Wider Material Participation Rules Could Increase Self-Employment Tax
In three recent cases, the Tax Court and Court of Federal Claims have held that a member of a limited liability company (LLC) or a limited liability partnership (LLP) should be treated as a general partner rather than presumptively as a limited partner for purposes of testing for material participation under the IRC § 469 passive activity rules.
See Garnett, 132 TC 19 (2009); Thompson, 87 Fed. Cl. 728 (2009); and Newell, TC Memo 2010-23. For previous JofA coverage, see “Deducting LLC Losses,” May 2010, page 70, and “Losses From Interests in LLCs and LLPs Not Presumptively Passive,” Oct. 2009, page 68.
In these cases, the courts have viewed the ability to participate in management as a more significant factor than limited liability in making this determination. While this may be a welcome development for holders of interests in pass-throughs that have recorded losses, it may be a double-edged sword. Members of an LLC or partners of an LLP who rely on these cases could be assessed self-employment taxes.
MATERIAL PARTICIPATION BY A LIMITED PARTNER
Generally, an individual who does not materially participate in an activity may deduct losses only to the extent of income from passive activities during the tax year, with any excess loss carried forward. Under Temp. Treas. Reg. § 1.469-5T(a), most taxpayers who meet any of seven tests are regarded as materially participating in an activity for purposes of the passive loss rules. However, under IRC § 469(h)(2), no interest in a limited partnership as a limited partner is treated as an interest with respect to which a taxpayer materially participates, unless the taxpayer meets any of a subset of three of the seven tests of Temp. Treas. Reg. § 1.469-5T(a). The three tests are:
- The individual participated in the activity for more than 500 hours during the tax year;
- The individual materially participated in the activity for any five taxable years (whether or not consecutive) during the previous 10 tax years; or
- The activity is a “personal service activity,” and the individual materially participated in the activity for any three previous taxable years (whether or not consecutive).
A personal service activity is one in any of eight fields also specified as those of personal service corporations subject to a 35% flat corporate income tax rate in section 448(d)(2): health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting, with the addition of “any other trade or business in which capital is not a material income-producing factor.”
For purposes of self-employment taxes, many members of LLCs have treated themselves as limited partners and have therefore reported that their distributive share of income was not subject to self-employment tax under section 1402(a)(13). The recent section 469 court cases did not specifically rule with respect to section 1402. However, if the rationale of the cases were to be applied beyond section 469, this self-employment tax position might be more difficult to sustain. The IRS acquiesced in the result only to the Court of Federal Claims’ holding in Thompson, meaning that it will observe the court’s conclusion in other cases but still disagrees with any or all of the court’s reasoning.
SELF-EMPLOYMENT TAX AND SERVICES
Section 1402(a)(13) generally exempts limited partners of limited partnerships from self-employment tax; however, a limited partner does pay self-employment tax on guaranteed payments received from the partnership for services. There is no statutory guidance on the treatment of members of an LLC. Legislation pending as of this writing, however, could impose self-employment tax on certain partners and perhaps by extension LLC members. Section 413 of the “extenders act” (the American Jobs and Closing Tax Loopholes Act (HR 4213)) would amend section 1402(m)(2) to provide that the section 1402(a)(13) exemption would not apply to partners who provide “substantial services” with respect to any partnership engaged in a “professional service business.” “Substantial services” are not defined in the bill. A professional service business is one whose activities substantially all involve providing services in health, law, lobbying, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, investment advice or management, or brokerage services.
Section 413 of the act has been criticized by many, mostly for its similar effects on certain S corporation shareholders. The partnership provision has been included in all three substitute amendments of the bill that have been considered in the Senate (it passed the House on May 28). As of late July, no version of the legislation (except for a portion—section 501, extending unemployment benefits) had gained the 60 votes needed to overcome a filibuster and bring it to a floor vote.
Also, twice, most recently in 1997 (REG-209824-96, Prop. Treas. Reg. § 1.1402(a)-2), the IRS has proposed regulations that would apply self-employment tax to members of LLCs and other entities treated as a partnership for tax purposes, but it has not issued final regulations.
PROPOSED SECTION 1402 REGS
The proposed regulations focus on the member’s relationship to the LLC in defining who is a limited partner for purposes of section 1402(a)(13). They would exclude an individual who (Prop. Treas. Reg. § 1.1402(a)-2(h)(2)):
- Has personal liability for the debts of, or claims against, the partnership;
- Has authority to contract on behalf of the partnership; or
- Participates in the partnership’s trade or business for more than 500 hours during the partnership’s tax year. Note, however, the exception below. Note also that this test is also one of the material participation tests for limited partners under Temp. Treas. Reg. § 1.469-5T for purposes of the passive loss limitation.
Also, under the proposed regulations, an individual who is a “service partner” in a service partnership (defined as in Temp. Treas. Reg. § 1.469-5T, only without the addition of “any other trade or business in which capital is not a material income-producing factor”) may not be a limited partner.
The proposed regulations provide two exceptions to the exclusions under Prop. Treas. Reg. § 1.1402(a)-2(h)(2) (that is, they would be treated as limited partners). The first would apply to holders of more than one class of interest. Under this exception, if an individual has rights and obligations with respect to a specific class of partnership interest that are identical to those of limited partners owning a substantial and continuing interest in that class, the individual would be treated as a limited partner for that class.
The second exception would apply to holders of one class of interest who are not treated as limited partners solely because they participate in the partnership’s trade or business for more than 500 hours. Under this exception, such an individual is treated as a limited partner if the individual’s rights and obligations with respect to the specific class of interest are identical to the rights and obligations of the specific class of partnership interest held by limited partners owning a substantial, continuing interest in that class.
Following their issuance, the proposed rules were criticized as being too narrow. Congress responded by placing a temporary moratorium on any final regulations. Although the moratorium expired on July 1, 1998, the regulations remain proposed.
It is unclear whether LLC members will be able to sustain the position that they are general partners under section 469 and maintain favorable limited partner status for section 1402 self-employment taxes. It is worth noting, however, that the IRS complained of this alleged inconsistency in Garnett, saying that the taxpayers “obtained a tax benefit by failing to designate their interests as ‘general partner’ interests, in that they thereby avoided self-employment tax.”
Consequently, LLC members who are considering taking a position consistent with the recent court cases for section 469 should evaluate the potential self-employment tax implications under section 1402.
(Editor’s note: A version of this article appeared in The Tax Adviser, July 2010, page 457.)
By Audrey Ellis, Esq., LL.M., director, (audrey.ellis@us.pwc.com) and Jeffrey Rosenberg, Esq., LL.M., managing director (jeffrey.i.rosenberg@us.pwc.com), both of PricewaterhouseCoopers, Washington, D.C.
To comment on this article or to suggest an idea for another article, contact Paul Bonner, senior editor, at pbonner@aicpa.org or 919-402-4434.
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