTIFF'S MOTION FOR PARTIAL SUMMARY JUDGMENT AND IN SUPPORT OF ITS CROSS MOTION FOR PARTIAL SUMMARY JUDGMENT.................................................. 1 I. II. III. IV. V. INTRODUCTION ...................................................................................... 1 QUESTION PRESENTED......................................................................... 3 STATUTES AND REGULATIONS INVOLVED .................................... 3 STATEMENT OF THE CASE................................................................... 4 ARGUMENT............................................................................................ 10

PLAINTIFF'S INTEREST IN MOUNTAIN AIR IS TREATED AS A LIMITED PARTNERSHIP INTEREST UNDER SECTION 469 ............................................ 10

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A. B.

Introduction ­ Section 469 Loss Limitations ............................................ 10 Treasury Regulations on Material Participation and Limited Partnership Interests................................................................................. 12 Plaintiff had a partnership interest in Mountain Air, and his liability for its obligations was limited. .................................................... 15 Plaintiff's arguments that the Regulation does not apply to his interest in Mountain Air are misconceived............................................... 17 CONCLUSION......................................................................................... 23

C.

D.

VI.

Appendix A............................................................................................................... 25 Internal Revenue Code § 469............................................................................ 25 Temporary Treasury Regulation § 1.469-5T .................................................... 35 Treasury Regulation § 301.7701-3 ................................................................... 40

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Table of Authorities

Cases Cases Batterton v. Francis, 432 U.S. 416 (1977) ............................................................. 2 Chevron U.S.A., Inc. v. Natural Resources Defense Council, Inc., 467 U.S. 837 (1984)......................................................................................................... 3 Gregg v. United States, 186 F. Supp. 2d 1123 (D. Or. 2000)............................... 22 Long Island Care at Home Ltd. v. Coke, 551 U.S. ___ (June 11, 2007) ................ 2 Rite Aid Corp. v. U.S., 255 F.3d 1357 (Fed. Cir. 2001).......................................... 2 Rowan Cos. v. U.S., 452 U.S. 247 (1981)............................................................... 2 United States v. Mead Corp., 533 U.S. 218 (2001) ................................................ 3 Union Carbide v. United States, 612 F.2d 558 (Ct. Cl. 1979)................................ 2 Statutes State Law State Law California Uniform Limited Parternship Act of 2008, CAL. CORP. CODE §§ 15900 to 15912.07......................................................... 21 Florida Revised Uniform Limited Partnership Act of 2005, FLA. STAT. §§ 620.1101 to 620.2205............................................................... 21 Hawaii Uniform Limited Partnership Act (Revised), HAW. REV. STAT. §§ 425E-111 to 425E-1206................................................. 21 Idaho Uniform Limited Partnership Act, IDAHO CODE §§ 53-2-101 to 53-2-1205........................................................... 21 Illinois Uniform Limited Partnership Act, 805 ILL. COMP. STAT. 215/0.01 to 215/1402 ................................................... 21 Iowa Uniform Limited Parternship Act, IOWA CODE §§ 488.101 to 488.1207................................................................ 21 Kentucky Uniform Limited Partnership Act (2006), KY. REV. STAT. §§ 362.2-102 to 362.2-1207................................................... 21 Maine Uniform Limited Partnership Act of 2007, ME. REV. STAT. tit. 31, §§ 1301 to 1461.......................................................... 21 Minnesota Uniform Limited Partnership Act of 2001, MINN. STAT. §§ 321.0101 to 321.1208 ............................................................ 21 North Dakota Uniform Limited Partnership Act (2001), N.D. CENT. CODE §§ 45-10.2-01 to 45-10.2-117............................................. 21 Texas Limited Liability Company Act, Tex Rev. Civ. Stat. art. 1528n §§ 1.01-11.07 ........................................ 5, 15, 16

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Federal Law Internal Revenue Code (26 U.S.C.) Internal Revenue Code § 168(k)................................................................................................................... 8 § 469............................................................................................................... passim § 7805.................................................................................................................... 12 §§ 1361-1379 .......................................................................................................... 9 Miscellaneous

Treasury Regulations Regulations Treas. Reg. § 301.7701-3...................................................................................... 15 Temporary Treasury Regulations Temporary Regulations Temp. Treas. Reg. § 1.469-5T ....................................................................... passim Legislative History Legislative History SENATE REPORT ON PUB. L. 99-514 (The Tax Reform Act of 1986) S. Rep. No. 313 (1986) as repinted in 1986-3 C.B. (Part 3) 1, 713-746 ........ 19 STAFF OF JOINT COMM. ON TAXATION, 99TH CONG. 2ND, GENERAL EXPLANATION OF THE TAX REFORM ACT OF 1986, MAY 4, 1987.................... 10 STAFF OF JOINT COMM. ON TAXATION, 99TH CONG., TAX REFORM PROPOSALS: TAX SHELTERS AND MINIMUM TAX, AUG. 7, 1985..................... 10 Tax Reform Act of 1986, Pub. L. 99-514, 100 Stat. 2085 (1986). ....................... 10 Administrative History Administrative History Treas. Dec. 8253, 1989-1 C.B. 121, 1989-24 I.R.B. 12, 54 F.R. 20527 (1989).............................................................................................................. 12 Treas. Dec. 8417, 1992-1 C.B. 173, 1992-24 I.R.B. 70, 57 F.R. 20747 (1992).............................................................................................................. 12

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Uniform Laws Uniform Laws Revised Uniform Limited Partnership Act 1976 §§ 101-1106 (1976) ................. 21 Uniform Limited Partnership Act 2001 §§ 101-1207 (2001) ......................... 21, 22

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Table of Exhibits Exhibit 1: Exhibit 2: Exhibit 3: Exhibit 4: Exhibit 5: James R. Thompson Deposition Transcript. www.orix.com/executive_thompson_james.htm. James R. Thompson 2002 Form 1040, Individual Income Tax Return. James R. Thompson 2003 Form 1040, Individual Income Tax Return. Mountain Air Charter, LLC Business Overview and Operating Results through Calendar Year 2004. Articles of Organization of Mountain Air Charter, L.L.C. Pilatus PC-12 Fact Sheet, available at www.pilatus-aircraft.com. Application for Air Carrier Operating Certificate, Letter of Intent and Preapplication Statement of Intent. Regulations of Mountain Air Charter, L.L.C. Articles of Incorporation of JRT Holdings, Inc. Promissory Note from Mountain Air Charter, L.L.C. to James R. Thompson. Plaintiff's Objections and Responses to Defendant's First Set of Interrogatories. USAIG Insurance Policy Effective May 15, 2002 ­ May 15, 2003. Resume of Thomas E. Travis. Affidavit of Thomas E. Travis. Thomas E. Travis Deposition Transcript. James R. Thompson Flight Log 2002 ­ 2003. Thomas E. Travis Flight Log 2002 ­ 2003. Mountain Air Charter, L.L.C. Operations Specifications. Select Mountain Air Charter, L.L.C. Statements of Revenue Calculation.

Exhibit 6: Exhibit 7: Exhibit 8:

Exhibit 9: Exhibit 10: Exhibit 11:

Exhibit 12:

Exhibit 13: Exhibit 14: Exhibit 15: Exhibit 16: Exhibit 17: Exhibit 18: Exhibit 19: Exhibit 20:

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Exhibit 21: Exhibit 22: Exhibit 23:

Michael D. Holderread Deposition Transcript. Resume of Michael D. Holderread. Mountain Air Charter, L.L.C. 2002 Form 1065, U.S. Return of Partnership Income. Mountain Air Charter, L.L.C. 2003 Form 1065, U.S. Return of Partnership Income. Form 4549A, Income Tax Examination Changes. Plaintiff's Refund Claim and Request for Immediate Disallowance.

Exhibit 24:

Exhibit 25: Exhibit 26:

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THE UNITED STATES COURT OF FEDERAL CLAIMS No. 06-211 T (Judge Victor J. Wolski) _______________________________________________ JAMES R. THOMPSON, Plaintiff, v. THE UNITED STATES Defendant. ______________________________________________ DEFENDANT'S BRIEF IN OPPOSITION TO PLAINTIFF'S MOTION FOR PARTIAL SUMMARY JUDGMENT AND IN SUPPORT OF ITS CROSS MOTION FOR PARTIAL SUMMARY JUDGMENT ______________________________________________ I. INTRODUCTION

Plaintiff filed this tax refund suit, seeking a federal income tax refund of $781,241, plus interest, for the tax years ended December 31, 2002 and 2003.1 (Compl. at 6). Plaintiff is an avid pilot who formed a limited liability company ("LLC"), and provided the funds to acquire an aircraft to be used in a charter operation and which plaintiff also used for personal purposes. The LLC claimed large depreciation deductions, and also sustained operating losses from its charter activities, resulting in a substantial loss. Plaintiff treated the LLC as a partnership for tax purposes and claimed a

1

The total refund plaintiff seeks is $863,124. $81,883 of plaintiff's claim for refund is attributable to interest that accrued on his deficiency through August 11, 2005, as determined by the Internal Revenue Service. (Def. Prop. Findings ¶ 52). 1

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pass-through of the LLC's losses on his personal returns, reducing the tax liability on his substantial income as a corporate executive. The Internal Revenue Service disallowed the losses for the years at issue, under Section 469 of the Internal Revenue Code.2 Section 469 provides that "passive activity" losses can only be applied against passive activity income, and any excess losses are carried forward to the next taxable year. Under the statute and applicable regulations, if a taxpayer has a partnership interest and has limited liability for the partnership's obligations, he will be treated as holding a limited partnership interest and is presumed to be subject to the loss limitations. The Internal Revenue Service determined that plaintiff should be treated as holding a limited partnership interest, since he owned an interest in an LLC which was treated as a partnership, and he only had limited liability with respect to the LLC's obligations. If a taxpayer holds a limited partnership interest, he may reverse the presumption that he is subject to the loss limitation if he meets any one of three tests. The IRS concluded that plaintiff did not meet any of the three tests, and therefore, his losses were limited under Section 469. Plaintiff does not challenge the validity of the regulation, which is entitled to the highest level of judicial deference, because it was promulgated pursuant to a specific grant of legislative authority.3 Rather, he argues that under the regulation, his interest in

2

Unless otherwise indicated, all references to "Section" or "§" are to the Internal Revenue Code of 1986 (26 U.S.C.).

3

Legislative regulations have the force and effect of law unless they are unreasonable, conflict with a statute, exceed the scope of authority granted, or are not issued in accordance with the proper procedure. Long Island Care at Home Ltd. v. Coke, 551 U.S. ___ (June 11, 2007). Batterton v. Francis, 432 U.S. 416, 426 (1977); Rite Aid Corp. v. U.S., 255 F.3d 1357, 1359 (Fed. Cir. 2001); Union Carbide v. U.S., 612 F.2d 558,563 (Ct. Cl. 1979); cf. Rowan Cos. v. U.S., 452 U.S. 247, 253 (1981); (continued) 2

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the LLC is not treated as a limited partnership interest. On that basis, he argues that four additional tests are available to him under the regulation in determining whether he is subject to Section 469's loss limitations. The parties' cross motions for partial summary judgment ask the Court to resolve the legal question of whether the regulation treats plaintiff's interest as a limited partnership interest, which will determine which tests apply to determine whether he is subject to the Section 469 loss limitations. Once the applicable tests are established, the parties, and if necessary, the Court, can resolve the remaining factual issues presented. II. QUESTION PRESENTED

Whether plaintiff's interest in a limited liability company, which he treated as a partnership interest, and with respect to which his liability was limited, should be treated as a limited partnership interest under Temp. Treas. Reg. § 1.469-5T(e)(3), which provides that "a partnership interest shall be treated as a limited partnership interest" if the "liability of the holder of such interest for obligations of the partnership is limited." III. STATUTES AND REGULATIONS INVOLVED

The relevant statutes and regulations are set forth in Appendix A, infra.

(continued from prior page) United States v. Mead Corp., 533 U.S. 218, 226-27 (2001); Chevron U.S.A., Inc. v. Natural Resources Defense Council, Inc., 467 U.S. 837 (1984). 3

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IV.

STATEMENT OF THE CASE

Plaintiff, James R. Thompson, is the Chief Executive Officer of Orix USA Corporation, a financial services company. (Def. Prop. Findings ¶ 1). Orix USA Corporation is the parent of approximately 95 subsidiary companies. (Def. Prop. Findings ¶ 2). Plaintiff holds various board positions with these subsidiaries in both an executive and non-executive capacity. (Def. Prop. Findings ¶ 3). He has been employed by Orix USA since 1990. (Def. Prop. Findings ¶ 4). He resides in Dallas, TX. (Def. Prop. Findings ¶ 5). On his Form 1040 U.S. Individual Income Tax Return for 2002, plaintiff reported wages of $8,175,485 from Orix. (Def. Prop. Findings ¶ 6). He reported wages of $7,246,711 in 2003. (Def. Prop. Findings ¶ 7). Plaintiff is also an avid and experienced pilot. He learned to fly in 1982 and by 2004, Mr. Thompson had logged more than 4,500 hours of flight time. (Def. Prop. Findings ¶ 8). Plaintiff owned and regularly flew a Mooney aircraft until approximately the time a larger, faster, and more capable aircraft was purchased, as described below, and whose ownership and use is central to the tax dispute in this case. (Def. Prop. Findings ¶ 9). In 2002, Mr. Thompson formed Mountain Air Charter, LLC (Mountain Air) to acquire and use a new Pilatus PC-12 aircraft. (Def. Prop. Findings ¶ 10). The Pilatus PC-12 is a several million dollar, large, luxurious, high performance, single-engine, turboprop aircraft. (Def. Prop. Findings ¶ 11). Configured for executive transportation, it can seat six to eight passengers and cruise at approximately 310 miles per hour. (Def. Prop. Findings ¶ 12). It is certified to be flown by a single pilot. (Def. Prop. Findings

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¶ 13). According to its Application for Air Carrier Operating Certificate, Mountain Air was to engage in the aircraft charter business. (Def. Prop. Findings ¶ 14). Mr. Thompson also intended to pilot and use the Pilatus PC-12 aircraft for personal purposes. (Def. Prop. Findings ¶ 15). Mountain Air was organized on March 19, 2002, as a limited liability company under Texas law. (Def. Prop. Findings ¶ 16). Mr. Thompson acquired a 99% interest in Mountain Air. JRT Holdings, Inc. (JRT Holdings) held the remaining 1% interest in Mountain Air. Mr. Thompson owns 100% of the stock of JRT Holdings. (Def. Prop. Findings ¶ 17). JRT Holdings was incorporated in Texas on April 15, 2002 and elected to be treated as a Subchapter S corporation for federal income tax purposes. (Def. Prop. Findings ¶ 18). Mr. Thompson made an initial capital contribution to Mountain Air of $928,621, and JRT Holdings contributed an additional $9,380. (Def. Prop. Findings ¶ 19). Mr. Thompson also loaned Mountain Air $2.6 million on the day it acquired the Pilatus aircraft. (Def. Prop. Findings ¶ 20). The loan was evidenced by a promissory note dated May 15, 2002. The terms of the note provided for interest only payments (at 6%) in five annual installments beginning May 15, 2003. The principal was to be repaid on the fifth annual installment date. Prepayment of the principal was allowed without any penalty or premium. (Def. Prop. Findings ¶ 21). Under Texas state law, Mr. Thompson's liability in Mountain Air is limited to his capital contribution, subject to any additional requirements imposed by the LLC's Articles of Organization and/or Regulations. TEX. REV. CIV. STAT. art. 1528n §§ 4.03, 5.02. Article 5.7 of the Regulations of Mountain Air specifically provides that "[l]oans

5

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by a Member to the Company shall not be considered Capital Contributions . . . [and] shall not result in any increase in the amount of the Capital Account of such Member." Neither the Articles of Organization nor the Regulations for Mountain Air imposed additional liabilities on Mr. Thompson. (Def. Prop. Findings ¶ 22). Accordingly, the $2.6 million loan from Mr. Thompson was not a capital contribution. Under Texas state law and the Regulations of Mountain Air, Mr. Thompson's total liability in Mountain Air was limited to $937,381 (the amount of his initial capital contributions from Mr. Thompson and JRT Holdings). If the LLC were dissolved, Mr. Thompson would have rights as a general creditor against the LLC for any unpaid balance of the $2.6 million loan to the LLC. Mountain Air used the loan proceeds and a portion of its capital contributions to purchase the new Pilatus PC-12 aircraft on May 15, 2002. (Def. Prop. Findings ¶ 23). The purchase price of the aircraft was $3,338,001. (Def. Prop. Findings ¶ 24). Mr. Thompson secured insurance for the aircraft, effective on its purchase date. (Def. Prop. Findings ¶ 25). The insurance coverage provided that Mr. Thompson would not be permitted to be the sole pilot of the aircraft until he accumulated 200 hours of flight time in the PC-12, accompanied by Mr. Thomas E. Travis. (Def. Prop. Findings ¶ 26). Mr. Travis is a retired American Airlines pilot with more than 22,000 hours of recorded flight time in a wide variety of aircraft. (Def. Prop. Findings ¶ 27). Mr. Travis is also an accomplished flight instructor, having recorded more than 7,000 hours in that capacity. (Def. Prop. Findings ¶ 28). Mr. Travis was hired as an employee of Mountain Air in March 2002. (Def. Prop. Findings ¶ 29).

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Upon acquisition of the aircraft, Mr. Thompson and Mr. Travis flew together regularly. They flew to many destinations, including an initial trip along the coast of California (where Mr. Thompson lived prior to moving to Texas) and to a location in New Mexico, where Mr. Thompson rented a vacation home. (Def. Prop. Findings ¶ 30). In his logbook, Mr. Travis recorded this flight time as an instructor; Mr. Thompson logged it as "dual", which Mr. Travis explained meant that Mr. Thompson was receiving instruction. (Def. Prop. Findings ¶ 31). Mr. Thompson continued to fly with Mr. Travis until he accumulated approximately 200 hours in the aircraft in November 2002, after which, the insurance documents were revised to provide that Mr. Thompson was authorized to fly the PC-12 as the sole pilot, which he did. (Def. Prop. Findings ¶ 32). Mountain Air did not begin offering to fly passengers for hire until on or about September 3, 2002, when the FAA approved its application to become a charter operator. (Def. Prop. Findings ¶ 33). Its charter customers during the years at issue were primarily Orix employees and Mr. Thompson's personal acquaintances. (Def. Prop. Findings ¶ 34). Mountain Air often offered these customers substantial discounts from its regular charter rates. (Def. Prop. Findings ¶ 35). Mr. Travis served as the pilot for these for-hire operations until he left the company in 2003 and was succeeded in that capacity by Mr. Michael D. Holderread. (Def. Prop. Findings ¶ 36). After he was authorized to fly the PC-12 as the sole pilot, Mr. Thompson sometimes flew persons he characterized as potential customers (and already knew), on flights without charge. (Def. Prop. Findings ¶ 37). He also flew the aircraft as the sole pilot on other flights he acknowledged were personal. On the flights characterized as personal, he declared minimal amounts of income on his personal income tax return to

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acknowledge his personal use of the aircraft. The income he declared was far less than the actual cost of owning and operating the aircraft. Mr. Thompson alleges that the amounts included were in accordance with IRS guidelines. (Def. Prop. Findings ¶ 38). Mountain Air did not elect to be treated as a corporation for federal tax purposes. (Def. Prop. Findings ¶ 39). Consequently, it was treated as a partnership for federal tax purposes and filed a partnership return (Form 1065, U.S. Return of Partnership Income) in both 2002 and 2003. (Def. Prop. Findings ¶ 40). In 2002, Mountain Air reported a loss of $1,235,446, which included a depreciation deduction of $1,112,700 on the Pilatus PC-12.4 (Def. Prop. Findings ¶ 41). The reported loss also apparently included deductions for the cost of all of Mr. Thompson's and Mr. Travis' flights together, as well as Mr. Thompson's flights after he was authorized to fly as the sole pilot. (Def. Prop. Findings ¶ 42) In 2003, Mountain Air reported a loss of $955,430 on its partnership return. (Def. Prop. Findings ¶ 43). Its reported loss included $635,810 of depreciation on the aircraft, and apparently also the costs attributable to Mr. Thompson's personal flights in the aircraft.5 (Def. Prop. Findings ¶ 44). Mountain Air's partnership returns also include an analysis of Net Income (Loss), reflecting the distributive shares of its losses to Mr. Thompson and JRT Holdings. Each was identified in this analysis as a limited partner, rather than a general partner. (Def. Prop. Findings ¶ 45). For 2002, Mountain Air submitted a Schedule K-1 to Mr. Thompson indicating that his 99% distributive share of the losses was $1,213,897, and
4

The original cost basis of the aircraft was $3,338,001. Section 168(k) provided for first year bonus depreciation of 30% of the purchase price ($1,001,400), plus additional depreciation under the double declining balance method for 7-year property using the half year convention ($111,300). Thus, total depreciation on the PC-12 was $1,112,700.

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JRT Holding's 1% distributive share was $12,359. (Def. Prop. Findings ¶ 46). For 2003, Mountain Air submitted a Schedule K-1 to Mr. Thompson indicating that his 99% distributive share of the losses was $931,065, and JRT Holding's 1% distributive share was $9,549. (Def. Prop. Findings ¶ 47). On his individual income tax returns for 2002 and 2003, Mr. Thompson reported his individual distributive share of Mountain Air's losses, and since he owned 100% of JRT Holdings, a Subchapter S corporation, its distributive share as well.6 Thus, after including some other minor items in 2002, he claimed a loss from Mountain Air of $1,225,869 on Schedule E of his personal return. (Def. Prop. Findings ¶ 48). After inclusion of similar items in 2003, he claimed a loss from Mountain Air of $939,878 on Schedule E of his personal Return. (Def. Prop. Findings ¶ 49). Mr. Thompson used these tax losses to offset a significant portion of his wage income from Orix Corporation USA and its affiliates. (Def. Prop. Findings ¶ 50). The Internal Revenue Service examined Mr. Thompson's 2002 and 2003 income tax returns and concluded that the Mountain Air losses he claimed on his personal returns were subject to the loss limitation provisions of Section 469. Accordingly, the Internal Revenue Service disallowed all of the losses from Mountain Air in 2002 ($1,225,869) and most of the losses Mr. Thompson claimed in 2003 ($783,878). (Def. Prop. Findings ¶ 51). Under Section 469, the losses were not permanently disallowed. Rather, they were to be carried forward to future tax years until such time as Mountain Air has income, or until plaintiff disposes of his interest in the LLC.
6

Subchapter S of the Internal Revenue Code, Sections 1361-1379 in particular, provide that the income or loss of a Subchapter S corporation flows through to be reported on the individual returns of its shareholders.

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The disallowances resulted in the Internal Revenue Service's determination that plaintiff owed additional tax and interest in the amount of $863,124 for 2002 and 2003.7 (Def. Prop. Findings ¶ 52). On September 9, 2005, plaintiff paid the tax and interest and filed a claim for refund, requesting immediate disallowance so he could file suit. (Def. Prop. Findings ¶ 53). On March 15, 2006, plaintiff filed suit in this court. (Def. Prop. Findings ¶ 54). V. ARGUMENT PLAINTIFF'S INTEREST IN MOUNTAIN AIR IS TREATED AS A LIMITED PARTNERSHIP INTEREST UNDER SECTION 469 A. Introduction ­ Section 469 Loss Limitations Prior to the enactment of the Tax Reform Act of 1986,8 there were few limitations on a taxpayer's ability to use deductions from one activity against income from another activity. The absence of rules encouraged the proliferation of a variety of tax driven transactions. STAFF OF JOINT COMM. ON TAXATION, 99TH CONG., GENERAL EXPLANATION
OF THE TAX REFORM ACT OF 1986, May

4, 1987 at 209. A tax shelter, according to

Congress, was an investment in which a significant portion of the taxpayer's return was derived from tax savings. STAFF OF JOINT COMM. ON TAXATION, 99TH CONG., TAX REFORM PROPOSALS: TAX SHELTERS AND MINIMUM TAX, Aug. 7, 1985 at 2. In an effort to curtail these tax shelters, Congress enacted Internal Revenue Code Section 469, which

7

For 2002, the Service determined that $473,186 in additional tax was due, plus $58,844 in interest that had accrued as of August 11, 2005. For 2003, the Service determined that $308,055 in additional tax was due, plus $23,039 in interest that had accrued as of August 11, 2005. Thus, Mr. Thompson's total deficiency was alleged to be $863,124. (Def. Prop. Findings ¶ 52).
8

Tax Reform Act of 1986, Pub. L. 99-514, 100 Stat. 2085 (1986). 10

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limits a taxpayer's ability to shelter positive income from tax by claiming losses from other activities in which his investment is considered "passive." Section 469 generally provides that an individual taxpayer's losses in a taxable year from a passive activity may be used to offset income in that year from another passive activity, but that any excess is not allowed and is instead carried forward as a passive activity loss to the next taxable year. Sections 469(a), (b), and (d). Section 469(c)(1) provides the starting point for determining whether a taxpayer's investment is considered passive and is subject to these limitations: (1) In General. ­ The term "passive activity" means any activity ­ (A) which involves the conduct of a trade or business, and (B) in which the taxpayer does not materially participate. Material participation is defined generally, but there is a special rule for limited partnership interests. The general rule is that a taxpayer is treated as materially participating in an activity only if he is involved in the operations of the activity on a "regular", "continuous", and "substantial" basis. Section 469(h)(1). But, "[e]xcept as provided in regulations" (emphasis added) no limited partnership interest "shall be treated as an interest with respect to which a taxpayer materially participates." Section 469(h)(2). Thus, under the statute, a taxpayer holding a limited partnership interest is, per se, subject to the Section 469 loss limitations, unless, pursuant to Congress' grant of legislative regulatory authority, the Secretary issues regulations providing exceptions. In addition to the rule-making authority given to the Secretary in Section 469(h)(2), Congress gave the Secretary additional authority in Section 469(l) to promulgate regulations "as may be necessary or appropriate to carry out the provisions of

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this section." Section 469(l). Among the regulatory areas cited, Congress specifically authorized the Secretary to prescribe regulations to "specify what constitutes an activity, material participation, or active participation". Section 469(l)(1). B. Treasury Regulations on Material Participation and Limited Partnership Interests Acting on these broad legislative grants of authority, the Secretary promulgated Temp. Treas. Reg. § 1.469-5T in 1988. The regulation remains in effect today9 and prescribes rules for determining material participation, including, specifically, rules regarding limited partnership interests. In general, an individual will be treated as materially participating in an activity for the taxable year if he meets any one of seven prescribed tests (Temp. Treas. Reg. § 1.469-5T(a)): (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 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;
9

Amendments to Temp. Treas. Reg. § 1.469-5T and a corresponding notice of proposed rulemaking were published in the Federal Register on May 12, 1989. T.D. 8253. Written comments were received on the amendments to the temporary regulations, and a public hearing was held on November 28, 1989. To avoid possible disputes about whether the amendments to Temp. Treas. Reg. § 1.469-5T would "sunset" under § 7805(e)(2), Treasury released a decision on May 15, 1992 adopting the amendments as final regulations, and preserving the cross references to the corresponding temporary regulations. T.D. 8417. 12

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(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 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.10 Temp. Treas. Reg. § 1.469-5T(e) addresses the special treatment of limited partnership interests and tracks Section 469(h)(2). As Section 469(h)(2) provides, the holder of a limited partnership interest is not treated as materially participating in an activity for purposes of applying Section 469, unless otherwise provided in the regulation. Temp. Treas. Reg. § 1.469-5T(e)(1). The exceptions are contained in Temp. Treas. Reg. § 1.469-5T(e)(2). It provides that paragraph (e)(1) does not apply to limit losses if an individual holding a limited partnership interest would be treated as materially participating for the taxable year under tests (1), (5), or (6) above. Temp. Treas. Reg. § 1.469-5T(e)(3) provides two definitions of a limited partnership interest for "purposes of Section 469(h)(2) and this paragraph (e)". The first definition is based on organizational formalities. It provides that a
10

For purposes of this facts and circumstances test, if an individual participates in an activity for 100 hours or less during the taxable years, the individual shall not be treated as materially participating in the activity. Temp. Treas. Reg. § 1.469-5T(b)(2)(iii). 13

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partnership interest shall be treated as a limited partnership interest if such interest is "designated a limited partnership interest in the limited partnership agreement or the certificate of limited partnership." Temp. Treas. Reg. § 1.4695T(e)(3)(i)(A). The second definition recognizes that form and labels are not controlling, but still offers a clear, easily applied rule. Temp. Treas. Reg. § 1.4695T(e)(3)(i)(B) provides that a partnership interest also will be treated as a limited partnership interest if the liability of the holder of such an interest for the partnership's obligations is limited under state law to a determinable, fixed amount. To summarize, if an individual holds a limited partnership interest under the regulation, he is subject to the Section 469 loss limitation rules unless he meets one of three tests. If he does not hold a limited partnership interest, he can avoid the loss limitations by satisfying any of those three tests, or any of four additional tests. Understandably, plaintiff seeks the broader, more expansive set of tests and a greater opportunity to avoid the loss limitations. The dispute in these cross motions over whether plaintiff's interest in Mountain Air is treated as a limited partnership interest thus reduces to applying Temp. Treas. Reg. § 1.469-5T(e)(3)(i) to determine the following: (1) Was plaintiff's interest in Mountain Air a partnership interest? and (2) Was his liability for Mountain Air's obligations limited under Texas law?

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C. Plaintiff had a partnership interest in Mountain Air, and his liability for its obligations was limited. Mountain Air Charter LLC was organized under Texas law as an LLC. TEX. REV. CIV. STAT. art. 1528n. For federal tax purposes, under the so-called "check the box" regulations, such non-corporate entities with two or more members may elect to be taxed as a corporation. Treas. Reg. § 301.7701-3(a). If no election is made, the organization is treated for tax purposes as a partnership. Treas. Reg. § 301.7701-3(b)(1)(i). Mountain Air did not elect to be treated as a corporation for federal tax purposes. (Def. Prop. Findings ¶ 39). Instead, consistent with its resulting treatment as a partnership, Mountain Air filed partnership returns. (Def. Prop. Findings ¶ 40). On its partnership returns for those years, Mountain Air reported relatively little charter income, a larger amount of out-of-pocket deductions, and very large deductions for depreciation. As a result, Mountain Air reported substantial partnership losses of $1,235,446 in 2002, and $955,430 in 2003. (Def. Prop. Findings ¶¶ 41, 43). The partnership also reported the distributive shares of those losses to its two owners ­ plaintiff (99%) and his wholly owned Subchapter S corporation, JRT Holdings, Inc. (1%). Def. Prop. Findings ¶ 45. Plaintiff was identified on the partnership's tax returns as a "limited partner." Id. Mountain Air's partnership returns also included Schedules K-1, "Partner's Share of Income, Credits, Deductions, etc." (emphasis added). A Schedule K-1 was prepared for "Partner #1", James R. Thompson, allocating a

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99% distributive share of losses to him. (Def. Prop. Findings ¶¶ 46, 47). Likewise, the partnership returns included Schedules K-1 for Partner #2, JRT Holdings, Inc., allocating a 1% share of losses to it.11 Id. Plaintiff reported 100% of the partnership's distributive losses from the K-1s on his individual income tax returns for 2002 and 2003. (Def. Prop. Findings ¶¶ 48, 49). He reported the details of the losses on Schedule E, "Supplemental Income and Loss (From rental real estate, royalties, partnerships, S corporations, estates, trusts, REMICs, etc.)" (emphasis added). Id. Part II of Schedule E addresses losses from partnerships and S corporations, and Mr. Thompson reported the Mountain Air losses there. Id. He reported his direct, 99% share of Mountain Air's losses as "P" for a partnership loss.12 Id. Under Texas law, plaintiff's liability for Mountain Air's obligations is limited to his capital contributions, subject to any additional responsibility specified in Mountain Air's Articles of Organization and Regulations. TEX. REV. CIV. STAT. art. 1528n §§ 4.03, 5.02. Plaintiff's initial capital contribution to Mountain Air was $928,621.13 Mountain Air's Articles of Organization and Regulations do not impose any further liability on plaintiff for its obligations. (Def. Prop. Findings ¶ 22). Plaintiff's loan to Mountain Air (used to purchase the Pilatus PC-12 aircraft) was not an additional capital contribution under the
11

Since JRT Holdings, Inc. was a Subchapter S corporation, its share of losses flowed through to its sole owner ­ plaintiff, James R. Thompson. He reported JRT Holding, Inc.'s loss as "S" for S corporation, but, of course, JRT Holding's loss was derived from Mountain Air's partnership loss.
13 12

Plaintiff also caused JRT Holdings, Inc. to make a $9,380 capital contribution to Mountain Air. Thus his total liability was limited to $938,001. 16

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Regulations and therefore did not increase his liability for Mountain Air's obligations. Article 5.7 of the Regulations of Mountain Air specifically provides that "[l]oans by a Member to the Company shall not be considered Capital Contributions . . . [and] shall not result in any increase in the amount of the Capital Account of such Member." Id. In summary, Mountain Air treated itself as a partnership and its two owners as partners. Plaintiff also reported his interest in Mountain Air as a partnership interest. These undisputed facts lead inescapably to the conclusion that Mr. Thompson held a partnership interest in Mountain Air. There also can be no dispute that, under Texas law, his liability with respect to his partnership interest was limited. Therefore, under Temp. Treas. Reg. § 1.469-5T(e)(3), plaintiff's interest in Mountain Air is treated as a limited partnership interest. D. Plaintiff's arguments that the Regulation does not apply to his interest in Mountain Air are misconceived As discussed above, plaintiff opted for Mountain Air to be treated for tax purposes as a partnership, with the result that it reported a substantial partnership loss, which plaintiff then claimed on his individual return. At the same time, plaintiff's liability for Mountain Air's obligations arising from its losses was limited to his capital contributions. Thus, plaintiff sought partnership treatment to obtain a pass-through of losses, but he seeks to avoid partnership treatment in evaluating whether the loss passthrough is subject to the limitations of Section 469. Plaintiff offers essentially two arguments why he should not be regarded as holding a limited partnership interest. One would give conclusive effect to organizational formalities; the other would ignore the

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regulatory language, which is consistent with the statute, in favor of policy arguments best addressed to Congress. Neither justifies ignoring the plain language result under the regulations ­ plaintiff held a partnership interest, his liability was limited, and, therefore, he held a limited partnership interest. Plaintiff's first argument is to the effect that the regulation can't treat him as holding a limited partnership interest, because Mountain Air was an LLC and not a limited partnership under state law. (Pltf.'s Br. at 15). Of course, if Mountain Air had been organized under state law as a limited partnership, and had plaintiff been designated as a limited partner, he would be considered to hold a limited partnership interest. Presumably, plaintiff would not dispute that the regulation goes this far. Indeed, that is precisely what Temp. Treas. Reg. § 1.469-5T(e)(3)(i)(A) provides.14 But the regulation does not end there. It goes on, in Temp. Treas. Reg. § 1.4695T(e)(3)(i)(B), to treat an interest as a limited partnership interest without regard to organizational and labeling formalities. This subsection of the regulation recognizes that designations and labels are part of the tax planning process and provides (without reference to whether there is a limited partnership agreement or a designated limited partner) that a partnership interest shall be treated as a limited partnership interest if "[t]he liability of the holder of such interest for obligations of the partnership is limited [under State law] to a determinable fixed amount." Id.

14

A partnership interest shall be treated as a limited partnership interest if "(A) such interest is designated as 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." (emphasis added). 18

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The regulation in this regard is consistent with Congress' view when it enacted Section 469 that the form of organization and form of ownership is not conclusive regarding whether a taxpayer is treated as having a limited partnership interest. For example, Congress explained that an interest should be treated as a limited partnership interest even when the taxpayer holds an interest through a tiered entity arrangement under which the taxpayer owns a general partnership interest or stock in an S corporation. S. Rep. No. 313, 99th Cong., 2d Sess. 713, 731 (1986). Similarly, the exercise of regulatory authority would be appropriate if taxpayers were permitted under State law to establish limited liability entities (that are not taxable as corporations) for personal service or other active businesses, by treating interests relating to the rendering of personal services as limited partnership interests. Id. at 731-32. Congress went on to state even more broadly that the Secretary's exercise of regulatory authority "might be appropriate where taxpayers sought to avoid limited partnership status with respect to substantially equivalent entities." Id. at 732. Thus, Congress made it quite clear that a taxpayer may be treated as holding a limited partnership interest, even if his interest was not designated as such, and, indeed, even if an entity other than a limited partnership that is not taxed as a corporation was utilized. Temp. Treas. Reg. § 1.469-5T(e)(3)(i)(B) does just that. Plaintiff is not entitled to attribute conclusive effect to whether a limited partnership was formed ­ the subject of subparagraph (A) ­ and thereby write subparagraph (B) out of the regulation.15

Plaintiff also argues (Br. at 16) that, even if his interest in Mountain Air is treated as a partnership interest, he should be considered a general partner under Temp. Treas. Reg. § 1.469-5T(e)(3)(ii). According to plaintiff, "[t]here can be no dispute" that this subparagraph "describes `general partner' solely with reference to management involvement." The language of the regulation provides no support for (continued) 19

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Plaintiff also seeks to avoid the straightforward application of the language of Temp. Treas. Reg. § 1.469-5T(e)(3)(ii) by making a policy argument best addressed to Congress, which can then consider whether to amend the underlying statute. Plaintiff points to Texas law regarding LLC's, which allows members to participate in its business activities. Plaintiff also points to Texas limited partnership law, which would cause a limited partner to lose limited liability if he was regularly involved in the partnership's business. (Pltf.'s Br. at 11-14). Relying on legislative history that referenced the usual circumstance in 1986 when Section 469 was enacted that limited partners were not engaged in the activities of a partnership, plaintiff argues that, since he was not so limited as an LLC member, he should not be treated as holding a limited partnership interest. Id. According to plaintiff, the distinguishing factor between LLC's and limited partnerships is "control." (Pltf.'s Br. at 13.) The law since 1986 has evolved considerably, and the distinction between limited partnerships and LLCs regarding the participation of owners is in full retreat. In many states, limited partners have gained increased rights of participation, without risking their limited liability.16 In 2001, the National Conference of Commissioners on Uniform State

(continued from prior page) plaintiff's hyperbolic argument. The regulation does not describe or define a general partner at all, much less by reference to management involvement. Moreover, it is elementary that the status of a limited partner is characterized by limited liability, which a general partner does not enjoy. Since plaintiff had limited liability, he is treated as holding a limited partnership interest under Temp. Treas. Reg. § 1.469-5T(e)(3)(i)(B) and not as a general partner under Temp. Treas. Reg. § 1.469-5T(e)(3)(ii).
16

The commentary to the Uniform Limited Partnership Act of 2001 indicates that erosion of the "control rule" began with the Revised Uniform Limited Partnership Act of 1976 (RULPA 1976) in which several safe harbors were designated as activities in which limited partners could participate without violating the general prohibition against participation in the partnership, unless the limited partner acted (continued) 20

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Laws released the Uniform Limited Partnership Act of 2001 (ULPA 2001), extending full rights of participation in the management and control of a partnership to limited partners.17 UNIF. LTD. PART. ACT 2001 § 303 (2001). The Commissioners made it clear in their Comment to Section 303 that they were eliminating the distinction based on control between limited partnerships and LLCs: This section provides a full, status-based liability shield for each limited partner, "even if the limited partner participates in the management and control of the limited partnership." The section thus eliminates the so-called "control rule" with respect to personal liability for entity obligations and brings limited partners into parity with LLC members, LLP partners and corporate shareholders. . . In a world with LLPs, LLCs and, most importantly, LLLPs, the control rule has become an anachronism. This Act therefore takes the next logical step in the evolution of the limited partner's liability shield and renders the control rule extinct. (emphasis added). Section 469(h)(2) provides simply that holders of limited partnership interests are subject to the loss limitations of that section, unless excepted by regulation. Under the statutory language, the determination whether a limited partnership interest exists does not turn on whether the holder of the interest may participate in the partnership's

(continued from prior page) "substantially the same" as a general partner. The control rule further deteriorated in the 1985 revisions to RULPA 1976, which eliminated the "substantially the same" rule from the act. With the introduction of ULPA 2001, the control rule was eliminated in its entirety. UNIF. LTD. PART. ACT 2001 § 303 (comment). As of June 11, 2007, ten states had adopted ULPA 2001, including California (Cal. Corp. Code §§ 15900 to 15912.07 (effective January 1, 2008)), Florida (F.S.A. §§ 620.1101 to 620.2205 (effective January 1, 2006)), Hawaii (H.R.S. §§ 425E-111 to 425E1206 (effective July 1, 2004)), Idaho (I.C. §§ 53-2-101 to 53-2-1205 (effective July 1, 2006)), Illinois (S.H.A. 805 ILCS 215/0.01 to 215/1402 (effective January 1, 2005)), Iowa (I.C.A. §§ 488.101 to 488.1207 (effective January 1, 2005)), Kentucky (KRS 362.2102 to 362.2-1207 (effective July 12, 2006)), Maine (31 M.R.S.A. §§ 1301 to 1461 (effective July 1, 2007)), Minnesota (M.S.A. §§ 321.0101 to 321.1208 (effective May 15, 2004)), and North Dakota (NDCC 45-10.2-01 to 45-10.2-117 (effective July 1, 2005)). 21
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activities. Thus, even if a limited partner of a limited partnership has the same ability to participate in business activities as a member of an LLC (i.e., he is a limited partner in a state that has adopted ULPA 2001), he is treated as holding a limited partnership interest under Section 469(h)(2). Temp. Treas. Reg. § 1.469-5T(e), merely implements that statute, and as Congress envisioned, treats taxpayers as holding limited partnership interests in entities that are not taxed as corporations, whether organized as a limited partnership, an LLC, or a similar entity. There is no basis under either the statute or the regulation to distinguish between persons holding limited liability interests in an LLC from one holding a limited liability interest in a limited partnership. While plaintiff makes a policy-based argument that Section 469 should not apply when the holder of a limited liability interest can participate in business activities, it is an argument whose acceptance would require amendments to both Section 469(h)(2) and the regulations. It is an argument best presented to Congress, not this Court.18 In the meantime, plaintiff is not entitled to be treated more favorably as a member of an LLC than many limited

The district court of Oregon in Gregg v. United States, 186 F. Supp. 2d 1123 (2000) nevertheless supported a participation test, rather than the limited liability test expressed in the regulations, in determining that a member of an LLC should not be treated as holding a limited partnership interest. Phrasing the issue as whether the taxpayer should be treated as a limited or general partner for Section 469 purposes (id. at 1127), the court went on to explain that a limited partner in a limited partnership "cannot, by definition, participate" in its management, while LLC members "retain their limited liability regardless of the level of participation in the management of the LLC." Id. at 1128. This foundation to the court's conclusion came, in 2000, before ULPA 2001, which eliminated the control rule for limited partnerships. In any event, the district court failed to apply the "limited liability" test under the regulations in distinguishing between a limited and general partnership interest. The court's conclusion that it would be inappropriate to treat an LLC member as a limited partner of a limited partnership without a regulation expressly so stating wrongly gives conclusive effect under the regulations to organizational formalities. As expressed above, doing so is contrary to the language of Temp. Treas. Reg. § 1.469-5T(e)(3)(i)(B) and Congress' intent. Gregg was (continued) 22

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partners of limited partnerships. Both types of owners are subject to the loss limitations of Section 469 unless they satisfy one of three regulatory tests. VI. CONCLUSION For tax purposes, Mountain Air Charter, LLC was a partnership, and plaintiff's ownership interest was a partnership interest. Plaintiff also had only limited liability for Mountain Air's obligations. As there is no dispute of material fact, defendant is entitled to partial summary judgment that plaintiff's interest in Mountain Air is treated as a limited partnership interest under Temp. Treas. Reg. § 1.469-5T(e)(3), and that he therefore is subject to the Section 469 loss limitations unless he satisfies one of the tests expressed in Temp. Treas. Reg. § 1.469-5T(a)(1), (5), or (6). Plaintiff's motion for partial summary judgment should be denied.

Respectfully submitted, June 11, 2007 s/Jeffrey R. Malo . JEFFREY R. MALO Attorney of Record U.S. Department of Justice Tax Division Court of Federal Claims Section Post Office Box 26 Ben Franklin Post Office Washington, D.C. 20044 (202) 305-7539 Fax (202) 514-9440

(continued from prior page) wrong to suggest that LLC members should not be treated as holding a limited partnership interest, and, in any event, the decision is not binding on this Court. 23

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EILEEN J. O'CONNOR Assistant Attorney General DAVID GUSTAFSON Chief, Court of Federal Claims Section STEVEN FRAHM Assistant Chief, Court of Federal Claims Section June 11, 2007 s/Steven Frahm Of Counsel .

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Appendix A

Internal Revenue Code § 469
Passive activity losses and credits limited (a) Disallowance.-(1) In general.--If for any taxable year the taxpayer is described in paragraph (2), neither-(A) the passive activity loss, nor (B) the passive activity credit, for the taxable year shall be allowed. (2) Persons described.--The following are described in this paragraph: (A) any individual, estate, or trust, (B) any closely held C corporation, and (C) any personal service corporation. (b) Disallowed loss or credit carried to next year.--Except as otherwise provided in this section, any loss or credit from an activity which is disallowed under subsection (a) shall be treated as a deduction or credit allocable to such activity in the next taxable year. (c) Passive activity defined.--For purposes of this section-(1) In general.--The term "passive activity" means any activity-(A) which involves the conduct of any trade or business, and (B) in which the taxpayer does not materially participate. (2) Passive activity includes any rental activity.--Except as provided in paragraph (7), the term "passive activity" includes any rental activity. (3) Working interests in oil and gas property.-(A) In general.--The term "passive activity" shall not include any working interest in any oil or gas property which the taxpayer holds directly or through an entity which does not limit the liability of the taxpayer with respect to such interest. (B) Income in subsequent years.--If any taxpayer has any loss for any taxable year from a working interest in any oil or gas property which is treated as a loss which is not from a passive activity, then any net income from such property (or any property the basis of which is determined in whole or in part by reference to the basis of such property) for any succeeding taxable year shall be treated as income of the taxpayer which is not from a passive activity. If the preceding sentence applies to the net income from any property for any taxable year, any credits allowable under subpart B (other than section 27(a)) or D of part IV of subchapter A for such taxable year which are attributable to such property shall be treated as credits not from a passive activity to the extent the amount of such credits does not exceed the regular tax liability of the taxpayer for the taxable year which is allocable to such net income.

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(4) Material participation not required for paragraphs (2) and (3).-- Paragraphs (2) and (3) shall be applied without regard to whether or not the taxpayer materially participates in the activity. (5) Trade or business includes research and experimentation activity.--For purposes of paragraph (1)(A), the term "trade or business" includes any activity involving research or experimentation (within the meaning of section 174). (6) Activity in connection with trade or business or production of income.--To the extent provided in regulations, for purposes of paragraph (1)(A), the term "trade or business" includes-(A) any activity in connection with a trade or business, or (B) any activity with respect to which expenses are allowable as a deduction under section 212. (7) Special rules for taxpayers in real property business.-(A) In general.--If this paragraph applies to any taxpayer for a taxable year-(i) paragraph (2) shall not apply to any rental real estate activity of such taxpayer for such taxable year, and (ii) this section shall be applied as if each interest of the taxpayer in rental real estate were a separate activity. Notwithstanding clause (ii), a taxpayer may elect to treat all interests in rental real estate as one activity. Nothing in the preceding provisions of this subparagraph shall be construed as affecting the determination of whether the taxpayer materially participates with respect to any interest in a limited partnership as a limited partner. (B) Taxpayers to whom paragraph applies.--This paragraph shall apply to a taxpayer for a taxable year if-(i) more than one-half of the personal services performed in trades or businesses by the taxpayer during such taxable year are performed in real property trades or businesses in which the taxpayer materially participates, and (ii) such taxpayer performs more than 750 hours of services during the taxable year in real property trades or businesses in which the taxpayer materially participates. In the case of a joint return, the requirements of the preceding sentence are satisfied if and only if either spouse separately satisfies such requirements. For purposes of the preceding sentence, activities in which a spouse materially participates shall be determined under subsection (h). (C) Real property trade or business.--For purposes of this paragraph, the term "real property trade or business" means any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business. (D) Special rules for subparagraph (B).-(i) Closely held C corporations.--In the case of a closely held C corporation, the requirements of subparagraph (B) shall be treated as met for any taxable year if more than 50 percent of the gross receipts of such corporation for such taxable year are derived from real property trades or businesses in which the corporation materially participates. (ii) Personal services as an employee.--For purposes of subparagraph (B), personal services performed as an employee shall not be treated as performed in real property trades or businesses. The preceding sentence shall not apply if such employee is a 5-percent owner (as defined in section 416(i)(1)(B)) in the employer. (d) Passive activity loss and credit defined.--For purposes of this section-(1) Passive activity loss.--The term "passive activity loss" means the amount (if any) by which-(A) the aggregate losses from all passive activities for the taxable year, exceed

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(B) the aggregate income from all passive activities for such year. (2) Passive activity credit.--The term "passive activity credit" means the amount (if any) by which-(A) the sum of the credits from all passive activities allowable for the taxable year under-(i) subpart D of part IV of subchapter A, or (ii) subpart B (other than section 27(a)) of such part IV, exceeds (B) the regular tax liability of the taxpayer for the taxable year allocable to all passive activities. (e) Special rules for determining income or loss from a passive activity.--For purposes of this section-(1) Certain income not treated as income from passive activity.--In determining the income or loss from any activity-(A) In general.--There shall not be taken into account-(i) any-(I) gross income from interest, dividends, annuities, or royalties not derived in the ordinary course of a trade or business, (II) expenses (other than interest) which are clearly and directly allocable to such gross income, and (III) interest expense properly allocable to such gross income, and (ii) gain or loss not derived in the ordinary course of a trade or business which is attributable to the disposition of property-(I) producing income of a type described in clause (i), or (II) held for investment. For purposes of clause (ii), any interest in a passive activity shall not be treated as property held for investment. (B) Return on working capital.--For purposes of subparagraph (A), any income, gain, or loss which is attributable to an investment of working capital shall be treated as not derived in the ordinary course of a trade or business. (2) Passive losses of certain closely held corporations may offset active income.-(A) In general.--If a closely held C corporation (other than a personal service corporation) has net active income for any taxable year, the passive activity loss of such taxpayer for such taxable year (determined without regard to this paragraph)-(i) shall be allowable as a deduction against net active income, and (ii) shall not be taken into account under subsection (a) to the extent so allowable as a deduction. A similar rule shall apply in the case of any passive activity credit of the taxpayer. (B) Net active income.--For purposes of this paragraph, the term "net active income" means the taxable income of the taxpayer for the taxable year determined without regard to-(i) any income or loss from a passive activity, and

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(ii) any item of gross income, expense, gain, or loss described in paragraph (1)(A). (3) Compensation for personal services.--Earned income (within the meaning of section 911(d)(2)(A)) shall not be taken into account in computing the in