Potential Implication of Recent Sec. 469 Court Decisions for Self-Employment Tax Rules

LLCs & LLPs

In several recent cases, courts have held that a member of a limited liability company (LLC) or a limited liability partnership (LLP) should be treated like a general partner for purposes of testing for material participation under the Sec. 469 passive activity rules. (See Garnett, 132 T.C. 19 (2009); Thompson, 87 Fed. Cl. 728 (2009), acq. in result (3/9/10); and Newell, T.C. Memo. 2010-23.) These cases concluded that a member of an LLC or an LLP who can exercise management authority is not automatically treated as a limited partner for purposes of applying the Sec. 469 material participation tests. The courts have viewed the ability to participate in management as a more significant factor than limited liability in making this determination.

Temp. Regs. Sec. 1.469-5T(a) provides seven tests for establishing a taxpayer’s material participation in an activity for purposes of the passive loss rules. However, under Sec. 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, except as provided in the regulations. The regulations apply a much more restrictive standard to limited partners, who can materially participate only to the extent that they meet one of three tests (rather than one of the seven tests). The court cases determined that the taxpayers did not hold LLC units as limited partners and therefore should not be treated as presumptively passive under Sec. 469(h)(2).

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 Sec. 1402(a)(13). The recent Sec. 469 court cases did not specifically rule with respect to Sec. 1402. However, if the rationale of the cases were to be applied beyond Sec. 469, this self-employment tax position might be more difficult to sustain.

Sec. 1402 Overview

Individuals are subject to self-employment tax on net earnings from self-employment income. Net earnings from self-employment are defined under Sec. 1402(a) as gross income derived by an individual from any trade or business carried on by the individual, less deductions, plus the individual’s distributive share of income or loss from any trade or business carried on by a partnership of which he or she is a member.

Self-employment tax is the equivalent of FICA tax in the nonemployee context. The current self-employment tax rate is 15.3%—i.e., the combined rate of the employer’s and employee’s share of the FICA tax. However, a self-employed person may deduct one-half of the self-employment tax from his or her income for income tax purposes. A partnership is not responsible for any portion of the self-employment taxes due with respect to a partner.

Sec. 1402(a)(13) generally excludes 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. Although the statute provides rules for limited partners, there is no statutory guidance on the treatment of members of an LLC. On two occasions, the IRS has proposed regulations on the application of self-employment tax to LLCs, but it has not issued final regulations. The IRS proposed the most recent regulations in 1997 (proposed regulations). As a result of the lack of statutory guidance, it may be necessary to look to the proposed rules under Regs. Sec. 1.1402(a)-2 for IRS guidance as to when a member of an LLC may be considered a limited partner for purposes of Sec. 1402(a)(13).

Proposed Sec. 1402 Regs.

The proposed regulations focus on the member’s relationship to the LLC in defining who is a limited partner for purposes of Sec. 1402(a)(13). They would exclude an individual from the definition if the individual:

• 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.

Under the proposed regulations, an individual who is a service partner in a service partnership may not be a limited partner.

The proposed regulations provide two exceptions under which individuals 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 the proposal of these regulations in 1997, the rules were criticized as being overly narrow. Congress responded by placing a temporary moratorium on any final regulations. Although the moratorium expired on July 1, 1998, the regulations remain proposed.

Potential Application of Recent Case Law to Sec. 1402

The reasoning of the recent Sec. 469 cases could be viewed as supporting the approach taken in the proposed regulations for defining a limited partner under Sec. 1402. As described above, these cases state that limited liability is not the only factor in determining whether a member is a limited partner. Rather, similar to the proposed regulations, the cases state that in determining whether a member should be treated as a general or a limited partner for Sec. 469 purposes, it is more relevant to look at the member’s activities.

If the same reasoning were applied in the Sec. 1402 context, the issue would be whether the member’s activities are more similar to a limited or a general partner in determining whether a partner’s distributive share of LLC income is subject to self-employment tax under Sec. 1402. At this point, it is unclear whether LLC members will be able to sustain the position that they are general partners for Sec. 469 and maintain favorable limited partner status for Sec. 1402 self-employment taxes. Consequently, LLC members who are considering taking a position consistent with the recent court cases for Sec. 469 should evaluate the potential self-employment tax implications under Sec. 1402.

Editor: Annette B. Smith, CPA

EditorNotes

Annette Smith is a partner with PricewaterhouseCoopers LLP, Washington National Tax Services, in Washington, DC.

For additional information about these items, contact Ms. Smith at (202) 414-1048 or annette.smith@us.pwc.com.