Investing in a Limited Partnership? Beware of the PAL Rules

In businesses structured as limited partnerships, the advantage of being a limited partner (as opposed to a general partner) is that you're typically not personally liable for the partnership's debts. This is why many ventures use limited partnerships to attract investors — because, as a limited partner, your liability is generally confined to your investment, which includes your initial capital contribution and any additional amounts you're required to contribute.

Another advantage of limited partner status is that your share of partnership income may be excluded from self-employment tax. However, the exclusion doesn't include guaranteed payments for providing services or capital to the partnership, regardless of whether the business is profitable.

With all that in mind, being a limited partner may seem like an attractive arrangement. But there's a notable risk to consider: You may be subject to the passive activity loss (PAL) rules, which can create a significant federal income tax challenge.

Suspended Losses

Under the PAL rules, you can deduct passive losses originating from your limited partnership interest only to the extent you have passive income from that or other passive activities. Disallowed passive losses are suspended until 1) they're "freed up" by future passive income from the partnership or other passive activities, or 2) you sell or otherwise transfer your loss-producing limited partnership interest in a taxable transaction.

Important: With limited exceptions, rental activities are generally treated as passive regardless of the taxpayer's level of participation. So, if you join a limited partnership formed to invest in rental properties, your ability to deduct losses as a limited partner is likely to be subject to the PAL rules.

Also, keep in mind that the PAL rules aren't the only potential restriction on loss deductions. Basis limitations, at-risk rules and, for noncorporate taxpayers, excess business loss rules may affect whether and when losses are deductible. (Your tax advisor can help you determine whether any of these apply to your situation.)

3 Material Participation Tests

Disallowed passive losses from a limited partnership can accumulate for years before they become deductible. But an exception may be available when losses attributable to your limited partnership interest qualify as nonpassive. In such instances, subject to applicable limitations, you can generally deduct the losses against your other taxable income.

Eligible losses may qualify as nonpassive if you materially participate in the business. As a limited partner, you're deemed to do so only if you pass at least one of the following three tests:

1. You participate in the business for more than 500 hours during the tax year,
2. You materially participated for any five of the 10 immediately preceding tax years, whether consecutive or not, or
3. You materially participated in a personal service activity for any three previous tax years, whether consecutive or not.

In this context, a personal service activity is generally defined as one involving certain professional fields or any other trade or business in which capital isn't a material income-producing factor. (Your tax advisor can explain further.)

These tests are applied for the relevant tax year. Special timing rules may apply when a partner holds both general and limited partner interests. (See "Dual-Status Partners" below.) However, most partnerships and almost all partners use the calendar year for tax purposes.

Also bear in mind that, if you're married, your spouse's participation in the limited partnership activity is treated as your participation — regardless of whether your spouse owns an interest in the partnership or whether you file a joint return.

Dual-Status Partners

A partner who holds both a general and limited partner interest in the same business is typically treated as a general partner for purposes of applying the material participation rules. General partners can pass the material participation test in four additional ways — for a total of seven — beyond the three tests described above.

However, this exception applies only if the general partner interest was held at all times during the partnership's tax year ending with or within the individual partner's tax year. If the partner directly or indirectly owned the limited partner interest for only part of that year, the general partner interest must have been held throughout the shorter ownership period.

Nonqualifying Activities

The general rule for determining a limited partner's level of material participation is that any participation in any capacity may be treated as qualifying participation. However, there are two exceptions to watch out for:

1. Work not customarily performed by an owner. If the work performed by a limited partner isn't of a type customarily done by a business owner — and one of the principal purposes of performing the work is to avoid disallowance of losses under the PAL rules — the limited partner's work may not count toward material participation.

For example, Hannah is a limited partner in a business that develops AI software for online retail stores. She wants to claim that she materially participates in the business to treat her share of the partnership's losses as nonpassive and, therefore, deductible. So, she performs about 25 hours of cleanup work per week at the partnership's office after it closes for the day. Because this isn't the type of work an owner would normally do, and its principal purpose is to circumvent the PAL rules, Hannah's janitorial duties wouldn't constitute material participation in the partnership.

2. Work done as an investor. Work performed by a limited partner in the capacity of an investor doesn't count toward material participation in the partnership — unless the partner has daily involvement in management or operations. Typical nonqualifying investor activities include:

• Studying and reviewing financial statements or operational reports,
• Compiling or preparing summaries or analyses of the finances or operations of the business for the partner's own use, and
• Monitoring the business in a nonmanagerial capacity.

For instance, Hunter is a limited partner in a start-up that owns 15 retail stores that sell products to tech enthusiasts. He's not involved in the partnership's day-to-day management or operations but follows the business closely.

Each month, for his own benefit, Hunter reviews the partnership's financial statements and summarizes the data. Then, using ratios and other financial analyses, he compares his results with data from other similar businesses. Hunter spends about 20 hours a month on these activities, but because his work is clearly that of an investor, it wouldn't count as material participation.

Look Before You Leap

Limited partner status can offer valuable liability protection and self-employment tax advantages. However, it can also complicate the deductibility of business losses.

Before investing in a limited partnership — or assuming that your losses will be currently deductible — be sure you fully understand how the PAL rules apply to your situation. For help with that, contact your tax advisor to discuss all the tax consequences before you commit to an investment or file a return reporting partnership losses.