                          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.
                                   - 3 -

     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.”
                               - 4 -

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.
                              - 5 -

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.
                              - 6 -

     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.
                                 - 7 -

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...)
                               - 8 -

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).
                               - 9 -

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
                              - 10 -

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
                                - 11 -

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).
                              - 12 -

          (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
                                - 13 -

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.
                               - 14 -

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.
                               - 15 -

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).
                                - 16 -

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
                                - 17 -

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
                              - 18 -

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.
                        - 19 -

To reflect the foregoing,


                                 Decision will be entered

                            for petitioners.
