Who is a “Limited Partner” and Why Do We Care?
– or –
We May Be Lost, But We Are Making Very Good Time
CBA Tax Section Luncheon
May 14, 2014
Robert R. Keatinge
Holland & Hart LLP
555 17th Street, Suite 3200
Denver, CO 80203
303/295-8595
rkeatinge@hollandhart.com
This presentation will discuss developments in the characterization of a “partner” in a tax
partnership as either a general partner or limited partner, and why that characterization is
important for purposes of self-employment tax, net investment income (NII) tax, and other
federal tax rules. While the definition continues to be uncertain, it’s importance has increased
with the advent of the NII tax.
Table of Contents
I. Introduction .................................................................................................................................1 II. The Stakes: Why do we care? .....................................................................................................1 A. Three Tax Systems ................................................................................................................1 1. FICA Taxes .......................................................................................................................1 2. SECA Taxes ......................................................................................................................3 3. NII Taxes. .........................................................................................................................5 4. Comparison. ......................................................................................................................6 B. Passive Losses .......................................................................................................................8 C. Retirement Payments to Partners ........................................................................................10 D. Tax Matters Partner .............................................................................................................10 III. Attempts to Define “Limited Partner” and “General Partner”...........................................11 A. Regulations and Legislation ................................................................................................11 1. The 1994 Proposed Regulations.. ...................................................................................11 2. The 1997 Proposed Regulations.. ...................................................................................12 3. The Moratorium and Its Aftermath.. ...............................................................................15 4. 2010 Proposed Legislation..............................................................................................17 B. Case Law .............................................................................................................................18 1. Plotkin. ............................................................................................................................18 2. Robucci.: .........................................................................................................................18 3. Renkemeyer.. ..................................................................................................................19 1. Howell. ............................................................................................................................21 2. Cvancara ........................................................................................................................22 C. Comments and Reports on the Definition of “Limited Partner” .........................................22 1. Joint Committee on Taxation Report JCS-3-01 (April 2001). ........................................22 2. The New York State Bar Association Comments...........................................................22 3. The American Bar Association Section of Taxation Report ..........................................23 4. The Congressional Budget Office Studyn. .....................................................................23 5. Banoff Recommendations...............................................................................................23 6. Joint Committee on Taxation Report JCX-66-12 (July 27, 2012) ..................................23 IV. Conclusion. ........................................................................................................................24 APPENDIX I Report JCS-3-01 (April 2001) Joint Committee on Taxation, Study of
the Overall State of the Federal Tax System and Recommendations for
Simplification Section V.B.1. Modernize References to “Limited Partner” and
“General Partner” ...................................................................................................................26 APPENDIX II ADDITIONAL OPTIONS TO IMPROVE TAX COMPLIANCE
(“2006 JCT PROPOSAL”) .....................................................................................................36 APPENDIX III New York State Bar Association Report 1247 November 2011 ...................42 APPENDIX IV American Bar Association Section of Taxation Report (December 2,
2011) ..........................................................................................................................................44 APPENDIX V Congressional Budget Office The Taxation of Capital and Labor
Through the Self-Employment Tax .......................................................................................45 ii
I.
Introduction
Whether a member of a tax partnership is a “general partner” or “limited partner” has
always been important for such matters as self-employment income, passive losses and
retirement payments. The new net investment income tax adds new significance to this
distinction. This session will review the recent cases, statutes and regulatory actions and their
significance in determining whether a tax partner is a general or limited partner.
II.
The Stakes: Why do we care?
A.
Three Tax Systems
There are three mutually exclusive taxes that may be applied to income applied to income
of an individual – and in the case of the NII tax, to a trust: FICA, SECA, and NII taxes.
1. FICA Taxes
a.
Definitions.
(1)
Employee – An individual meeting the definition of a
common law employee, and certain other individuals who perform certain specified jobs.2
1
Tax.8
(2)
Employer – A person who pays wages to an Employee.
(3)
FICA – Federal Insurance Contributions Act.3
(4)
FICA Taxes – Taxes imposed under FICA.4
(5)
HI – Medicare hospital insurance.5
(6)
HI Tax – The portion of the FICA Tax to fund the HI.6
(7)
OASDI – Old Age Survivor and Disability Insurance.7
(8)
OASDI Base – The amount of Wages subject to OASDI
1
IRC § 3121(d)(2).
2
IRC § 3121(d).
3
IRC §§ 3101-3102, 3111-3113, 3121-3128.
4
IRC §§ 3101, 3111.
5
IRC §§ 3101(b), 3111(b).
6
IRC §§ 3101(a), 3111(a).
7
IRC §§ 3101(a), 3111(a).
8
Social Security Act § 230, 42 U.S.C. § 430.
OASDI.
(9)
9
OASDI Tax – The portion of the FICA Tax to fund the
(10) Wages – Generally, all remuneration for employment,
including the cash value of all remuneration (including benefits) paid in any medium other than
cash.10
(11) Threshold Amount – The threshold amount for an
individual is $250,000 in the case of a joint return or surviving spouse, $125,000 in the case of a
married individual filing a separate return, and $200,000 in any other case (unmarred individual
or head of household). In the case of the Additional HI Tax, it is applied to the Wages of an
individual taxpayer (or of the taxpayer and spouse if they file a joint return). In the case of
Additional SECA Taxes, it is applied to the SEI of an individual taxpayer (or of the taxpayer and
spouse if they file a joint return). In the case of the NII Tax, it is applied to the MAGI of an
individual taxpayer (or of the taxpayer and spouse if they file a joint return).
b.
Operation of FICA Taxes. FICA imposes the FICA Tax on
Employers based on the amount of wages paid to an employee during the year. The FICA Tax imposed is
composed of two parts: (1) the OASDI Tax equal to 6.2% of Wages up to the OASDI Base ($110,100 in
2012 and $113,700 for 2013); and (2) the HI Tax amount equal to 1.45% of covered wages. In addition
to the tax on Employers, each Employee is subject to FICA taxes generally equal to the amount of tax
imposed on the employer. The Employee level tax generally must be withheld and remitted to the Federal
government by the Employer.
In addition to FICA taxes, employers are subject to a Federal unemployment insurance
payroll tax equal to 6% of the total wages of each employee (up to $7,000) on covered employment.
Employers are eligible for a Federal credit equal to 5.4% for State unemployment taxes, yielding a 0.6%
effective tax rate. Federal unemployment insurance payroll taxes are used to fund programs maintained
by the States for the benefit of unemployed workers.
One-half of the FICA Tax is imposed on the employee,11 collected through a deduction
from the employee’s wages,12 and not deductible from income by the employee.13 The other half of the
FICA Tax is imposed on the employer14 and deductible by the employer.15 The FICA Tax has two
components: (1) the old-age, survivors, and disability insurance (“OASDI”) component consisting of
6.2% of wages imposed on each of the employee16 and the employer17 for a total OASDI tax of 12.4%;
9
IRC §§ 3101(a), 3111(a).
10
IRC § 3121(a). Technically, not all remuneration is included in “wages” as IRC §§ 3121(a) and 3306(b)
contain a long list of exclusions, which, as a concession to the brevity of life, this paper will not go into here.
11
IRC § 3101.
12
IRC § 3102.
13
IRC § 275(a)(1)(A).
14
IRC § 3111.
15
IRC § 162(a)(1)(A).
16
IRC § 3101(a).
17
IRC § 3111(a).
2
and a hospital insurance (“HI”) component of 1.45% of wages, imposed on each of the employee18 and
the employer19 for at total HI Tax of 2.9%. The OASDI portion of the FICA taxes are only imposed on
wages up to the OASDI Contribution and Benefit Base (“OASDI Base”), which is determined under
Social Security Act § 230.20 For 2013, the OASDI Base is $$113,700 and will be $117,000 for 2014.21
The HI taxes are uncapped (not limited to wages below the OASDI Base).
c.
Additional HI Tax. The Additional HI Tax is an additional .9%
tax on individuals having Wages in excess of the Threshold Amount. Unlike the existing HI
Tax, it is imposed entirely on the Employee (rather than being divided between the Employer
and the Employee), as a result of which it is completely non-deductible. Nonetheless, it is
collected by the Employer, but only to the extent an individual Employee receives Wages in
excess of $200,000. The remaining balance, including an NII Tax imposed as a result of the
combined Wages of the spouses exceeding the Threshold Amount, the Employee’s filing as
married filing separately, or, apparently, as a result of the Employer’s failing to withhold, is
required to be paid by the Employee. Presumably the amounts required to be paid by the
Employee will be calculated and reported on the Employee’s individual return in a manner
similar to SECA Taxes.
2.
SECA Taxes
a.
Definitions
(1)
SECA – Self-Employment Contributions Act.22
(2)
SECA Taxes – The Taxes imposed under SECA.23
(3)
NESE – Net Earnings from Self-Employment is the gross
income derived by an individual from any trade or business carried on by the individual, less the
deductions attributable to the trade or business that are allowed under the self-employment tax
rules.24
18
IRC § 3101(b).
19
IRC § 3111(b).
20
42 U.S.C. § 430.
21
See Contribution and Benefit Base, 1937-2012, available at http://www.ssa.gov/oact/COLA/cbb.html.
The OASDI Base was $106,800 for years 2009 through 2011, stands at $110,100 for 2012, $113,700 for 2013 and is
117,000 for 2014.
22
IRC § 1401.
23
IRC § 1401.
24
IRC § 1402(a). For purposes of determining NESE, taxpayers are permitted a deduction from net
earnings from self-employment equal to the product of the taxpayer’s net earnings (determined without regard to
this deduction) and one-half of the sum of the rates for OASDI (12.4%) and HI (2.9%), i.e., 7.65% of net earnings.
Section 601(b) of 2010 Tax Relief Act, in order to maintain parity with the employment tax system, permits a
deduction of 59.6% of the OASDI portion of the SECA taxes for so long as the Payroll Tax Holiday continues
(while continuing the 50% deduction to the HI portion).
3
(4)
b.
SEI – NESE with certain adjustments.25
Operation of SECA Taxes.
(1)
In General. As a parallel to FICA Taxes, SECA imposes
taxes on the net income from self-employment of self-employed individuals. The rate of the
OASDI portion of SECA Taxes is equal to the combined employee and employer OASDI FICA
Tax rates and applies to self-employment income up to the OASDI Base. Similarly, the rate of
the HI portion is the same as the combined employer and employee HI rates and there is no cap
on the amount of self-employment income to which the rate applies.26
SECA imposes SECA Taxes on SEI.27 NESE Specified types of income or loss are
excluded from the computation of NESE, including rentals from real estate in certain
circumstances,28 dividends and interest,29 and gains or losses from the sale or exchange of a
capital asset30 or from timber, certain minerals, or other property that is neither inventory nor
held primarily for sale to customers, and certain retirement payments to partners.31 NESE is
calculated without net operating loss carryovers32 and personal exemptions.33 The definition of
NESE includes a partner’s distributive share of ordinary income (other than certain interest,
dividends, and rents) from the trade or business carried on by the partnership,34 but excludes the
distributive share of a limited partner (other than guaranteed payments to the limited partner for
services provided to the limited partnership).35
(2)
The Above-the-Line Deduction (IRC § 164(f)). Because
the employer is entitled to deduct its share (generally one-half) of the FICA Taxes on the wages
it pays, individuals are entitled to an above-the-line deduction equal to one-half of the SECA
25
Technically, SEI is NESE in excess of $400, and for purposes of OASDI, SEI is limited to NESE up to
the OASDI Base. IRC § 1402(b).
26
For purposes of computing net earnings from self-employment, taxpayers are permitted a deduction
equal to the product of the taxpayer’s earnings (determined without regard to this deduction) and one-half of the sum
of the rates for OASDI (12.4%) and HI (2.9%), i.e., 7.65% of net earnings. This deduction reflects the fact that the
FICA rates apply to an employee’s wages, which do not include FICA taxes paid by the employer, whereas a selfemployed individual’s net earnings are economically equivalent to an employee’s wages plus the employer share of
FICA taxes.
27
IRC § 1401.
28
IRC § 1402(a)(1).
29
IRC § 1402(a)(2).
30
IRC § 1402(a)(3).
31
IRC § 1402(a)(10).
32
IRC § 1402(a)(4).
33
IRC § 1402(a)(7).
34
IRC § 1402(a).
35
IRC § 1402(a)(13) discussed in greater detail at Part II.B.3.a.2. below.
4
Taxes he or she pays.36 As noted below, the deduction reduces the effective rate of the SECA
taxes.37
Additional SECA Taxes. The additional .9% SECA Tax
increases the SECA Tax liability of some self-employed individuals. There are two additional
considerations that will apply. First, married individuals filing jointly will have to compute the
Additional SECA Taxes taking into consideration their combined SEI. Thus, if a wife has
reached or exceeded the Threshold Amount, all of the husband’s (or more accurately stated, the
couple’s additional combined) SEI will be subject to the Additional SECA Tax. As noted above,
the Additional HI Tax imposed on Employees is entirely non-deductible. Thus, in maintaining
the parity between FICA and SECA Taxes, the above-the-line deduction under IRC § 164(f) will
not be available for the Additional SECA Tax. The effect of this provision is reflected in the
chart below. For purposes of determining the “Threshold Amount” for SECA, the “Threshold
Amount” is reduced by “the amount of wages taken into account in determining” the additional
FICA HI Taxes.
c.
3.
NII Taxes.
Net Investment Income (“NII”) is the (a) sum of (i) gross income from interest,
dividends, annuities, royalties, and rents not derived in a trade or business that is a passive
activity for the individual, (ii) other gross income of any sort derived from a passive activity or
from the trade or business of trading in financial instruments or commodities, and (iii) net
income from the disposition of property of a trade or business other than that used in a trade or
business that is a passive activity for the individual less (b) allowed deductions that are properly
allocable to such gross income or net gain.38 In the case of a trade or business, the tax applies if
the trade or business is a passive activity with respect to the taxpayer or the trade or business
consists of trading financial instruments or commodities.39
NII does not include: (a) wages, which are subject to Additional HI Tax described above;
(b) SEI, which is subject to the Additional SECA tax described above;40 (c) gain from the
disposition of an interest in an S corporation or partnership in which the taxpayer actively
participates, except “to the extent of the net gain which would be so taken into account by the
transferor if all property of the partnership or S corporation were sold for fair market value
immediately before the disposition of such interest;”41 (d) income excluded from gross income
such as tax-exempt interest and excluded gain from the sale of a personal residence; (e) income –
other than net gain attributable to disposition of property and income, gain, or loss on working
capital42 – from a trade or business (other than the trade or business of trading in financial
instruments or commodities) in which the individual actively participates; (f) gain on the
36
IRC § 164(f).
37
See Part III.B.4.b, below.
38
IRC § 1411(c).
39
IRC § 1411(c)(2).
40
IRC § 1411(c)(6).
41
IRC § 1411(c)(4).
42
IRC § 1411(c)(3).
5
disposition of an interest in an S corporation or partnership in which the individual or trust is not
subject to the passive loss rules with respect to such S corporation or partnership and which is
not engaged in a trade or business of trading in financial instruments or commodities;43 and (g)
distributions from qualified plans.44 Thus, the NII Tax will apply to investment income and
capital gains, ordinary income from an activity in which the individual does not actively
participate, or income which is considered passive and which has been excluded from the
computation of SEI.
NII does not include trade or business income (including interest, dividends, annuities,
royalties, and rents, other than such income which is derived in the ordinary course of that trade
or business) provided that the individual taxpayer actively participates in that trade or business
and the business is not a trade or business of trading in financial instruments or commodities.
The proposed regulations state that the “ordinary course of the trade or business” requires that
the income must be derived from a trade or business (other than one described in IRC §
1411(c)(2)) and must be derived in the ordinary course of that trade or business, and cannot be
from working capital.
Even if the taxpayer actively participates in the trade or business, the return from working
capital will constitute NII.45 Thus, to the extent an individual may actively participate in a
business without having either Wages or NESE, the individual may not be subject to any of the
ACA Taxes. To the extent that the business is a tax partnership, the individual will be subject to
SECA Taxes on all income other than rents, interest, and dividends.46
4.
Comparison.
The FICA, SECA, and NII taxes are mutually exclusive, and computed in slightly
different fashions. Although for individuals above the Threshold Amount, FICA, SECA, and
NII taxes are all facially 3.8%, because in the case of FICA and SECA, one-half of the first 2.9%
is deductible47 while in the case of the NII tax, no portion of the tax is deductible, the effective
rate of the FICA and SECA taxes of individuals in the top income tax bracket (39.6%) is
3.2258%, while the effective rate for individuals on income subject to the NII tax is 3.8%.
There is a fourth type of income that is not subject to any of the FICA, SECA, or NII
taxes. This type of income (described in the chart below as in the “Sweet Spot”) includes
Income attributable to a limited partnership interest in which the limited partner actively
participates in the limited partnership activity. Income from such an interest, arguably, would
not constitute SEI as a result of IRC § 1402(a)(13), but could qualify as nonpassive depending on
the circumstances of the limited partner’s participation. Such an interest would appear not to be
the interest of a “limited partner” as described in Renkemeyer, and therefore not entitled to the
43
IRC § 1411(b)(4).
44
IRC § 1411(c)(5).
45
IRC § 1411(c)(3).
46
IRC § 1402(a).
47
In the case of FICA, because it is paid by the employer and is a deductible tax and in the case of SECA,
as a result of the IRC §164(f) deduction.
6
exclusion
n under IRC § 1402(a)(1
13). Thus, th
his approachh is subject too risk until thhere is true
clarificattion of the deefinition of “limited
“
parttner” for purrposes of IRC
C § 1402(a)((13).48
The fo
ollowing chaart shows thee alternativee treatment oof income in these differeent
categoriees:
• 3.225
58%
• 3.22
258%
SEC
CA
SSweet
NIII
Spot
• 3.8
8%
48
FICA
• 0%
%
Other sorts off income in the Sweet spot inccluded
a. Income of an
n individual or individual parttner derived froom a trade or bbusiness in whiich the individdual
actively paarticipates but which
w
income does not consttitute NESE. T
The income of aan individual oor of an individdual
partner from a trade or bu
usiness carried
d on by the indiividual or partnnership is geneerally characterrized as net earrnings
from self-eemployment. That income will
w be excluded
d from NESE tto the extent itt consists of cerrtain rentals froom
real estate and from perso
onal property leased
l
with thee real estate or certain dividennts and interesst. Thus, this rrental,
interest, orr dividend inco
ome will be exccluded from NE
ESE. To the exxtent that (a) thhe trade or bussiness does nott
constitute a passive activity to the indiv
vidual or partneership, (b) the rrental, interest, or dividend innterest is derivved in
the ordinarry course of thee trade or busin
ness, and (c) th
he trade or busiiness of a tradee or business of trading in finnancial
instrumentts or commoditties, the incomee should not co
onstitute NII annd should, therrefore not be suubject to the N
NII
Tax.
b.. Income of an S corporation shareholder who
w actively parrticipates in thee business of thhe S corporatioon.
To the exteent an S corporration sharehollder who activeely participatess in the trade orr business of thhe S corporatioon has
income fro
om the S corporration’s trade or
o business in excess
e
of his orr her salary, thhat amount shouuld not be subjject to
FICA or th
he NII. At leasst in the case off closely held S corporations and those engaaged in providing personal
services, th
his would appeear to be similaar to the situatio
on Congress w
was concerned aabout in conneection with the “tax
gap.” As in the case of the
t active limitted partner described above, iit seem peculiaar that the situaations in whichh
F
SECA, and NII are tho
ose that are alrready problemaatic to Congresss and the Treaasury.
individualss would avoid FICA,
c. Some Rental Income. To th
he extent rentall income can bee said to be derrived from a trrade or businesss,
without being characterizzed as SEI, it may
m be possiblee to avoid all thhree prongs off the ACA Tax.. If rental incoome
may be exccluded from SE
EI under IRC § 1402(a)(1) bu
ut still be treateed as derived fr
from a trade or business, it maay be
possible to
o avoid both thee SECA Tax an
nd NII Tax.
Th
hese types of income are bey
yond the scope of this discusssion.
7
As a result of this difference, it may be possible to have income that is excluded from
NESE under the exclusion of IRC § 1402(13) but that is not subject to NII taxes because it is not
passive income. The availability of this sweet spot will turn on the definition of “limited
partner.”
B.
Passive Losses
The passive loss rules apply special rules to “limited partners.”49 The regulations
interpreting these rules have varied with respect to the definition of “limited partner.” The
temporary regulations dealing with material participation (which was proposed in 1988 and
amended in 1992 – before the advent of limited liability companies)50 based the definition of
limited partnership on the liability of the partner for the obligations of the partnership.51
Notwithstanding this definition of “limited partner,” several courts determined that LLC
members should not be treated as holding an interest in a limited partnership as a limited partner
for purposes of applying the section 469 material participation tests.52 In response to these cases
49
IRC §§ 469(i)(6)(C) (“Except as provided in regulations, no interest as a limited partner in a limited
partnership shall be treated as an interest with respect to which the taxpayer actively participates.”); 469(l)(3) (“The
Secretary shall prescribe such regulations as may be necessary or appropriate to carry out provisions of this section ,
including regulations . . .(3) requiring net income or gain from a limited partnership or other passive activity to be
treated as not from a passive activity,”); 469(h)(2) (“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
participates.”).
50
T.D. 8175 (Feb. 19,1988), amended by T.D. 825 (May 11, 1989) and T.D. 8417 (May 11, 1992).
51
Treas. Reg. 1.469-5T(e)(3) (dealing with material participation provides:
(3) Limited partnership interest.
(i) In general. Except as provided in paragraph (e)(3)(ii) of
this section, for purposes of section 469(h)(2) and this paragraph (e), a
partnership interest shall be treated as a limited partnership interest if—
(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).
(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).
52
In Gregg v. U.S., 186 F.Supp.2d 1123 (D. Or. 2000), an Oregon district court concluded that, in the
absence of regulations to the effect that an LLC member should be treated as a limited partner, the limited partner
8
Treasury proposed a change in this definition of “limited partner” for purposed of the material
participation and other tests.53 The proposed regulations provide that an interest in an entity will
be treated as a limited partnership interest under section 469(h)(2) if the entity in which the
interest is held is classified as a partnership under reg. section 301.7701-3 and the holder of the
interest doesn't have rights to manage the entity at all times during the entity's tax year under the
law of the jurisdiction in which the entity was organized and under the governing agreement.
The rights to manage include the power to bind the entity.
Similarly, the regulations on the aggregation of activities, do not define “limited partner,”
but do include a reference to the ability of “limited partners and limited entrepreneurs” for
purposes of determining the ability of a partner to group activities.54
exception in section 469(h)(2) was not applicable to LLC members. In Garnett v. Comm'r, 132 T.C. 368 (2009), the
Tax Court found that the taxpayers' ownership interests in limited liability partnerships and LLCs were not interests
in limited partnerships because their interests fit within the general partner exception in §1.469-5T(e)(3)(ii). In
Thompson v. U.S., 87 Fed. Cl. 728 (2009), the Court of Federal Claims concluded that the regulations under section
469(h)(2) require the taxpayer's ownership interest to be in a partnership under State law rather than a partnership
under Federal income tax law. Accordingly, because an LLC member is not a limited partner under State law, the
court concluded that section 469(h)(2) did not apply to an LLC member. Most recently, the Tax Court in Newell v.
Comm'r, T.C. Memo. 2010-23, concluded that section 469(h)(2) did not apply to the managing member of an LLC
and that the member fell within the general partner exception in §1.469-5T(e)(3)(ii). On April 5, 2010, the IRS
issued an Action on Decision acquiescing in the result only in Thompson v. U.S., AOD 2010-02, 2010-14 I.R.B.
515.
53
Prop. Treas. Reg. 1.469-5(e)(3) as proposed by REG-109369-10, FR Doc. 2011-30611 (Nov. 25, 2011)
Fed. Reg. Vol. 76, No. 228, p. 72875 provides:
(3) Interest in a limited partnership as a limited partner.
(i) In general. Except as provided in paragraph (e)(3)(ii) of this section,
for purposes of section 469(h)(2) and this paragraph (e), an interest in an entity
shall be treated as an interest in a limited partnership as a limited partner if:
(A) The entity in which such interest is held is classified as a
partnership for Federal income tax purposes under §301.7701-3; and
(B) The holder of such interest does not have rights to manage
the entity at all times during the entity's taxable year under the law of
the jurisdiction in which the entity is organized and under the
governing agreement.
(ii) Individual holding an interest other than an interest in a limited
partnership as a limited partner. An individual shall not be treated as holding an
interest in a limited partnership as a limited partner for the individual's taxable
year if such individual also holds an interest in the partnership that is not an
interest in a limited partnership as a limited partner (as defined in paragraph
(e)(3)(i) of this section), such as a state-law general partnership interest, at all
times during the entity's taxable year ending with or within the individual's
taxable year (or the portion of the entity's taxable year during which the
individual (directly or indirectly) owns such interest in a limited partnership as a
limited partner).
54
Treas. Reg. §1.469-4(d)(3)(i) provides:
“In general. Except as provided in this paragraph, a taxpayer that owns an
interest as a limited partner or a limited entrepreneur (as defined in section
464(e)(2)), in an activity described in section 465(c)(2), may not group that
9
C.
Retirement Payments to Partners
Under IRC §736, payments to a retiring or deceased partner will be treated as a sale or
exchange of the interest except to the extent such payment constitutes a guaranteed payment, a
distributive share determined by income, a payment for unrealized receivables, or a payment for
good will.55 The Revenue Reconciliation Act of 1993,56 amended IRC §736(b)(3) to repeal the
provision allowing a partnership to take an ordinary deduction for payments to retiring or
deceased partners except with respect to a “general partner” in a partnership in which capital is
not a material income-producing factor. The Conference Report makes clear that this exception
is intended to allow professional practices to continue to use this provision.57 It is also unclear
whether a partner in a limited liability partnership will be a “general partner” for this purpose.58
D.
Tax Matters Partner
Partnerships with more than 10 members or which have a nonresident alien as a partner
or have a partner other than a natural person will generally be subject to comprehensive unified
audit proceedings.59 These proceedings are designed to facilitate audits by determining
activity with any other activity. A taxpayer that owns an interest as a limited
partner or a limited entrepreneur in an activity described in the preceding
sentence may group that activity with another activity in the same type of
business if the grouping is appropriate under the provisions of paragraph (c) of
this section.
55
IRC §736.
56
Pub. L. No. 103-66, 107 Stat. 312.
57
Joint Committee on Taxation, Technical Explanation of the Tax Simplification Act of 1993 (H.R.13) PL
103-66 JCS 1-93 HR 13 at page 169-170 (January 8, 1993) describes the purpose of the change as follows:
The bill generally repeals the special treatment of liquidation payments
made for goodwill and unrealized receivables. Thus, such payments would be
treated as made in exchange for the partner's interest in partnership property, and
not as a distributive share or guaranteed payment that could give rise to a
deduction or its equivalent. The bill does not change present law with respect to
payments made to a general partner in a partnership in which capital is not a
material income- producing factor. The determination of whether capital is a
material income-producing factor would be made under principles of present
and prior law. For purposes of this provision, capital is not a material incomeproducing factor where substantially all the gross income of the business
consists of fees, commissions, or other compensation for personal services
performed by an individual. The practice of his or her profession by a doctor,
dentist, lawyer, architect, or accountant will not, as such, be treated as a trade or
business in which capital is a material income- producing factor even though the
practitioner may have a substantial capital investment in professional equipment
or in the physical plant constituting the office from which such individual
conducts his or her practice so long as such capital investment is merely
incidental to such professional practice. In addition, the bill does not affect the
deductibility of compensation paid to a retiring partner for past services.
(footnote omitted)
58
See Collins and Dance, Treatment of Liquidating Payments to LLC Members: How Will Section 736 Be
Applied to LLCs?, 2 J. Ltd. Liab. Cos 51 (1995).
59
IRC §6231(a).
10
adjustments at the partnership level rather than forcing the Service to audit each individual
partner. Every partnership or LLC subject to these provisions must have a tax matters partner.60
The statute defines tax matters partner as the general partner so designated or the general partner
with the largest profits interest if there is no designated general partner.61
An LLC will find it difficult to meet the statute's literal terms; it has no general partner.
Arguably any member of an LLC should qualify as a general partner to the extent all members
have the right to participate in the LLC's management. Until guidance is issued clarifying which
members may be designated as a tax matters partner, the Service theoretically could require the
member with the largest profits interest to serve as the tax matters partner.
Treas. Reg. §301.6231(a)(7)-2 provides that in a manager-managed LLC, any manager
(defined as “a member of an LLC who, alone or together with others, is vested with continuing
exclusive authority to make management decisions necessary to the business for which the LLC
was formed”) may be a tax matters partner. If there are no managers, then any member may be a
tax matters partner. If the person designated as “manager” is not a tax partner, i.e., a person
holding a capital or profits interest under the Culbertson and Tower cases,62 the “manager” may
not act as tax matters partner, but a manager who has a current capital and profits interest of zero
but has an interest in future profits or capital appreciation may.63 The definition of “LLC” for
purposes of this regulation is broad enough to include some, if not all, LLPs. Chief Counsel
advised that if no other member of an LLC taxable as a partnership is a manager, then all
members are deemed to be member-managers eligible to be designated as TMP. Interestingly, in
an LLC with nonmember managers, no member would be treated as a general partner for
purposes of IRC §1402(a)(13), but all members would be treated as general partners for purposes
of IRC §6231. However, if any other member is a manager under state law and the designated
member is not, then the designation as TMP is invalid. 64
III.
Attempts to Define “Limited Partner” and “General Partner”
A.
Regulations and Legislation
1.
The 1994 Proposed Regulations. On December 29, 1994, Proposed
Regulation § 1.1402(a)-1865 (the “1994 Proposed Regulation”) was released dealing with “Self60
IRC §6231(a)(7). The Tax Court has held that it does not have jurisdiction in a partnership-level
proceeding to determine the treatment of indirect individual partners (i.e., members of an LLC that was a partner in
the partnership) for purposes of determining net earnings from self-employment. In Olsen-Smith, Ltd. v. C.I.R., T.C.
Memo. 2005-174, T.C.M. (RIA) P 2005-174, 90 T.C.M. (CCH) 64 (2005) the Tax Court declined to determine that
none of the income of a partnership the partners in which were LLCs would not generate net earnings from selfemployment for members of the LLCs that were partners.
61
IRC §6231(a)(7).
62
Commissioner v. Culbertson, 337 U.S. 733, 742 [37 AFTR 1391] (1949), Commissioner v. Tower, 327
U.S. 280, 287 [34 AFTR 799] (1946). See also, CCA 201319026 (May 10, 2013) (“State law is irrelevant under the
Supreme Court cases Culbertson and Tower. For federal tax purposes you are only a partner if you join capital or
services together in a trade or business for profit.”).
63
CCA 201326018 (June 28, 2013).
64
See, Treas. Reg. §301.6231(a)(7)-2(b)(3).
65
59 Fed. Reg. 67253.
11
Employment Tax Treatment of Members of Certain Limited Liability Companies.” Under the
proposed regulation, a member of a manager-managed LLC would have been treated as a limited
partner for purposes of IRC § 1402(a)(13) if the member was not a manager of the LLC; the LLC
could have been formed as a limited partnership rather than an LLC in the same jurisdiction; and
the member could have qualified as a limited partner in that limited partnership under applicable
law.
For purposes of the 1994 Proposed Regulation, a “manager” was “a person who,
alone or together with others, was vested with the continuing exclusive authority to make the
management decisions necessary to conduct the business for which the LLC was formed.” If
there were no elected or designated managers, all members were treated as managers.66
Under the 1994 Proposed Regulation, a member would have been treated as a
limited partner if the LLC had designated or elected managers and the member was not a
manager. The proposed regulation suggested that there did not need to be a member-manager so
that, at least for purposes of net income from self-employment, there was no member who was
subject to self-employment taxes.67 There were two areas of uncertainty under the 1994
Proposed Regulation: (1) when is there an elected or designated manager? and (2) when would a
member cease to be a limited partner if, instead of organizing an LLC, the members had formed
the business as a limited partnership?
The second requirement under the 1994 Regulations, that the member could have
qualified as a limited partner if the LLC were a limited partnership under applicable law, turns
on the member’s participation in the control of the LLC. Under RULPA § 303(a), a limited
partner would be liable as a general partner if the partner participated in the control of the
business. However, if the limited partner participated in the control of the business, the limited
partner was liable only to persons who transacted business with the limited partnership
reasonably believing, based upon the limited partner’s conduct, that the limited partner was a
general partner. Thus, as long as the activity of the member was less than that necessary to
subject a limited partner to liability under the limited partnership act of the state, the member
should have been able to avoid self-employment tax.
2.
The 1997 Proposed Regulations. On January 10, 1997, the Treasury
withdrew the proposed regulations68 and released new proposed regulations (the “1997
Regulations”).69 Unlike the 1994 Proposed Regulation, the 1997 Regulations provide rules for
distinguishing between general partners and limited partners for all forms of unincorporated
business organizations, including general and limited partnerships. Rather than adding new
subsections to the regulations, the 1997 Regulations modify existing subsections to define
“limited partner” in all tax partnerships.
66
Prop. Reg. § 1.1402(a)-18(c)(3).
67
Prior to the adoption of the “check-the-box” regulations, a manager-managed LLC without a membermanager would possess the corporate characteristic of centralized management, and the dissolution events and
approval for the admission of transferees must be measured by reference to all of the remaining members. Rev. Proc.
95-10, 1995-1 C.B. 501.
68
See Withdrawal of Notice of Proposed Rulemaking (Reg-209729-94), RIN 1545-AS94 (Jan. 10, 1997).
69
Proposed amendments to Treas. Reg. § 1.1402(a)-2 (Reg-209824-96), released January 10, 1997.
12
The 1997 Regulations, while generally clear, rational and fair, drew a firestorm of
criticism from Congress and others.70 Critics were concerned that, because the regulations
applied to all tax partnerships, including state law limited partnerships, the regulations might (in
some highly unusual circumstances) cause an individual who owned a limited partnership
interest under state law not to be treated as a limited partner for purposes of determining NESE.71
The 1997 Regulations are intended to distinguish between distributive shares that
are allocated to general partners and those allocated to limited partners. In light of the legislative
history of the act that added IRC § 1402(a)(13), the 1997 Regulations also set forth rules dealing
with the circumstance in which the same individual is both a general partner and a limited
partner. The 1997 Regulations accomplish these objectives by setting forth rules for both
partners (the individual members or partners) and for partnership interests (the interests that
members or partners have to allocations of income or gain). Thus, a partner may have more than
one partnership interest in a partnership, and the character of the partner’s distributive share as
NESE is determined by reference to the identity of the partner and the various partnership
interests that the partner and others hold.
Under the 1997 Regulations, a member will be treated as a limited partner unless
one of four exceptions applies:72
1. The Liability Test. The member has personal liability for the debts of or
claims against the LLC by reason of being a member;73
2. The Authority Test. The member has authority (under the law of the
jurisdiction in which the LLC is formed) to contract on behalf of the LLC;74
70
See, e.g., letter from Christopher Bond to Robert Rubin, April 9, 1997; Archer, Roth Protest Limited
Partnership Regs, 97 Tax Notes Today 70-41 (1997); Congressional Republicans Assail Limited Partnership Regs,
97 Tax Notes Today 70-6 (1997); Louis Lyons, Forbes Chides GOP Leaders for Waffling on Tax Cuts, 97 Tax
Notes Today 69-5 (1997); Review and Outlook: Stealth Tax, Wall Street Journal, Monday, May 5, 1997 Section A;
Page 18, Column 1.
71
A state law limited partnership interest would be treated as not being a limited partnership interest for
NESE purposes only if:
(1) The individual participates for more than 500 hours during the year in the activities of the limited
partnership and does not hold an interest that is identical to the interest of a person who is treated as a
limited partner under the 1997 Regulations; or
(2) The individual holding the interest provides more than a de minimis amount of services to a limited
partnership substantially all the activities of which involve the performance of services in the fields of
health, law, engineering, architecture, accounting, actuarial science, or consulting.
Thus, the circumstances in which the distributive share of income allocable to an individual’s limited
partnership interest would be subject to NESE are limited to cases in which all limited partners either participated in
the business or also hold general partnership interests or where the limited partnership is engaged in a licensed
profession or consulting and the partner is providing services. Neither of these circumstances is common, and the
individuals owning limited partnership interests who will be adversely affected by the 1997 Regulations should be
very few, particularly in comparison to the large number of members of LLCs who will benefit from the certainty
that the regulations provide. This outline does not address this controversy except to note that it imposed greater
uncertainty about using the 1997 Regulations as basis for planning and compliance.
72
Prop. Reg. § 1.1402(a)-2(h)(2).
73
Prop. Reg. § 1.1402(a)-2(h)(2)(i).
13
3. The Participation Test. The member participates in the trade or business
of the LLC for more than 500 hours during its taxable year;75 or
4. The Personal Services Test. The member provides more than a de
minimis amount of services to or on behalf of the trade or business of an LLC,
substantially all the activities of which involve the performance of services in the
fields of health, law, engineering, architecture, accounting, actuarial science, or
consulting.76
The 1997 Regulations, unlike the 1994 Regulation, provide that although an
individual is not treated as a limited partner under the rules set forth above, the individual’s
distributive share of income attributable to certain partnership interests may be treated as the
distributive share of a limited partner. In other words, the same individual who would otherwise
be treated as a general partner may hold an interest as a limited partner. The 1997 Regulations
accomplish this result by comparing a partnership interest of an individual treated as a general
partner with an interest held by individuals who would be treated as limited partners under the
tests set forth above. These rules are designed to provide for the same results as would obtain in
the case of a general partner who also holds a limited partnership interest. They accomplish this
goal by testing both the member and the interest owned by the member.
There are two alternative tests under which the interest of a member who might
otherwise be treated as a general partner will be treated as a limited partnership interest:
1. The Two Classes of Interest Test. An individual who is not treated as a
limited partner under the liability test, the authority test, or the participation test,
may be treated as a limited partner with respect to the second class of interest that
meets certain requirements. Under the regulations, the second class of interest
must be held by persons who are treated as limited partners under the tests
described above.77 A person who is not treated as a limited partner as a result of
the personal services test is not eligible for the two classes of interest exception.
2. The Single Class of Interest Test. An individual who is not treated as a
limited partner solely by virtue of participating for more than 500 hours in a year,
may nonetheless be treated as a limited partner if that individual’s rights and
obligations by virtue of owning that interest are identical to the rights and
interests of other partners who have substantial continuing interests in the
partnership and who are treated as limited partners.78 This provision would
74
Prop. Reg. § 1.1402(a)-2(h)(2)(ii).
75
Prop. Reg. § 1.1402(a)-2(h)(2)(iii).
76
Prop. Reg. § 1.1402(a)-2(h)(5).
77
The Proposed Regulation provides that it applies to “Limited partners within the meaning of paragraph
(h)(2).” Prop. Reg. § 1.1402(a)-2(h)(3). Under Prop. Reg. § 1.1402(a)-2(h)(2), all partners are limited partners
unless they meet one of the liability test, the authority test, or the participation test. It is unclear whether a partner
who fails the service test (i.e., is a service partner in a service partnership) but otherwise does not have personal
liability or authority or participate for 500 hours a year would be a “limited partner within the meaning of paragraph
(h)(2).” It appears that because Prop. Reg. § 1.1402(a)-2(h)(5) provides that “an individual who is a service partner
in a service partnership may not be a limited partner under paragraphs (h)(2), (h)(3), or (h)(4) of this section” that a
service partner in a service partnership would not be treated as a limited partner.
78
Prop. Reg. § 1.1402(a)-2(h)(4).
14
prevent a member of an LLC with one class of interest from being treated as a
general partner simply by contributing 500 hours.
In order for the general partner to be able to take advantage of these rules, the
limited partners must own a “substantial, continuing interest in a specific class of partnership
interest.”79 The 1997 Regulations provide that the ownership of 20% of a particular class of
interest will be considered substantial.80 Under the 1997 Regulations, the distributive share
attributable to a partnership interest of an individual who would otherwise be considered a
general partner will be treated as the distributive share of a limited partner if that partnership
interest is identical to the interest held by “limited partners within the meaning of paragraph
(h)(2).”81 Thus, to determine the applicability of the class of interest exceptions, one must
determine who a “limited partner” is and what an “identical interest” is.
The 1997 Regulations suggest that the only partners who will be considered as
“limited partners” are individuals. The interests being considered are interests held by “limited
partners within the meaning of paragraph (h)(2).”82 Proposed Regulation § 1.1402(a)-2(h)(2)
refers to individuals being treated as limited partners. A rigorous reading of the regulations
would suggest that the limited partners owning the substantial continuing interest must be
individuals. There is no policy reason for the requirement that the “limited partners” be
individuals, but planners should carefully consider whether they will be able to take advantage of
the 1997 Regulations with limited partners that are entities.
The question of whether the general partner’s rights and obligations with respect
to a particular class of interest are identical to the rights and obligations of a limited partner also
requires careful consideration. While the text of the 1997 Regulations does not explain what
identical rights and obligations are, the example provides some guidance.83
In the example, A, B, and C form an LLC that is not a service partnership. LLC
allocates all items of income, deduction, and credit of LLC to A, B, and C in proportion to their
ownership of LLC. A and C each contribute $1x for one LLC unit. B contributes $2x for two
LLC units. Each LLC unit entitles its holder to receive 25% of LLC’s tax items, including
profits. A does not perform services for LLC; however, each year B receives a guaranteed
payment of $6x for 600 hours of services rendered to LLC, and C receives a guaranteed payment
of $10x for 1000 hours of services rendered to LLC. C also is elected LLC’s manager. Under
state law, C has the authority to contract on behalf of LLC.84
3.
The Moratorium and Its Aftermath. Section 935 of the Taxpayer Relief
Act of 199785 provided, “No temporary or final regulation with respect to the definition of a
limited partner under Section 1402(a)(13) of the Internal Revenue Code of 1986 may be issued
79
Prop. Reg. § 1.1402(a)-2(h)(3)(i) and 1.1402(a)-2(h)(4)(i).
80
Prop. Reg. § 1.1402(a)-2(h)(6)(iv).
81
Prop. Reg. § 1.1402(a)-2(h)(3)(i) and 1.1402(a)-2(h)(4)(i).
82
Prop. Reg. § 1.1402(a)-2(h)(3)(i) and 1.1402(a)-2(h)(4)(i).
83
Prop. Reg. § 1.1402(a)-2(i).
84
Prop. Reg. § 1.1402(a)-2(i)(i).
85
Pub. L. No. 105-34, 111 Stat 788.
15
or made effective before July 1, 1998.” Inasmuch as the 1997 Regulations have already been
issued but have not yet become effective, it is unclear what the effect of this provision on the
proposed regulations is. A sense of the Senate resolution urging the withdrawal of the 1997
Regulations was considered as part of the legislative process, but the final legislation merely
provides that no regulations be issued (presumably after the effective date of the Taxpayer Relief
Act). This moratorium continues congressional misconceptions of the operation of limited
partnerships at the expense of providing workable guidance to limited liability companies. The
impact of the 1997 Regulations on state law limited partnerships is trivial at best both because
limited partnerships are largely being supplanted by limited liability companies and because the
vast majority of the remaining limited partnerships would not be affected by the regulations.
Inasmuch as under all state limited partnership acts a limited partner as such does not have
individual liability or the authority to bind the limited partnerships, the only limited partners who
would be affected by the 1997 Regulations would be those who spend more than 500 hours in
the trade or business or the limited partnership (and then only if the interest held by that limited
partner is not identical to the interest of another limited partner who does not spend 500 hours in
the business of the partnership) or a limited partner in a service partnership. While there may be
some limited partnerships in which all limited partners participate for more than 500 hours, these
would be quite exceptional.86 The other possible application of the 1997 Regulations, the
services partner in a services partnership, will only apply in the case of limited partnerships
devoted to health, law, engineering, architecture, accounting, actuarial science, or consulting.
Even assuming that it is inappropriate from a policy standpoint to treat the consideration given to
partners who provide significant services as self-employment income, the number of limited
partners who would be subject to these rules would not be significant in comparison with the
treatment of all individual members in limited liability companies as having net income from
self-employment.
Possibly, as a result of the moratorium, there has not been formal authority with respect
to the appropriate treatment of a member’s distributive share of income and loss since, which
means that members and their advisers will have to determine how to account for ordinary
income based on the sparse authority available. The only guidance in this area is in the form of
private letter rulings holding that a member is a partner and “the members’ distributive shares of
income are not excepted from net earnings from self-employment by Section 1402(a)(13).”87
This would suggest that all members, regardless of the level of their activities or their authority
or participation in management, will be subject to self-employment tax. If this is the correct
approach, individuals wishing to limit their exposure to self-employment tax would be
constrained to use S corporations. A second approach would be to assume that all members are
“limited partners” and, except to the extent the payments represent guaranteed payments for
services, the entire distributive share of ordinary income is excluded from net earnings from selfemployment. There is no authority for this approach and several private letter rulings have
suggested that, to the contrary, a member is presumed to be a general partner unless expressly
made a limited partner by regulations. A third alternative is to assume that the 1997 Regulations
86
Even Congress recognizes this. The Statement of Managers with respect to the Taxpayer Relief Act
describing the “Passive Loss” provisions of § 1221 provides: “Limited partners generally do not materially
participate in the activities of a partnership.”
87
Priv. Ltr. Ruls. 9432018 (May 16, 1994) , 9452024, and 9525058.
16
as proposed are close to what the final regulations for LLCs will look like, and to draft and report
based on a reading of those regulations. The dissension over the regulations discussed above is
not that they make too many individuals limited partners, but that they take the benefits of being
a limited partner away from some state law limited partners. That being the case, it seems
reasonable to assume that regardless of the disagreement between Congress and the Service, the
final regulations will resemble or be more generous than the 1997 Regulations. As noted above,
there is no authority for this position (or for the proposition that in absence of regulations, a
taxpayer may take “any reasonable position”). Under Regulation § 1.6662-4(d)(3)(iii), proposed
regulations are “substantial authority” for purposes of avoiding the accuracy-related penalty with
respect to understatement of income tax.88 The taxes imposed on net earnings from selfemployment are not “income taxes,” so the substantial authority rules do not apply to the
determination of net earnings from self-employment. Nonetheless, in the absence of other
authority, the proposed regulations provide some basis for a reporting position. In any case, as in
all areas in which there is uncertainty, the ultimate decision should be made by an informed
client.
In August 2006, the Staff of the Joint Committee on Taxation presented to thenChairman Grassley and Ranking Member Baucus of the Senate Committee on Finance a report
entitled “Additional Options to Improve Tax Compliance” (the “2006 JCT Report”),89 The 2006
JCT Report focuses on service-based passthrough businesses, proposing that the rules applicable
to general partners be applied to shareholders in S corporations. It is unclear whether other
proposals in the 2005 JCT Report or the recommendations of the ABA or AICPA would also be
incorporated. In the 2006 JCT Report, employment taxes were considered to constitute 17% of
the Tax Gap, or $59 billion dollars.90 The 2006 JCT Report went further than the 1997
Regulations by suggesting that members and partners would be treated as employees with
respect to all guaranteed payments for services under IRC § 707(a) or deemed nonpartner
payments under IRC § 707(c). In addition, the distributive share of all limited partners or
members of LLCs who participate in the business of the limited partnership or the LLC in excess
of a certain number of hours would be treated as NESE except to the extent that such distributive
share represents a return on the member or limited partner’s capital (determined by multiplying
the capital by an applicable federal rate).91
On March 15, 2007, the American Bar Association Section of Taxation released
comments on the JCT recommendations for the treatment of both tax partnerships and S
corporations.92
4.
2010 Proposed Legislation. The American Jobs and Closing Tax
Loopholes Act of 2010 (“AJCTLA”),93 which was considered by Congress in early to mid-2010,
88
IRC § 6662(d)(2)(B).
89
The 2006 Joint Committee Report does not have an identifying number but is available at
http://finance.senate.gov/press/Gpress/2005/prg101906.pdf. Excerpts from the 2006 Report are attached as
APPENDIX II.
90
U.S. Department of the Treasury, Office of Tax Policy, A Comprehensive Strategy for Reducing the Tax
Gap, Table 1 (Sept. 26, 2006).
91
JCT Report at 34 footnote 84.
92
The comments are available at https://www.abanet.org/tax/pubpolicy/2007/070315jctreport.pdf.
17
would have made significant changes to the way in which compensation is taxed and have a
profound impact on the structure and form of business organizations in which compensation is a
significant component. Under the AJCTLA the exclusion from NESE available to “limited
partners” would have applied to any partner who provides substantial services with respect to a
partnership engaged in a “professional service business.”94 This section would have to codified
and expanded a provision of the 1997 Regulations described above.95 Under the ACJTLA, the
definition of personal services would have been expanded beyond that in the 1997 Regulations.96
B.
Case Law
1.
Plotkin. In Plotkin v. Commissioner,97 Plotkin was convicted of failing
to report income paid by Rolla Health Care Associates (“RHCA”) to Autumn Years
Investments, L.P., a limited partner in FHCA (“Autumn Years”). Autumn Years was owned by
Plotkin’s children and girlfriend, but Plotkin treated its assets as his own. The government
disregarded the existence of Autumn Years, and Plotkin argued that any amount of income
which he was treated as having received constituted a distribution to him as a limited partner in
RHCA. Both the tax court and the Court of Appeals held that the income of Autumn years did
not constitute a distribution but rather “Schedule C income,” and even if Plotkin were considered
a partner in RHCA, the income would be treated as IRC § 707(a) income received by a partner
other than in his capacity as a partner.
2.
Robucci. In Robucci v. Commissioner98 a psychiatrist's solely owned
professional corporation (“Robucci PC”) was the “managing member” of an LLC of which the
psychiatrist and a management corporation (“Westsphere”) were the other members. The Service
argued and the Tax Court found that neither Robucci nor Westsphere had employees or assets,
there was no evidence that either performed any services for the LLC and that the formation of a
multiple member LLC did not provide additional liability against personal liability under
Colorado law. Thus, the court, citing Moline Properties, Inc. v. Commissioner99 held that:
A corporation will be recognized as a separate
taxable entity if (1) the purpose for its formation is the
equivalent of business activity or (2) the incorporation is
followed by the carrying on of a business by the
93
Section 413(a) of the AJCLTA, H.R. 4213, 111th Cong. 2d Sess. As of September 15, 2010, the fate of
the AJCLTA is uncertain.
94
Prop. IRC § 1402(m)(2).
95
Prop. Reg. § 1.1402(a)-2(h)(6).
96
The proposed rules for determining who is a general partner for purposes of determining the SECA
treatment of partners use similar tests to determine whether a partnership is a “service partnership.” Under Prop.
Reg. § 1402(a)-2(h)(6) partners in a “service partnership” would be treated as “general partners” for purposes of
determining NESE. The AJCLTA would have expanded the definition of “professional service business” beyond
that of “service partnership” to add several new categories of services: lobbying, performing arts, athletics,
investment advice or management, and brokerage services.
97
10 AFTR 2d 2012-6796 (11th Cir., 2012) aff’g T.C. Memo 2011-260.
98
Robucci v. Comm., T.C. Memo. 2011-19, T.C.M. (RIA) P 2011-019, 101 T.C.M. (CCH) 1060 (2011).
99
319 U.S. 436 (1943).
18
corporation found that neither the professional corporation
nor the management corporation had business purposes
other than the avoidance of federal tax.12
Under this test, the court found that neither Robucci PC nor Westsphere
should be recognized as partners and the LLC was held to be a disregarded entity. As a result the
psychiatrist was held to be a sole proprietor, and any net income arising from his medical
practice was compensation subject to self-employment tax and the psychiatrist was liable for a
penalty under IRC §6662(a).
3.
Renkemeyer. On February 9, 2011, the Tax Court decided Renkemeyer v.
Commissioner,100 which dealt with the treatment of the distributive shares of income from a law
firm known as Renkemeyer, Campbell & Weaver, LLP v. Commissioner (for 2004) and
Renkemeyer, Campbell, Gose & Weaver LLP (for 2005) organized as a Kansas LLP for purposes
of the determination of NESE and other purposes. For 2004, the firm claimed its written
partnership agreement—which the law firm could not produce—provided for allocations of 30%
each to three individual partners and 10% by an S corporation owned by an ESOP of which the
partners were the beneficiaries. Despite this and the fact that the ESOP did not have any capital
interest in the partners, the law firm made a special allocation in 2004 of 87.557% of its income
to the ESOP. The Service reallocated the income in accordance with percentages in the
partnership agreement (30% to each individual and 10% to the ESOP). The Tax Court, after
reviewing the law on special allocations, found the special allocation of 87.557% of the income
to the ESOP to be invalid and upheld the Service’s determination.
Of greater interest is Judge Jacobs’ extensive discussion of the treatment of the
individual partners’ distributive shares of income in 2004 and 2005. As discussed above, the
distributive share of a partner in a partnership engaged in a trade or business is generally
included in NESE, but the distributive share of a “limited partner in a limited partnership” is not.
The partners in the law firm asserted that they should be treated as “limited partners” for
purposes of IRC § 1402(a)(13), because “(a) their interests are designated as limited partnership
interests in the law firm’s organizational documents, and (b) his and Messrs. Campbell’s and
Weaver’s interests in the law firm enjoy limited liability pursuant to Kansas law.” While the
court correctly noted that a LLP is a general not a limited partnership – which might in itself
have resolved the issue in favor of the Service – the court chose to make a more thorough
analysis of what a constitutes a “limited partner.” The court discussed the 1997 Regulations –
which would have held the partners’ interests as general partner interests under either the
authority test or the personal services exception – and the moratorium, and determined that the
moratorium suggested that Congress, not the Department of Treasury, should resolve the
question of who is a limited partner in light of the development of LLCs and LLPs. The court
apparently felt that as neither Congress nor the Department of Treasury has acted, it needed to
100
Renkemeyer, Campbell & Weaver, LLP v. Commissioner and Renkemeyer, Campbell, Gose & Weaver
LLP v. Commissioner, 136 T.C. 137 (2011). For an extensive an thoughtful analysis of the impact of Renkemeyer
see, Sheldon Banoff, Renkemeyer Compounds the Confusion in Characterizing Limited and General Partners—
Part 1, Journal of Taxation, at 306 (Dec. 2011) and Compounds the Confusion in Characterizing Limited and
General Partners—Part I1, Journal of Taxation, at 300 (Jun. 2012). See also, Shamik Trivedi, News Analysis:
Healthcare Reform Tax Effective Dates Coming Fast, With Little Direction For Taxpayer. 2012 TNT 191-1
(October 2, 2012).
19
analyze the status of “limited partner” under the legislative history of IRC § 1402(a)(13). The
court noted that in the 1977 enactment Congress has stated that the exclusion of limited partners
in limited partnerships was to “exclude for coverage purposes certain earnings which are
basically of an investment nature.”101 Based on this history the court held
The insight provided reveals that the intent of section
1402(a)(13) was to ensure that individuals who merely invested in
a partnership and who were not actively participating in the
partnership’s business operations (which was the archetype of
limited partners at the time) would not receive credits toward
Social Security coverage. The legislative history of section
1402(a)(13) does not support a holding that Congress contemplated
excluding partners who performed services for a partnership in
their capacity as partners (i.e., acting in the manner of selfemployed persons), from liability for self-employment taxes.
136 T.C. at 150.
The court went on to determine that as the income of the law firm came from the efforts
of the partners, the partners’ distributive share of income constituted NESE.
The opinion calls into question whether the 1997 Regulations have application to partners
in LLPs and members in LLCs. Further, it may raise the question of whether even traditional
limited partners in state law limited partnerships are considered “limited partners” for purposes
of IRC § 1402(a)(13). If, as the opinion suggests, “limited partner” must be understood by
reference to whether the partner performs services, the opinion might be broadly read to hold that
a limited partner under state law who performs services is not a “limited partner” for purposes of
IRC § 1402(a)(13). The better reading, in light of the fact that IRC § 1402(a)(13) expressly
considers a limited partner who performs services and the legislative history expressly permits a
person to be both a general and a limited partner.102 As such, a better interpretation may be that
the opinion (and the definition of “limited partner in a limited partnership” in the opinion) is
limited to partnerships other than state law limited partnerships.
The IRS has recently confirmed that while Renkemeyer dealt with a limited liability
partnership (LLP), its logic may apply to a member of an LLC.103 A the May meeting of the
ABA Tax Section Janine Cook, deputy division counsel/deputy associate chief counsel in the
101
Renkemeyer, 136 T.C. at 150 (citing H. Rept. No. 95-702 (Part 1), at 11 (1977)).
102
H. Rept. No. 95-702 (Part 1), at 40 (1977) (“Also, if a person is both a limited partner and a general
partner in the same partnership, the distributive share received as a general partner would continue to be covered
under present law.”).
103
Lydia Beyoud, ‘Renkemeyer' Rationale May Apply to LLCs For Self-Employment Purposes, Official
Says” Bloomberg BNA Daily Tax Report (May 12, 2014), 91 DTR G-14 (quoting Janine Cook, deputy division
counsel/deputy associate chief counsel in the IRS Office of Chief Counsel to the effect that while Renkemeyer dealt
with an LLP, Renkemeyer is “certainly a case of interest to all about what its ramifications could be in the LLC
environment, where sometimes a lot of the same facts are true: The LLC member is often very much engaged in the
business. I think it's still a stay-tuned kind of item, but definitely something to be aware of,”).
20
IRS Office of Chief Counsel. stated that Renkemeyer dealt with LLPs is a case of interest about
what its ramifications could be in the LLC world.104
1.
Howell. In Howell v. Commissioner. The holding in Renkemeyer was
followed in Howell v. Commissioner.105 In which Judge Marvel considered a member of a
California LLC that was engaged in information technology infrastructure. The member
contributed intellectual property developed by her husband, a business, and organizational design
for her interest in the LLC and contended that because she did not contribute any services to the
LLC her distributive share of income should not constitute NESE. The court found that the
petitioner provided marketing advice, signed documents and entered into contracts on behalf of
Intelemed, and allowed Intelemed to use her credit card and credit rating.” Noting that although
she delegated management authority to her husband, she still consulted with him from time to
time and contributed a business plan and thus participated in the business. Thus, the court found
that the wife must include her share in NESE:
Section 1402(a)(13) does not define the term “limited
partner”. In Renkemeyer, Campbell & Weaver, LLP v.
Commissioner, 136 T.C. 137, 149-150 (2011), we applied accepted
principles of statutory construction to decide whether the
taxpayers’ partnership interests in a law firm should be considered
limited partner interests for purposes of section 1402(a)(13),
stating as follows:
The insight provided reveals that the intent
of section 1402(a)(13) was to ensure that
individuals who merely invested in a partnership
and who were not actively participating in the
partnership’s business operations * * * would not
receive credits toward Social Security coverage.
The legislative history of section 1402(a)(13) does
not support a holding that Congress contemplated
excluding partners who performed services for a
partnership in their capacity as partners (i.e., acting
in the manner of self-employed persons), from
liability for self-employment taxes.
This Court held that the taxpayers were not limited partners
for purposes of section 1402(a)(13) because the distributive shares
received “arose from legal services * * * [the taxpayers] performed
on behalf of the law firm” and “did not arise as a return on the
partners’ investment”. Id. at 150.
An interesting sidelight in the Howell is that the court actually held that Mrs. Howell’s
guaranteed payments were NESE, but did not actually hold her to be a “general partner.” As
104
Lydia Beyoud, ‘Renkemeyer' Rationale May Apply to LLCs For Self-Employment Purposes, Official
Says, ”91 DTR G-14
105
T.C. Memo. 2012-303 (Nov. 1, 2012).
21
such, the discussion of Renkemeyer is entirely superfluous as guaranteed payments constitute
NESE even when made to limited partners under IRC § 1402(a)(13).106
2.
Cvancara In Aimee A. & Ryan A. Cvancara v. Commissioner,107 Judge
Marvel again dealing with an LLC, noted in dicta that Renkemeyer would have been the basis for
the determination of whether the petitioner was a “limited partner” if the LLC had had income
(which the court found it did not).
C.
Comments and Reports on the Definition of “Limited Partner”
1.
Joint Committee on Taxation Report JCS-3-01 (April 2001). In April
2001, the Joint Committee on Taxation issued a Study of the Overall State of the Federal Tax
System and Recommendations for Simplification one of which was to modernize references to
“Limited Partner” and “General Partner.” (the “2001 JCT Recommendation”)108 The JEB
outlined both the provisions of the Code and regulations that were based on the distinction
between general partners and limited partners, and identified alternative methods of dealing with
the uncertainty engendered by using the terms ‘general partner’ and ‘limited partner.’ This
would be accomplished by removing the reference to ‘general partner’ or ‘limited partner’ and
making a reference in each section in which the distinction is made to: (1) a person whose
participation in management is(limited partner) or is not (general partners) limited by state law,
(2) a person who does (general partner) or does not (limited partner) actively participate in
management of the enterprise, or (3) a person who has (general partner) or does not have (limited
partner) income from the partnership from his own personal services.
The 2001 JCT Recommendation identifies two principal differences between general
partners and limited partners: “(1) whether the partner's liability for partnership obligations is
limited; and (2) whether the partner may participate in management or business activity of the
partnership.” The recommendation principally focusses on the partner’s participation rather than
the partner’s vicarious liability, and suggests dispensing with the term “limited partner” and
replacing it with a better term such as “a person whose participation in the management or
business activity of the entity is limited under applicable State law.”
2.
The New York State Bar Association Comments. While the issue of
the treatment of limited partners for self-employment purposes may seem almost hoary by
106
See Banoff, Who's a ‘Limited Partner’? More Confusion Courtesy of Renkemeyer and Howell, Journal
of Taxation, 118 Tax Notes 212 (Apr 2013). (“This failure to characterize Lauren as subject to SE tax on her
ordinary income (i.e., treat her as a "general partner" with respect to her LLC interest in Intelemed) for 2000 and
2001 is all the more confusing, in light of the Service's requested findings of fact from the Tax Court. Request No.
71 states: ‘During the examinations of Intelemed and petitioners, respondent's examiners determined that Ms.
Howell was active in Intelemed, and could not be considered a limited partner for self-employment tax purposes
under section 1402(a)(13).’ As is evident from the opinion, the Tax Court made no such finding of fact that Lauren
was other than a limited partner for purposes of Section 1402(a)(13).”).
107
T.C. Memo 2013-20 (Jan. 17, 2013).
108
Report JCS-3-01 (April 2001) Joint Committee on Taxation, Study of the Overall State of the Federal
Tax System and Recommendations for Simplification Section V.B.1. Modernize References to “Limited Partner”
and “General Partner” attached as APPENDIX I.
22
comparison of the ACA Taxes, discussed below, the issues are, as the New York State Bar
Association Tax Section recently noted,109 “closely linked.” The NYSBA recommends:110
As reflected in the attached report, in our view the term
“limited partner” for purposes of Section 1402 should be divorced
from state law classifications. We recommend that in order to best
reflect the Congressional intent underlying the Section 1402(a)(13)
exclusion, the term “limited partner” should be defined by
reference to the level of participation of an individual in relevant
partnership activities. A test that is analogous to the material
participation test that applies under Section 469 of the Code would
in our view further the intent of the self-employment tax provisions
of the Code, and would be consistent with Congress' goal in
enacting the statutory provisions contained in Section 1411.
3.
The American Bar Association Section of Taxation Report. On
December 2, 2011 the American Bar Association Section of Taxation sent a report to
Congressional leaders on Options for Tax Reform Relating to Partnerships recommended the
adoption of a reasonable compensation method of distinguishing general and limited
partnerships.111
4.
The Congressional Budget Office Study. In September 2012, the
Congressional Budget Office released a study in which it outlined three different methods of
distinguishing general partners from limited partners: (1) material participation, (2) reasonable
return on capital, and (3) reasonable compensation.112
5.
Banoff Recommendations. Shelly Banoff’s encyclopedic analysis of the
issue gives a total of twenty-one alternatives for definitional treatment of “limited partners”
and “general partners.” His conclusion, similar to that of the 2001 JCT Recommendation is that
an appropriate analysis on a section-by-section basis, attempting to adduce the congressional
intent in each case, with the possibility of expunging the terms “limited partner” and “general
partner” from the Code.
113
6.
Joint Committee on Taxation Report JCX-66-12 (July 27, 2012). In
July of 2012, the Joint Committee on Taxation issued a report entitled Selected Issues Relating to
Choice Of Business Entity in which it states (for purposes of IRC § 1402(a)(13) “limited partner
109
NYSBA Report 1247 (November 14, 2011) excerpts from which are attached as APPENDIX III.
110
Cover letter from Jodi Schwartz, Chair, New York State Bar Association Tax Section, to Emily S.
McMahon Deputy Assistant Secretary (Tax Policy) Department of the Treasury, dated November 14, 2011,
transmitting Report 1247.
111
Letter dated December 11, 2011 from the American Bar Association Section of Taxation to Senator
Max S. Baucus, Representative Dave Camp, Senator Orrin G. Hatch, and Representative Sander Levin excerpts
from which are attached as APPENDIX IV.
112
Congressional Budget Office, The Taxation of Capital and Labor Through the Self-Employment Tax
excerpts from the Congressional Budget Office Study are attached as APPENDIX V.
113
See Banoff, Defining “General Partner” and “Limited Partner” for Tax Purposes, So What’s the
Solution, Taxes, the Tax Magazine March 2013.
23
status is determined under State law.”114 The report goes on to note the changes in the ability of
state law limited partners to participate in management and to cite Renkemeyer for the
proposition that “legislative history of section 1402(a)(13) does not support a holding that
Congress contemplated excluding partners who performed services for a partnership in their
capacity as partners (i.e., acting in the manner of self-employed persons), from liability for selfemployment taxes.”115
IV.
Conclusion.
Until a greater certainty is brought to the rules which turn on whether a tax partner will
be determined to be a “general partner” or “limited partner,” advisers and clients will be forced
to speculate – or, more to the point, allowed to choose – which definition to use. This apparent
flexibility will make both planning and certainty much harder to come by, but we have lived with
this problem for many years. As he does with most things, Shelly Banoff 116 says it best:
Upon emerging from the trees and looking back at what
was the forest before the pages of this article were printed, we
asked ourselves: “Why do we have a problem here, and why did
this article have to be written?” This topic has long been and
remains today “an intriguing issue” (to quote the Tax Court’s 1980
characterization in Block) because the draftspersons of various
Code and Regulations provisions used (and continue to use) state
law terms – i.e., limited partner and general partner – to create
significant operative distinctions in the tax law. The characteristics
– i.e., the rights, obligations and liabilities of limited partners and
general partners – have continued since the 1970’s to evolve for
state law purposes, yet the tax law remains tethered to those
evolving state law definitions. The use of state law terms creates a
multi-layer hermeneutic problem – to understand the tax law, one
must first understand the non-tax law which has been engrafted
into it. But both the tax law and the non-tax law are constantly
changing. Sometimes they change completely independently.
Sometimes a change in one affects a change in the other (as when,
for example, state LLC law developed to comply with the
partnership tax status classification test, or the income and loss
allocation regulations under Section 704 attempt to draw the state
law meaning out of partnership economic relationships).
Sometimes, they may both be changed by some external force.
Even if one is able to divine the meaning of the state law, there is
no indication whether the state law being applied to define the
status of members of then-unforeseen and unforeseeable state law
114
Report JCX-66-12 (July 27, 2012) Joint Committee on Taxation, Selected Issues Relating to Choice of
Business Entity, page 45 footnote 113.
115
Id. at footnote 115.
116
See Banoff, Defining “General Partner” and “Limited Partner” for Tax Purposes, So What’s the
Solution, Taxes, the Tax Magazine March 2013.
24
pass-through entities (such as LLCs, LLPs and LLLPs) taxable as
partnerships as general or limited partners is the law as it was
understood when the state legislation was passed, when the tax
rules were adopted, or at the time the taxable events being tested
occurred. Thus, a fourth dimension is added to the already tough
problem of fitting a square peg into a round hole.
Thus, one lesson to be learned from this exhaustive (and
exhausting) search for the meaning for tax purposes of the terms
“limited partner” and “general partner” is simply that, when
drafting tax statutes and interpretative regulations and rulings, it is
better not to rely on state law ‘labels’ upon which substantive tax
law consequences will turn. The contents of the ‘packages’ may
change, while the labels remain the same; that is precisely what has
happened with respect to the rights, obligations and (most
importantly) permissible activities of limited partners under the
various versions of ULPA and RULPA. Alternatively, the
packages may hold contents (e.g., interests in LLCs, LLPs and
LLLPs) for which the old labels do not properly fit or, worse yet,
the labels may misdescribe the contents. That has further
compounded the confusion.
25
APPENDIX I
Report JCS-3-01 (April 2001) Joint Committee on Taxation, Study of the Overall State of
the Federal Tax System and Recommendations for Simplification Section V.B.1. Modernize
References to “Limited Partner” and “General Partner”
Present Law
State law defines types of entities for conducting business, such as corporations and
partnerships, and describes basic characteristics of such entities and the rights, duties and
obligations of their owners. The laws of all 50 States and the District of Columbia provide for the
establishment of partnerships, including limited partnerships, and have so provided for many
decades.
In general, under State law, a partnership is a mutual agency arrangement, and each
partner is an agent of the firm. State law provides rules for general partnerships, in which all
partners ordinarily can bind the partnership, can participate in control of the partnership's
business, and have personal liability for debts and obligations of the partnership. State law also
provides rules for limited partnerships, which can have as owners both general partners and
limited partners. Under State law, a limited partner normally is not personally liable for the debts
and obligations of the partnership, and generally cannot participate in the control of the
partnership's business activities. Thus, State law historically has distinguished between general
partners, who do have personal liability and can participate in control of the business (whether in
a general partnership or limited partnership), and limited partners, who do not have personal
liability and cannot participate in control of the partnership's business.
Within the past two decades, a new form of unincorporated business entity has arisen
under State law: the limited liability company. The laws of all 50 States and the District of
Columbia now provide for limited liability companies. State laws differ as to the rights of limited
liability company owners to participate in control of the limited liability company 's business;
State law often provides for several classes of ownership interests with different rights as to
distributions, voting, and participation in management, for example.117 However, the common
characteristic of limited liability company owners is that they ordinarily are not personally liable
for the debts and obligations of the limited liability company. Utilization of limited liability
companies (rather than corporations or partnerships under State law) as the choice of entity for
new business activities has increased significantly.
For Federal income tax purposes, limited liability companies generally are classified as
partnerships rather than as corporations.118 The owners of a limited liability company that is
classified as a partnership for tax purposes are treated as partners for Federal income tax
117
In some States, members of limited liability companies are classified as managing and non-managing
members.
118
Under Federal income tax law, generally income of entities classified as partnerships is subject to one
level of tax (i.e., only to owner-level but not to entity-level income tax on earnings), whereas income of entities
classified as corporations is subject to two levels of tax (i.e., both to owner-level and entity-level income tax on
earnings). Treasury regulations issued in 1996 provide that Federal tax classification of an entity that is not a
corporation under State law, such as a limited liability company, as either a corporation or a partnership is elective.
A limited liability company that does not elect to be treated as a corporation for Federal tax purposes generally is
treated as a partnership (unless it is a single-member limited liability company that is treated as a disregarded entity),
under these regulations.
26
purposes. However, under State law, limited liability company owners are not defined as either
general partners or limited partners.
Nevertheless, a number of provisions of the tax law refer to either “general partners” or
“limited partners.” These references generally predate the widespread use of limited liability
companies, and are based on the distinction made under State law with respect to general and
limited partners of partnerships. The distinction is difficult to interpret when applied to owners of
a limited liability company, who, though treated as partners for Federal income tax purposes, are
not subject to the State-law rules relating to partners and partnerships, and are neither general
partners nor limited partners under State law.
Present-law references to “general partners” in the Internal Revenue Code are found in:
(1) section 465(c)(7)(D)(ii)(I), in a rule identifying an active business of a corporation
eligible for an exception to the at-risk rules;
(2) section 736(b)(3)(B), in a rule identifying service partners eligible for exchange
treatment of payments for good will upon retirement or death;
(3) section 988(c)(1)(E)(v)(I), in a rule identifying owners of funds eligible for special
treatment of foreign currency gains and losses;
(4) section 2701(b)(2)(B)(II), in a rule to determine “control” under special valuation
rules of the generation skipping tax; and
(5) section 6231(a)(7), in a rule identifying the “tax matters partner” under the 1982 Act
partnership audit rules.
Present-law references to “limited partners” in the Internal Revenue Code are found in:
(1) section 464(c)(1)(B) and (e)(2)(A), in rules identifying holdings attributable to active
management and defining farming syndicates under a limitation on farming
deductions;
(2) section 469(h)(2) and (i)(6)(C), in rules identifying investors that do not materially
participate in a business activity or actively participate in a rental real estate activity;
(3) section 772(f), in a rule specifying the operation of simplified flow-through rules for
electing large partnerships;
(4) section 1256(e)(3) and (e)(4)(A), in rules identifying “active management”
transactions eligible for a hedging exception to mark-to-market rules; limited liability
company that does not elect to be treated as a corporation for Federal tax purposes
generally is treated as a partnership (unless it is a single-member limited liability
company that is treated as a disregarded entity), under these regulations.
(5) section 1258(d)(5)(C), in a rule identifying passive investments that are not eligible
for an exception for options dealers and commodities traders to ordinary income
treatment;
(6) section 1402(a)(13), in a rule excluding from tax on self-employment income
partnership income that is not a guaranteed payment for the partner's personal
services; and
(7) section 9701(c)(2), in a rule identifying employers that are subject to Coal Industry
Health Benefits rules.
Sources of Complexity
References in the Code to “general partners” and “limited partners” have become out-ofdate, due to the increase in utilization of limited liability companies. Limited liability companies
27
are generally treated as partnerships -- and their owners as partners -- for Federal income tax
purposes. Nevertheless, limited liability company owners are neither general nor limited partners
under applicable State law. Applying provisions of the tax law that refer specifically to general
or limited partners to limited liability company owners creates difficult questions of
interpretation.
The development of limited liability companies under State law and the resulting change
in business practices have made it advisable to modernize references in the Code to general and
limited partners to accommodate the existence of persons who are partners within the meaning of
the Federal tax law, but are not either general partners or limited partners.
Recommendation for Simplification
The Joint Committee staff recommends that references in the
Internal Revenue Code to “general partners” and “limited
partners” should be modernized consistently with the purpose
of the reference. In most cases, the reference to limited
partners may be updated by substituting a reference to a
person whose participation in the management or business
activity of the entity is limited under applicable State law (or,
in the case of general partners, not limited). In a few cases, the
reference to limited partners can be retained because the
provisions also refer to a person (other than a limited partner)
who does not actively participate in the management of the
enterprise, which can encompass limited liability company
owners with interests similar to limited partnership interests.
In one case, the reference to a general partner can be updated
by referring to a person with income from the partnership
from his own personal services.
In general
Two principal differences between general and limited partners under State law are
important for Federal tax purposes: (1) whether the partner's liability for partnership obligations
is limited; and (2) whether the partner may participate in management or business activity of the
partnership.
If the relevant aspect of references to general or limited partners were limited liability,
then the appropriate update of references to limited partners would be to substitute a reference to
partners whose liability for partnership obligations is limited (or, in the case of general partners,
not limited). State law generally does provide limited liability for limited liability company
owners with respect to obligations of the limited liability company. Under this approach, then, all
limited liability company owners would be treated as limited partners under the present-law
rules, even if the limited liability company owners were active in the management or business of
the limited liability company. This approach119 would tend in some cases to change the scope of
the present-law rules that include such references, rather than just modernize the reference so
119
See Gregg v. U.S., D. Or., No 99-845-AA, Nov. 29, 2000, a recent case in which the court refused to
take this approach.
28
that the rule retains its present scope. Further, it would not take into account the purpose of the
reference to serve as a shorthand measure of the partner's personal involvement in the
management or activity of the partnership, a purpose that appears to be common to many of the
provisions that include such references, as illustrated by the provision-by-provision analysis
below.
Therefore, it is argued, the relevant aspect of the references to general or limited partners
is probably not limited liability in most cases, but rather, is whether the partner's participation in
the management or business activity of the partnership is limited under State law. State limited
liability company laws do not invariably provide, as does most State law with respect to limited
partners, that a limited liability company owner is prohibited from, or limited in, participation in
the management or business of the partnership. State laws vary, but most provide that at least
some classes of limited liability company owners are permitted to participate without restriction.
Under this approach, the appropriate update for references to limited partners would be to
substitute a reference to a person whose participation in the management or activity of the
partnership is limited under State law (or, in the case of general partners, not limited).120
Provision-by-provision analysis
Below is a provision-by-provision analysis of the direct references in the Code to limited
partners and general partners. Other, indirect references to these terms generally are assumed to
be for purposes similar to the direct references, and therefore, are not specifically discussed. For
example, the definition of a syndicate (which includes a reference to limited partners in section
1256) is incorporated indirectly by reference in rules governing whether the taxpayer may use
the cash method of accounting for Federal tax purposes (sec. 448). This indirect reference is not
separately discussed. Similarly, references to general partners or limited partners in Treasury
regulations are not discussed. While the purpose of the reference in each provision that is
discussed may not be precise or explicit in the legislative history, it may generally be inferred
from the context of the provision.
References to general partners
At-risk rules (sec. 465(c)(7)(D)(ii)(I)).--The at-risk rules serve to limit individuals' and
closely held corporations' losses and deductions from a business activity to the amount that the
taxpayer could actually lose in the activity, i.e., the taxpayer's amount at risk. A special rule
provides an exception for certain active businesses conducted by closely held corporations. To
qualify for this active business exception, a corporation must have a certain minimum number of
full-time employees performing services in the business. If the business is conducted by a
partnership in which the closely held corporation is a partner, then to qualify for the active
business exception, the corporation must be a general partner. In addition, the corporation must
satisfy tests based on minimum percentage ownership and dollar value investment in the
partnership. Although the legislative history of these requirements for corporate partners in
120
One provision of present law, further discussed below, provides a definition of a limited entrepreneur,
which means a person with an interest in an enterprise other than as a limited partner, who does not actively
participate in the management of the enterprise. Although this is a somewhat different notion than relying on the
interest-holder's right to participate in management or activities of the business as defined under State law, it could
be a starting point for drafting.
29
active businesses is not explicit about the purpose of the general partner requirement,121 it would
not be inconsistent with the sense and scope of the provision to substitute for the general partner
requirement a requirement that the closely held corporate partner not be prohibited or limited
under applicable State law from participation in the management or business of the partnership.
This approach would provide simplification by eliminating the reference to general partners,
without changing the meaning or effect of the reference. The partner would still be required to
satisfy the other parts of the test, relating to its minimum percentage ownership and dollar value
investment. In addition, a minimum full-time employee requirement applies. Thus, for example,
under this approach, a closely held corporation conducting an active business as an owner of an
limited liability company could qualify for the active business exception under the at-risk rules,
provided that applicable State law governing the corporation's interest in the limited liability
company did not limit the corporation's participation in management or business of the limited
liability company. This result would follow even though the corporation's liability for obligations
of the limited liability company is limited under State law. This approach would continue the
same result as under present law with respect to general partners, as the new language generally
would correlate to rights of general partners under State law. Payments to retiring partner (sec.
736(b)(3)(B)).--Special rules provide for the character as either ordinary income, or capital gain,
of payments made in liquidation of the partnership interest of a retiring or deceased partner.
Under this rule, a payment that is treated as a distributive share (which can be ordinary income to
the partner) is effectively deductible by the partnership, while a payment that is treated as a
distribution in exchange for the partner's partnership interest (which is generally capital gain to
the partner) is not deductible by the partnership. A payment to a retiring partner may be treated
as in exchange for the partnership interest (with capital gain treatment), unless it is a payment for
unrealized receivables, or for good will. An additional special rule provides that a payment for
unrealized receivables or good will may nevertheless qualify for favorable exchange treatment, if
two requirements are met. The first requirement is that capital is not a material incomeproducing factor for the partnership, and the second requirement is that the partner was a general
partner. Both of these requirements are intended to ensure that the retiring or deceased partner
performed personal services for a service partnership.122 It would be consistent with this intent
to substitute for the general partner requirement a requirement that the retiring or deceased
partner was subject to tax on self-employment income from the partnership. This approach
would serve the same purpose as the present-law reference to a general partner, that is, to provide
that the retiring or deceased partner was not merely an investor but actually performed personal
services in the partnership's service business. It would serve this purpose better than merely
providing a reference to whether the partner was limited by State law in the participation in
management or business of the partnership, because the self-employment income would be
evidence of his performance of services.
Foreign currency transactions (sec. 988(c)(1)(E)(v)(I)).--Section 988 provides generally
that foreign currency gains and losses are treated as ordinary. Transactions that are defined as
section 988 transactions subject to this rule generally include (among other things) entering into
or acquiring any forward contract, futures contract, option or similar financial instrument, that is
121
See Joint Committee on Taxation, General Explanation of the Revenue Provisions of the Deficit
Reduction Act of 1984 (JCS-41-84), Dec. 31, 1984, at 730 (reasons for change), 735
122
See H. Rep. 103-111 (May 25, 1993), at 782-783.
30
denominated in, or by reference to, a foreign currency. In the case of taxpayers that elect to be
treated as “qualified funds,” however, these types of transactions are not treated as section 988
transactions if they would otherwise be marked to market under section 1256, which provides for
40-percent/60-percent short-term/long-term capital gain or loss treatment.123 A “qualified fund”
means an electing partnership meeting certain statutory requirements, including a requirement
that at all times while its election is in effect, it has at least 20 partners, and no single partner
owns more than 20 percent of the interest in the capital or profits of the partnership. This rule has
the effect of diversifying the ownership of the partnership. An exception is provided to the 20percent limit in the case of an interest of a general partner, “if neither that partner, nor any person
whose taxable income is combined with such general partner's taxable income in a consolidated
return, has ordinary income that is foreign currency gain or loss. . .”124 The legislative history
further explains, “[t]hus, a general partner's share of profits or capital may be any percentage if
none of that partner's ordinary income or loss is exchange gain or loss from a section 988
transaction.”125 The reference appears to be to a partner that is active in a business (outside the
qualified fund) other than one involving section 988 transactions.
The reference in the qualified fund election to a general partner could be modernized by
substituting a reference to a person not limited as to participation in the management or activity
of the qualified fund. The effect of the present-law reference is to require partners with a greaterthan-20 percent interest in the fund to be general partners, that is, to give up the limited liability
for fund obligations that they would have as limited partners. Unlimited liability in a qualified
fund has the potential for significant consequences because of the inherent volatility of foreign
currency derivatives, particularly if the unlimited liability cannot be hedged with offsetting
foreign currency transactions outside of the qualified fund. Changing the reference to
accommodate limited liability company owners that can participate in management or activity of
the fund would have the effect of allowing fund owners to have greater-than-20-percent interests
without giving up limited liability.126 Arguably, this could be a substantive change in the scope
of the qualified fund exception to section 988 treatment; it could make the section 1256
treatment available even though no owner of the qualified fund has to give up limited liability for
it. If this result is inconsistent with the original purpose of the provision, then expanding the
general partner exception to the 20-percent limit to encompass limited liability company owners
may be inappropriate.
Special valuation rules for generation-skipping tax (sec. 2701(b)(2)(B)(II).—The
generation-skipping transfer tax is imposed on transfers, either directly or through a trust or
similar arrangement, to a beneficiary in a generation more than one generation below that of the
123
The qualified fund election has the effect of benefiting “commodity pool” partnerships that might not
otherwise have uniform capital treatment for all of their foreign currency contracts under the general section
988(a)(1)(B) election, which provides for capital treatment of gains and losses on foreign currency contracts unless
they are part of a straddle under section 1092.
124
125
H. Rep. 100- 1104 (October 21, 1988), at 19.
Id.
126
The limited liability company owner would still be precluded from engaging in section 988 transactions
outside of the qualified fund, and so would not be able to hedge the (albeit limited) liability associated with its
ownership interest through offsetting foreign currency contracts.
31
transferor. Special valuation rules apply for valuing interests in corporations and partnerships.
These rules provide that the value of control of the corporation or partnership that is retained by
the transferor is treated as zero, for purposes of determining whether the property transferred to
the younger generation is a gift. In determining control of a partnership, the rules provide that
control means holding an interest as a general partner, in the case of a limited partnership.
Because the provision relates to control, the ability of the transferor to participate in the
management or activity of the partnership is relevant. To update the references, the provision
could be rewritten to provide that in the case of a partnership, any members of which are limited
as to participation in management or activity of the partnership, control means holding an
interest that is not limited as to participation in management or activity of the partnership. This
would broaden the definition of control to cover a situation that is not addressed in present law,
giving greater certainty, a transactional simplification benefit.
1982 Act partnership audit rules (sec. 6231(a)(7).--Rules for audits of partnerships, in
which determinations can be made at the partnership level so that items are treated consistently
for all partners, were added by the Tax Equity and Fiscal Responsibility Act of 1982. Under
these rules, a “tax matters partner” is selected who may represent other partners and transmit
information to them about the audit process. The tax matters partner is defined as the general
partner designated in accordance with procedures set forth in regulations, or if none is
designated, the general partner with the largest profits interest. These references are designed to
point to a partner who is familiar with the operations of the partnership.127 It would be consistent
with the purpose of the provision to substitute for the reference to a general partner a reference to
a partner who is not limited as to participation in management or activity of the partnership.
References to limited partners
Concept of “limited partner or limited entrepreneur” (secs. 464(c)(1)(B) and (e)(2)(A),
1256(e)(3)(B) and (C) and (e)(4)(A), and 1258(d)(5)(C)).--Several provisions of the tax law
utilize the concept of “limited partner or limited entrepreneur,” generally to disallow or limit tax
benefits with respect to those persons. Rules deferring certain farming deductions in the case of a
farming syndicate include in the definition of farming syndicate a partnership, if more than 35
percent of the losses during any period are allocable to limited partners or limited entrepreneurs.
This same concept is applied to exclude from the hedging exception to the mark-to-market rules
for section 1256 contracts any transaction entered into by or for a syndicate. For this purpose, a
syndicate includes any partnership, if more than 35 percent of the losses for the taxable year are
allocable to limited partners or limited entrepreneurs. In a rule recharacterizing gain from certain
financial transactions as ordinary income, an exception from the recharacterization rule for
options dealers and commodities traders does not apply in the case of any gain recognized by a
limited partner or limited entrepreneur. Each of these rules refers to the section 464 definition,
which provides that a limited entrepreneur is a person other than a limited partner who does not
actively participate in the management of the enterprise. In each case, the reference to a limited
partner is coupled with a reference to a limited entrepreneur. A limited entrepreneur, under the
present-law definition, encompasses a limited liability company owner that is not permitted to
127
See Joint Committee on Taxation, General Explanation of the Revenue Provisions of the Tax Equity and
Fiscal Responsibility Act of 1982 (JCS-38-82), December 31, 1982, at 268-274 (describing the role of the tax
matters partner).
32
participate in the management or activity of the limited liability company; if State law prevents
the limited liability company owner's participation, then the limited liability company owner
would clearly not be actively participating. It can be argued, therefore, that there is no harm in
retaining the limited partner references in these provisions, because the accompanying notion of
limited entrepreneur picks up the parallel case of the limited liability company owner.
Alternatively, if the concern about limited partners is their lack of participation, then the
definition of limited entrepreneur under present law covers the case involving limited partners
that gives rise to concern. Therefore, the limited partner reference could be dropped and only the
limited entrepreneur notion retained, without changing the meaning or effect of the provisions.
Material participation and active participation under the passive loss rules (sec. 469 (h)(2) and
(i)(6)(C)).--The passive loss rules serve to defer losses and deductions from activities in which
the taxpayer does not materially participate, until the taxpayer disposes of the entire interest in
the activity in a taxable transaction. These rules were developed to stem the growth of tax
shelters among individual taxpayers in the md-1980's. The definition of material participation
includes a provision that an interest in a limited partnership as a limited partner is not an interest
with respect to which the taxpayer materially participates. Similarly, in a special rule for
individuals who actively participate in a rental real estate activity, the definition of active
participation includes a provision that an interest in a limited partnership as a limited partner is
not an interest with respect to which the taxpayer actively participates. These references are
found in provisions whose basic purpose relates to the taxpayer's level of personal involvement
in the activity of the entity. It would be consistent with this purpose to substitute for the
references to interests as a limited partner in a limited partnership a reference to a person whose
participation in the management or business activity of the entity is limited under applicable
State law. This would provide certainty that limited liability company owners who, like limited
partners, may not participate in partnership management or activities, are not treated as
materially or actively participating. It would also have the effect of clarifying that a limited
liability company owner who is not so restricted is treated like a general partner under the
material or active participation tests, with the result that his or her participation is assessed under
regulations applicable to everyone who is not a limited partner.128
Reporting rules for large partnerships (sec. 772(f)).--Partnerships with more than 100
partners may elect simplified reporting and audit rules. Under the reporting rules, the number of
separately stated items that are reported to partners (and to the IRS) is reduced. Certain
provisions are not modified or consolidated for purposes of these simplified reporting rules, such
as the passive loss rules. The reference to limited partners in the simplified reporting rules
conforms the reporting of passive losses under these rules to the reporting of passive losses from
partnerships that do not elect simplified reporting. The same substituted reference as is
recommended above under the passive loss rules would be appropriate. However, in a separate
128
This approach would be consistent with the result in Gregg v. U.S., above. In that case, the issue was
whether a limited liability company owner would be treated as a limited partner or a general partner in determining
his material participation under the passive loss rules. The court concluded that the limited liability company owner
should not be treated as a limited partner solely because of his limited liability, but rather, should be treated as a
general partner. The court noted, “the legislative history clearly shows that Congress enacted the limited partnership
test for the purpose of the passive activity loss rules to thwart the deduction by investors, such as limited partners in
a limited partnership, of 'passive' losses from 'tax shelter' investments against other non-passive income, since 'a
limited partner generally is precluded from participating in the partnership's business if he is to retain his limited
liability status.'“ See S. Rep. 99-313 (May 29, 1986), at 731.
33
section of this study, it is recommended that these reporting and audit rules be repealed, so the
reference would be eliminated.
Self-employment tax rules (sec. 1402(a)(13)).--The tax on net earnings from selfemployment applies to gross income derived by an individual from any trade or business carried
on by the individual, less the allowable deductions attributable to the trade or business. In the
case of a partner, net earnings from self-employment include the partner’s distributive share
(whether or not distributed) of income or loss from any trade or business carried on by the
partnership. A special rule provides that net earnings from self-employment does not include the
distributive share of any partnership item of income or loss of a limited partner (other than
guaranteed payments for services actually rendered). The issues involved in modernizing this
limited partner reference are discussed in a separate section of this study.
Coal industry health benefit provisions (sec. 9701(c)(2)).--These provisions provide
special health benefit rules with respect to a particular industry. They serve nontax purposes, and
modifying the limited partner reference in these provisions is outside the scope of this
simplification study.
Other possible approaches
Some have argued that an approach based on actual performance of services would be an
appropriate replacement for references to limited or general partners. Ordinarily the reference
was a shorthand method of identifying the partner's level of involvement in the partnership's
business activity. If the purpose of the reference in the present-law rules is to identify a partner
who not only is permitted under State law to participate in the entity's business, but actually is
providing personal services, then a rule defining minimum personal services by hours per year
could be substituted for the current limited or general partner reference. It could be argued that
an hours-per-year test would be better than a reference to whether the person is limited under
State law from participating in management or activity of the entity.
It is argued that an hours-per-year test more precisely focuses on the difference between
limited and general partners. In a limited partnership, a limited partner normally has to give up
his limited liability and become a general partner, in order to participate in management or
activity of the partnership. Thus, if someone is a general partner in a limited partnership, that
person probably is involved in partnership activities. Similarly, if the choice of entity is a general
partnership rather than a limited partnership, the liability risk taken on by the partners is the
trade-off for the ability to participate in the partnership's activity. Thus, a general partner is
relatively likely to be performing services, having given up limited liability. This calculus does
not apply in the limited liability company context, however, because the limited liability
company owner does not have to give up limited liability in order to have an ownership interest
that permits participation in the partnership's activities. Thus, it is argued, the analogy to a
limited or general partner is not complete if one merely substitutes a reference to whether the
person is (or is not) permitted under State law to participate in the management or activities of
the entity. Some reference to the limited liability company owner's level of personal service for
the limited liability company is also needed, it is argued. Thus, it could be argued, a minimum
number of hours per year of personal service for the partnership would be an appropriate test,
providing an easy-to-administer, simple, bright-line test.129 On the other hand, an hours-per-year
129
An hours-per-year test would be administratively simpler, and easier for taxpayers to apply, than a
subjective test that did not provide for quantifiable services.
34
test could be criticized on several grounds. The particular minimum number of hours could be
criticized as either too many or too few, depending on the factual circumstances. The same
number of hours might not be appropriate for each provision. Another difficulty of a minimum
hours test is that it would impose a recordkeeping burden on taxpayers. They would need to keep
a log or other record of their hours, which generally would not be viewed as a simplification. In
some instances, there could be a perverse incentive to work up to or past the minimum. For
example, while escaping limited partner treatment would be beneficial to taxpayers under many
of the above provisions, working significant hours might have the result of subjecting the
taxpayer's income from the activity to self-employment tax (depending on what the test might be
under that provision; no recommendation is made in this study). A further concern would be the
need for aggregation, or disaggregation, as the case might be, of an individual's services in
multiple activities. An aggregation rule would be a complex but probably necessary addition to a
minimum hours test. In addition, it is argued that actually imposing a minimum level of service
measured in hours is substantively different from examining the status of a person as a general or
a limited partner under State law. No such requirement applies to general partners either as a
matter of State law or under Federal income tax law, so any attempt to quantify the services that
a general partner is likely to perform in any particular instance would alter the substantive results
of the affected provisions. Thus, it is argued, trying to assess taxpayers' level of involvement in
partnership activities based on an hours-per-year test could be more complex than present law.
35
APPENDIX II
ADDITIONAL OPTIONS TO IMPROVE TAX COMPLIANCE
(“2006 JCT PROPOSAL”)
A. Modify the Determination of Amounts Subject to Self-Employment Tax for Partners
and S Corporation Shareholders in Personal Service Businesses
Present Law
As part of the financing for Social Security and Medicare benefits, a tax is imposed on
the wages of an individual received with respect to his or her employment under the Federal
Insurance Contributions Act (the FICA tax).130 A similar tax is imposed on the net earnings
from self-employment of an individual under the Self-Employment Contributions Act (the SECA
or self-employment tax).131 Under the present-law self-employment tax rules (sec. 1402), the net
earnings from self-employment of an individual who is a general partner in a partnership
generally include the partner’s distributive share (whether or not distributed) of income or loss
from any trade or business carried on by the partnership. Specified types of income or loss are
excluded from net earnings from self-employment of a general partner, such as rentals from real
estate in certain circumstances, dividends and interest, gains or loss from the sale or exchange of
a capital asset or from timber, certain minerals or other property that is neither inventory nor held
primarily for sale to customers, and retirement payments from the partnership if the partner
rendered no services for the partnership and certain other requirements are met.
A special rule applies for limited partners of a partnership. 132 In determining a limited
partner’s net earnings from self-employment, an exclusion is provided for his or her distributive
share of partnership income or loss. The exclusion does not apply to guaranteed payments to the
limited partner as remuneration for services.
A shareholder of an S corporation who performs services as an employee of the S
corporation is subject to FICA tax on his or her wages, but generally is not subject to FICA tax
on amounts that are not wages (such as distributions to shareholders).133 Nevertheless, an S
corporation employee is subject to FICA tax on the amount of his or her reasonable
compensation, even though the amount may have been characterized as other than wages. A
significant body of case law has addressed the issue of whether amounts paid to shareholder
employees of S corporations constitute reasonable compensation and therefore are wages subject
to the FICA tax, or rather, are properly characterized as another type of income that is not subject
to FICA tax. 134
130
See Chapter 21 of the Code.
131
Sec. 1401.
132
Sec. 1402(a)(13). For this purpose, limited partner status is determined under State law.
133
Though unrelated to the FICA tax, present law provides that an S corporation is treated as a partnership
and a two-percent shareholder is treated as a partner, for purposes of applying rules relating to employee fringe
benefits. Sec. 1372.
134
See, e.g., Renewed Focus on S Corp. Officer Compensation, AICPA Tax Division’s S Corporation
Taxation Technical Resource Panel, Tax Advisor, May 2004, at 280.
36
Compliance Issue
The employment tax treatment of partners who are neither limited nor general partners is
uncertain. In particular, owners of a limited liability company may view themselves as
comparable to limited partners, even though they are not limited partners under applicable State
law. This uncertainty makes compliance with the law difficult for taxpayers and administration
of the law difficult for the IRS. The uncertainty in treatment creates an opportunity for abuse by
taxpayers willing to make the argument that they are not subject to any employment tax (FICA
or self-employment), even though this argument is contrary to the spirit and intent of the
employment tax rules. In addition, the increasing ability of individuals who are limited partners
under State law to perform services for the partnership suggests that the limited partner rule is
out of date and should be changed.
It has become increasingly common for individuals who perform services in businesses
that they own to choose the S corporation form to seek to reduce their FICA taxes. S corporation
shareholders may pay themselves wages below the wage cap, while treating the rest of their
compensation as a distribution by the S corporation in their capacity as shareholders.135 They
may take the position that no part of the S corporation distribution to them as shareholders is
subject to FICA tax. While present law provides that the entire amount of an S corporation
shareholder’s reasonable compensation is subject to FICA tax in this situation, enforcement of
this rule by the government may be difficult because it involves factual determinations on a caseby-case basis. A 2005 study stated that “the S corporation form of ownership has become a
multibillion dollar employment tax shelter for single-owner businesses.”136
More broadly, there are significant differences in the employment tax treatment of
individuals who are owners of interests in passthrough entities and who perform services in the
business. S corporation shareholder-employees are treated like other employees (i.e., subject to
FICA), whereas a broader category of income of some partners (other than limited partners) is
subject to self-employment tax. These discontinuities cause taxpayers’ choice-of-business form
decisions to be motivated by a desire to avoid or reduce employment tax, rather than by nontax
considerations. The NRP updated estimate of the gross tax gap for 2001 included an estimated
$39 billion of the tax gap attributable to self-employment tax and an estimated $15 billion of the
tax gap attributable to FICA and unemployment taxes.137
Description of Proposal
Several approaches could be effective in addressing these compliance problems. One
approach would be to provide a uniform rule for owners receiving compensation from
passthrough entities (i.e., partnerships and S corporations). That approach provides that the
present-law rule for general partners generally applies to any partner of a partnership, or
135
Because the HI tax has no wage cap, this approach may be viewed as a tax planning opportunity with respect to
HI tax even at higher wage levels.
136
Treasury Inspector General for Tax Administration, Actions are Needed to Eliminate Inequities in the
Employment Tax Liabilities of Sole Proprietorships and Single-Shareholder S Corporations, May 2005, Reference
No. 2005-30,080, at 2. The report discusses options for addressing the compliance problem, including an option to
apply employment tax generally to the operating income of an S corporation in which any one individual (including
his or her family members) owns more than 50 percent of the stock. Id. at 18-1 9.
137
Internal Revenue Service, IRS Updates Tax Gap Estimates, IR-2006-28, Feb. 14,2006.
37
shareholder of an S corporation, for determining the individual’s net earnings from selfemployment.138
A more targeted approach, more narrowly focusing on income from labor, might
concentrate on income from service businesses conducted through passthrough entities (i.e.,
partnerships and S corporations). This approach, limited to service businesses, might provide that
the present-law rule for general partners applies to any partner for determining net earnings from
self-employment, provided the partnership is a service partnership. For this purpose, a service
partnership is a partnership (including an LLC or other entity that is treated as a partnership for
Federal income tax purposes), substantially all of whose activities involve the performance of
services in the fields of health, law, engineering, architecture, accounting, actuarial science,
performing arts, or consulting (similar to sec. 448(d)(2)). Similarly, for purposes of employment
tax, an S corporation that is a service business is treated as a partnership and shareholders of the
S corporation are treated as general partners. Wages paid to a shareholder employee of an S
corporation would not be treated as deductible by the S corporation for employment tax
purposes. Regulatory authority is provided under the proposal to prevent avoidance of the
provision through the aggregation of business activities within entities or the recharacterization
of income as other than service income (e.g., as rent, interest, or gain).
Discussion
The conceptual premise of the proposal relating to service businesses is that the base for
the employment and self-employment tax should be labor income. Historically, the employment
tax has applied to labor income, relating very roughly to the rules for accruing benefits under the
Social Security system, which require the individual to perform quarters of labor.139 The
proposal applies this notion more uniformly than does present law to individuals who perform
services for or on behalf of a service business conducted by a passthrough entity in which they
own an interest (i.e., a partnership, limited liability company, or S corporation). The proposal
treats such individuals similarly to sole proprietors in service businesses, as well as similarly to
138
Joint Committee on Taxation, Options to Improve Tax Compliance and Reform Tax Expenditures, JCS-02-05
(January 27,2005), 95. Under that proposal, all partners and S corporation shareholders are subject to selfemployment tax on their distributive share (whether or not distributed) of income or loss of the partnership or S
corporation. As under present law, specified types of income or loss are excluded from net earnings from selfemployment, such as certain rental income, dividends and interest, certain gains, and other items. However, under
the proposal, in the case of a service partnership or S corporation, all of the partner’s or S corporation shareholder’s
net income from the partnership or S corporation is treated as net earnings from self-employment. A service
partnership or S corporation is one, substantially all of whose activities involve the performance of services in the
fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting (similar
to sec. 448(d)(2)). Wages paid to a shareholder employee of an S corporation would not be treated as deductible by
the S corporation for employment tax purposes. If, however, any partner (regardless of whether he or she is a
general partner, limited partner, or neither a general nor limited partner, such as a limited liability company member)
or S corporation shareholder does not materially participate in the trade or business of the partnership, a special rule
provides that only the partner’s reasonable compensation from the partnership is treated as net earnings from selfemployment. Thus, some general partners who would be subject to self-employment tax on their distributive share
of partnership income under present law will be subject to tax only on reasonable compensation from the partnership
under this approach.
139
See Patricia E. Dilley, Breaking the Glass Slipper - Reflections on the Self-Employment Tax, 54 Tax Law. 65
(Fall 2000) at note 18. Benefit accruals have historically been tied to performance of labor (quarters of service), but
the amount of FICA taxes collected does not necessarily relate to the individual’s Social Security benefits.
38
each other. Not only does this more uniform treatment improve the fairness of the tax law and
increase the internal theoretical consistency of the tax rules, it also tends to improve tax
neutrality by reducing the importance of FICA and self-employment tax differences in taxpayers’
choice of business entity.
The self-employment tax (and the earlier-instituted FICA tax) were originally designed
both to measure Social Security benefit accruals by determining whether individuals earned
income from working, and to collect revenues to fund such benefit accruals.140 However,
taxpayers’ incentives have changed as the wage base and the resulting tax cost to individual
taxpayers of accruing benefits has risen, and the value of Social Security benefits to high-income
taxpayers has become relatively lower as a percentage of income. A portion of Social Security
benefits became taxable to higher-income individuals in 1984.141 The motivation of higher
income taxpayers to avoid the employment tax was further increased by the elimination of the
cap on the HI component of the tax by the Revenue Reconciliation Act of 1993.142 Benefits
under the HI component that may be paid to the taxpayer in the future generally do not increase
as the tax cost of the HI component to the taxpayer increases. Rather than having an incentive to
accrue benefits, taxpayers now have the opposite incentive: to avoid or reduce the tax cost,
which may exceed the value to them of the social insurance benefit. The tax rules are not
currently designed to prevent avoidance, and indeed, may facilitate it because the rules apply
unevenly depending on whether the taxpayer chooses to do business through an S corporation,
partnership, or sole proprietorship. Eliminating this unevenness, at least with respect to service
businesses, not only increases the fairness of the tax as between similarly situated taxpayers, but
also is consistent with a purpose to raise revenue from labor income among all workers
comparably.
In particular as it relates to S corporation shareholders, the proposal relating to service
businesses aims to reduce the use of S corporations to avoid the employment tax by
recharacterizing wages from service businesses as some other type of S corporation distribution.
Disparate treatment of wages and other distributions under present law creates an undesirable
incentive for individuals performing services to avoid FICA tax on labor income, including on
the uncapped HI component, by setting up business as an S corporation and characterizing as
wages a small amount of service income below the wage cap, while the rest is passed through the
S corporation to the shareholder-employee free of FICA tax.
Under the proposal, taxpayers’ choice of entity for service businesses is not skewed by
differing FICA and self-employment tax results. By treating S corporation shareholders who
perform services for or on behalf of the S corporation’s service business in the same manner as
140
See Dilley, supra, at notes 23-30.
141
Social Security Amendments of 1983, Pub. L. No. 98-21, sec. 121(a) (1983). Both the FICA and the
SECA tax bases have two components, OASDI and HI. Under the OASDI component, the rate of tax is 12.40
percent. Under the HI component, the rate is 2.90 percent. The amount subject to employment tax under the OASDI
component is capped for 2012 at $110,100 of wages and for 2013 at $113,700 of wages (under FICA) or selfemployment income (under SECA) (for 2009, 2010, and 2011 it had been capped at $106,800). However, the
amount subject to the HI component is not capped.
142
Because eligibility for hospital insurance under Medicare is based on an individual’s quarters of
coverage, not the amount of the individual’s wages, paying HI tax on higher wages does not increase the
individual’s Medicare benefits.
39
partners who perform services for or on behalf of the partnership’s service business, the proposal
improves the neutrality of the tax law.
The proposal has the effect of applying the self-employment tax collection system to S
corporation shareholder-employees, rather than the withholding regime that applies to them
(along with other employees) under the present-law FICA tax rules. There are both drawbacks
and advantages to this approach. One drawback is that withholding may be a more effective and
faster collection mechanism than self-assessment as under the self-employment rules. Another is
that the income tax deduction for wages or compensation paid by an S corporation would have to
be added back or disallowed for employment tax purposes calculating self-employment tax of
the S corporation shareholder.
Other disadvantages would arise from retaining the FICA withholding system from some
compensation while imposing the self-effecting SECA rules on other compensation of the same
individual. For example, preserving a withholding regime on S corporation shareholder wages,
and imposing self-employment tax only on the portion of the shareholder’s distributive share that
exceeds previously taxed wages, would require a mechanism to prevent double-counting from
one taxable year to the next, which could impose additional administrative and recordkeeping
burdens on the S corporation. Imposing two separate employment tax regimes on S corporation
compensation payments to one individual could be criticized as unnecessarily complex.
Therefore, the proposal applies the self-employment tax rules to S corporation shareholderemployees of service businesses in the same manner that those rules apply to partners in service
partnerships.
Focusing on service businesses could be viewed as an incomplete capture of labor
income earned through passthrough entities, as labor income is also earned by employee-owners
of passthrough entities conducting capital-intensive businesses. Nevertheless, targeting the
proposal to service businesses has the advantage that it is not very likely to affect non-labor
income, and is at the same time likely to address FICA or SECA tax avoidance opportunities in
which taxpayers now may attempt to engage.
Limiting the proposal to service businesses provides several simplification benefits.
Focusing on service businesses may eliminate any need for a bifurcated approach to income from
labor and from capital. In the case of a service business, it is assumed that the income is
generally from personal services. Previous proposals have suggested that the self-employment
tax not apply to income from a business that is from capital rather than from labor. For example,
one way to attempt to limit employment tax to labor income would be to provide a special rule to
exclude from the employment tax base some measure of the return on capital, in the case in
which a business pays a worker-owner a return that represents income both from his or her labor,
and from his or her capital invested in the business.143 This type of approach raises
administrability concerns, as rates of return (including return on capital) can vary significantly
143
The AICPA has proposed this type of approach to modernize the self-employment tax reference to
limited partners in section 1402(a)(13). See Letter of David A. Lifson, Chair, Tax Executive Committee of AICPA,
to the Honorable William V. Roth, Chairman, Senate Committee on Finance, dated June 22, 2000, enclosing such a
recommendation originally made by letter dated July 6, 1999. The AICPA proposal would provide that if the partner
works less than a minimum number of hours in the partnership’s business, none of his income would be treated as
subject to the self-employment tax. The AICPA proposal would provide that a limited liability company owner’s
income would be treated as subject to the self-employment tax, except for a defined rate of return on his capital in
the partnership.
40
among different types of businesses, at different times in the life of a business activity, and with
different management of the business, among other factors.144 By way of comparison, no such
special rule is provided under present law for sole proprietors subject to the self-employment tax.
Another simplification benefit of limiting the proposal to service businesses is to
eliminate the need for the present-law inquiry into whether the individual’s compensation from
the service business is reasonable, for employment tax purposes.145 This inquiry is inherently
factual and can cause uncertainty in some cases, encourage taxpayer noncompliance, and give
rise to disputes and litigation. The question of whether an individual’s compensation is
reasonable is one that has been repeatedly addressed in case law. The addition of the independent
investor test used in the Seventh Circuit and partially adopted in some other Circuits has changed
the previously predictable analysis under the multi-factor test applied in many judicial decisions
to determine reasonable compensation.
144
Alternatively, this approach might specify a definition for a reasonable rate of return on capital. It could
be based, for example, on a percentage or multiple of the applicable Federal rate, as defined under present law.
While this approach may conceptually take account of a partner’s return on capital, it may not represent the simplest
and most direct approach, nor would it be accurate in most cases.
145
Reasonable compensation has also been suggested as a standard for determining the net earnings from
self-employment of all limited partners and LLC members, but the administrative concerns with the standard could
make this approach less attractive than the more mechanical approach taken under the proposal.
41
APPENDIX III
New York State Bar Association Report 1247
November 2011
Summary of Recommendations
A.
Definition of “Limited Partner” for Purposes of Section 1402(a)(13): Adopt a
“Material Participation” standard analogous to that of Section 469. Regulations should
be issued under Section 1402 delineating the meaning of the phrase “any item of income
or loss of a limited partner” contained in subsection (a)(13). We recommend that the
regulations give no weight to state law classifications; instead, we recommend that the
distinction between “limited partner” and someone other than a limited partner for
purposes of (a)(13) be determined pursuant to a test that looks at what the individual
actually does; we recommend using guidelines similar to those contained in the “material
participation” rules of Temporary Treasury Regulations Section 1.469-5T(a). In the case
of a “service partner” in a “service partnership” (terms we discuss below), we
recommend that all of the income or loss of that service partner attributable to the
provision of services by the partnership (whether or not by that partner) not be treated as
“income or loss of a limited partner” for purposes of Section 1402(a)(13).
B.
Definition of “Service Partnership” and “Service Partner.” Given our
recommendation above, regulatory guidance will need to define the terms “service
partnership” and “service partner.” We generally support the definition used in the 1997
Proposed Regulations, which focused on certain enumerated businesses that are not
capital-intensive enterprises, but would eliminate the requirement that “substantially all”
of the partnership’s activities involve the performance of the relevant services. We also
recommend that consideration be given to including other non-capital intensive
businesses within the scope of “service partnerships.”
C.
Bifurcation Issues. We make certain recommendations regarding situations where a
person might hold multiple classes of interests. In the case of service partnerships, we
generally do not support bifurcation; rather, we recommend that a service partner’s
distributive share of income from a service partnership attributable to the provision of
services by that partnership be treated as income of a “general partner,” regardless of
whether that service partner holds different classes of interests for state law purposes. In
the cases involving “non-service” partnerships, interests that are identical to those held by
a person who is not a “material participant” could be treated as “limited partner”
interests, recognizing that income attributable to such interests should then be subject to
the tax imposed by Section 1411.
D.
Tiered Structures. Special provisions should be included to address, to the extent
possible, tiered partnership structures, particularly where a member of an upper tier
partnership materially participates in the activities of a lower tier partnership.
E.
Retired Partners. Any guidance should make clear that the provisions will not override
the exception contained in Section 1402(a)(10) for retired partners.
F.
Application of Section 1411 to Investment Partnerships. Future regulations or other
guidance should clarify that, subject to certain limited exceptions, all net income
42
allocable to the carried interest of a typical investment partnership that otherwise
constitutes “net investment income” should be subject to tax under Section 1411 without
regard to whether such individual (or any upper-tier partnership of which such individual
is a member) is engaged in a trade or business and without regard to whether such
individual “materially participates” in that trade or business.
43
APPENDIX IV
American Bar Association Section of Taxation Report (December 2, 2011)
Executive Summary
1.
Partners as Employees. The position of the Internal Revenue Service (the “Service”) is
that a partner who performs services for his/her partnership cannot be classified as an
employee, even if the partner would be an employee under general tax law principles and
regardless of the size of the individual’s interest in the partnership. Employee status
provides more certainty in the application of the tax rules, more security to the
government in the collection of tax revenue and less administrative cost to the employer
and employee. Therefore, we recommend consideration of the following option: (1) that
partners who would otherwise qualify as employees under general tax principles and who
own 10% or less of the profits and capital of a partnership (“de minimis partners”) may be
classified by their employer partnership as employees, and (2) that the partnership may
make a one-time non-revocable election to treat as wages the guaranteed payments for
services provided to the partnership by all of its de minimis partners.
2.
Income from Self-Employment of Limited Partners. Section 1402(a)(13) provides
that, other than with respect to a guaranteed payment for services, the distributive share
of a limited partner is excluded from self-employment income. The statutory language of
section 1402(a)(13) is outdated since it does not address the tax treatment of new legal
entities such as limited liability companies. In addition, partners who provide both
services and capital to a partnership have no definitive guidance to determine which
portion of their income is subject to SECA. Therefore, we recommend consideration of
the following option: that section 1402(a)(13) be amended to focus on whether income is
attributable to services provided or capital contributed to a partnership (rather than state
law labels) and to provide that income that is attributable to capital is not subject to
SECA. Treasury should be given the regulatory authority to provide clear rules and safe
harbors under this section.
44
APPENDIX V
Congressional Budget Office
The Taxation of Capital and Labor Through the Self-Employment Tax
http://www.cbo.gov/sites/default/files/cbofiles/attachments/09-27-SECA.pdf
September 2012
The Taxation of Labor and Capital Income Under Alternative Options
CBO examined three policy options that would alter the
structure of the SECA tax:
A material participation standard would change the criteria
for determining which partners must pay SECA taxes on
their share of business income and extend those criteria to
LLC members. Such a standard would clarify much of the
ambiguity surrounding the SECA tax but, on balance,
would subject more income from capital to the selfemployment tax.
A reasonable compensation standard for identifying labor
income and including it in the SECA tax base would
exclude capital income from the SECA tax base by
definition and require all labor income to be included. If the
option was limited to partnerships (including multimember
LLCs), it would, on average, increase the included share of
labor income. If sole proprietorships were included,
however, the opportunity to mischaracterize labor income
as capital income (a choice not available under current law)
would probably reduce the included share of labor income.
A safe harbor for a return on capital would provide
taxpayers with a formula that used their tangible assets to
calculate how much capital income should be excluded
from the SECA tax base. The policy that CBO examined
would shelter a relatively small share of capital income,
probably reflecting the importance of intangible capital
(such as patents, trademarks, and intellectual property) in
generating income for unincorporated businesses.
Furthermore, such a policy would reduce the included share
of labor income in cases where the return on capital was
less than the safe-harbor amount.
45