Partners’ Income Allocations and the New Net Investment Income Tax

Editor: Jon Almeras, J.D., LL.M.

Partners & Partnerships

Starting in 2013, the Patient Protection and Affordable Care Act, P.L. 111-148, and the Health Care and Education Reconciliation Act of 2010, P.L. 111-152 (health care acts), impose a new 3.8% income tax on net investment income (less applicable expenses) for high-income individual taxpayers. Since the U.S. Supreme Court upheld the constitutionality of the health care acts (National Federation of Independent Business v. Sebelius, Sup. Ct. Dkt. 11-393 (U.S. 6/28/12)), it is important for owners of business entities structured as partnerships to consider their income streams and the tax effect on partners who are taxed as individuals. In particular, these partnerships may be in a position to arbitrage between the net investment income tax and self-employment (SE) tax for their partners and potentially limit the effect of both taxes by altering the partnership’s legal structure.

Background on Self-Employment Taxes

Many self-employed individuals and partners in a partnership are subject to the SE tax for “net earnings from self-employment” under Secs. 1401 and 1402. SE tax generally has two main components: (1) a 12.4% tax for “old age, survivors, and disability insurance” (Social Security tax); and (2) a 2.9% tax for “hospital insurance” (HI, or Medicare, tax). An annual cap limits the amount of income subject to the 12.4% Social Security portion of the SE tax ($113,700 for tax year 2013), but the cap does not apply to the 2.9% HI tax. To put partnerships on an equal footing with corporate employers, partners who are individual taxpayers may deduct 50% of both parts of the SE tax from gross income in determining their federal income tax liabilities; this deduction excludes the new 0.9% additional Medicare contribution tax on earned income for certain higher-income individual taxpayers.

This item does not focus on general income tax rules or the 12.4% Social Security portion of SE tax, but instead discusses the HI portion (including the 0.9% additional Medicare tax) and the net investment income tax and their effect on partners. The examples below focus on that part of the SE tax and on the net investment income tax.

Net Earnings From Self-Employment

Sec. 1402 generally states that, in determining net earnings from self-employment, a partner must include his or her distributive share of partnership ordinary trade or business income (subject to some exclusions for rental real estate income, interest, dividends, capital gains, etc.).

Example 1: Partner A, with adjusted gross income (AGI) in excess of $1 million, is a one-third partner in ABC general partnership and receives an ordinary trade or business distributive share allocation of $10,000 for the year ending Dec. 31, 2013. Partner A’s activity in ABC is nonpassive under Sec. 469. If income tax rules and Social Security tax are ignored, this $10,000 generally would be subject to the effective HI tax rate of 3.23% (net of the 50% deduction for the 2.9% HI tax; the 0.9% additional Medicare contribution tax is not deductible), or a tax of $323, calculated as follows:

• $10,000 × 3.8% combined HI and additional Medicare contribution tax rates = $380 tax

• $10,000 × 2.9% HI tax) × 50% = $145 deduction from income for HI tax
• $145 deduction × 39.6% (highest individual tax rate) = $57
• $380 – $57 = $323 tax after taking deduction for HI tax into account

Self-Employment Tax on Limited Partners

The general SE tax rules provide an important exception for limited partners. Sec. 1402(a)(13) states that “there shall be excluded the distributive share of any item of income or loss of a limited partner” from the SE tax. Further, Prop. Regs. Sec. 1.1402(a)-2(h) states that if a partner holds a limited partner and general partner interest in a limited partnership, the SE tax applies only to the income allocated to the general partner interest.

This statutory exception does not take into account a limited partner’s participation, or level of activity, in the limited partnership. In 1997, Treasury issued proposed regulations under Sec. 1402 that sought to impose mechanical tests like those under the passive activity rules of Sec. 469. Believing Treasury had overstepped its authority, Congress imposed a one-year moratorium on the proposed regulations in July 1997 (see Section 935 of the Taxpayer Relief Act of 1997, P.L. 105-34).

Since then, although the moratorium expired long ago and the rules are still in proposed form, many tax practitioners have assumed that the mechanical tests do not apply and instead state law treatment of an individual as a limited partner controls whether the Sec. 1402(a)(13) exception applies. In addition, tax practitioners have disagreed on whether this exception applies to members of a limited liability company (LLC). Some practitioners apply the mechanical tests from the 1997 proposed regulations, while others believe that the exception should apply to the distributive share earned by an LLC member, but not to any guaranteed payments as provided under Sec. 1402(a)(13) for partners. Yet others believe that none of the income earned by an LLC member qualifies for the exception.

Revised Uniform Limited Partnership Act (RULPA) Section 303(a) provides that “a limited partner is not liable for the obligations of a limited partnership unless . . . he (or she) participates in the control of the business. However, if the limited partner participates in the control of the business, he (or she) is liable only to persons who transact business with the limited partnership reasonably believing, based upon the limited partner’s conduct, that the limited partner is a general partner.” Hence, for purposes of legal liability, the role of the limited partner must be clearly defined and monitored.

The authors are not aware of any situations in which the IRS has challenged the status of a limited partner in a limited partnership as such by reference to state law or RULPA. However, the IRS has successfully challenged the treatment of partners in a limited liability partnership (LLP). As a result, the LLP partners were not entitled to the Sec. 1402(a)(13) exception. See, e.g., Renkenmeyer, Campbell, and Weaver LLP, 136 T.C. 137 (2011).

Example 2: Assume the same facts as Example 1, but partner A is a limited partner of XYZ, a limited partnership. Partner A does not violate the rules of RULPA Section 303(a). The $10,000 of income allocated to A is not subject to the HI tax. Partner A’s status as a limited partner qualifies him for the Sec. 1402(a)(13) exception.

Traditionally, partnerships could structure the business to provide their partners with an allocation of income that is exempt from SE tax. A common example is a hedge fund manager who is a partner in the actual hedge fund and receives a promote or incentive fee (commonly called a “carry”) in the form of an allocation of the fund’s profits, taxed as capital gains, instead of a fee payment, which is ordinary compensation income and subject to SE tax.

Example 3: Assume the same facts as Example 1, except partner A is a limited partner in XYZ, a limited partnership. Partner A does not violate RULPA rules and receives an income allocation of short-term capital gain, instead of an ordinary trade or business distributive share allocation, for the tax year ending Dec. 31, 2012. The same $10,000 of income is not subject to HI tax under the exception in Sec. 1402(a)(3) for capital gains. The income would be subject to the net investment income tax for tax years after 2012.

Thus, before 2013, the carry allocation would be subject only to income tax. However, in light of the net investment income tax imposed by the health care acts, investment managers should reconsider their business structures. A partner who previously received an allocation of net investment income may gain tax efficiency by receiving an ordinary income allocation as a limited partner instead.

Net Investment Income Tax

The 3.8% net investment income tax rate imposed by the health care acts equals the regular 2.9% HI tax plus the 0.9% additional Medicare tax; however, the net investment income tax is not deductible for an individual taxpayer. As noted earlier, for taxpayers in the 39.6% tax bracket, the net rate for the combined HI and additional Medicare taxes is 3.23% because of the former’s deductibility.

For purposes of the new 3.8% net investment income tax, net investment income includes interest, dividends, annuities, royalties, rents, and other gross income attributable to passive activities and trades or businesses of trading in financial instruments and commodities, less certain expenses. Treasury recently issued proposed regulations that clarify these rules (REG-130507-11).

Example 4: Assume the same facts as Example 1, except partner A receives an income allocation of short-term capital gain instead of an ordinary trade or business distributive share allocation. The same $10,000 of income is now subject to the net investment income tax of 3.8%, or a tax of $380.

This example indicates that net investment income is now subject to a higher tax rate than the effective rate for the HI and additional Medicare tax portions of SE tax. Partnerships that have the ability to control the character of their income may be in a position to reduce the impact of both the HI and net investment income taxes.

The net investment income tax permits deductions that are “properly allocable” to the income or gain. For partnerships that invest in passively managed real property, depreciation and operating expenses should be included as allocable expenses. In addition, tax preparation fees, which are indirect expenses, may qualify (Sec. 1411(c)(1)(B)).

Limitations on the deductibility of expenses imposed at the individual taxpayer level generally will apply when determining whether an expense is properly allocable to investment income. For example, if a hedge fund is treated as engaged in a trade or business, such expenses are generally deductible under Sec. 162 without limitation. Yet, expenses of a hedge fund treated as an investment, or those of the typical private-equity fund, are generally subject to limitations imposed under Sec. 212. If these expenses are ultimately determined to be nondeductible under Sec. 212, they would not be deductible in determining the net investment income tax. Similarly, in either a hedge or a private-equity fund that uses leverage, interest expense may only be deductible in determining the net investment income tax after it has been subjected to the limitations imposed by Sec. 163(d) on investment interest expense; under the proposed regulations, these limitations would apply for purposes of the net investment income tax as well (preamble to REG-130507-11).

Sec. 1411(c)(6) specifies that the net investment income tax is not applicable to any income that would be subject to the SE tax under Sec. 1401(b); therefore, it could be concluded that this includes nonpassive income that does not fall within the scope of Sec. 469. It is important to note, however, that the net investment income tax does apply to income from investing or trading in financial instruments and commodities.

Example 5: Assume the same facts as Example 1, except partner A, a limited partner who does not violate RULPA in the limited partnership of XYZ, receives an income allocation of ordinary trade or business income of $10,000. Partner A has neither an HI nor a net investment income tax liability for this income. (Note that partner A acts in the capacity of a limited partner under RULPA and applicable state law. Again, the authors are not aware of the IRS challenging partner status under RULPA.)

Secs. 1411(b) and (d) provide that the net investment income tax applies to the lesser of net investment income or modified AGI (MAGI) above $200,000 for individuals and heads of household, $250,000 for joint filers and surviving spouses, and $125,000 for married taxpayers filing separately. MAGI is AGI increased by foreign earned income that is otherwise excluded under Sec. 911.

Conclusion

Careful attention to the structuring of a partnership may be useful for certain limited partners who receive ordinary trade or business income. Although structural planning clearly involves more than tax considerations, certain legal structures may decrease the individual partner’s overall tax liability. The health care acts, along with recently issued Treasury guidance on the applicability of the additional Medicare tax (REG-130074-11), may prompt partnerships to reevaluate the potential tax impact of the structure on their individual partners.

EditorNotes

Jon Almeras is a tax manager with Deloitte Tax LLP in Washington, D.C.

For additional information about these items, contact Mr. Almeras at 202-758-1437 or jalmeras@deloitte.com.

Unless otherwise noted, contributors are members of or associated with Deloitte Tax LLP.