Historically, distributive shares of partnership income to a general partner are treated as net earnings from self-employment and are subject to Self-Employment Contributions Act taxes. At the same time, earnings from an S corporation that are allocated to its shareholders are not treated as net earnings from self-employment and are not subject to SECA tax. A number of factors can affect the decision whether to conduct a business as a partnership, S corp, or another type of entity; this difference in employment tax treatment can be important.
Recognizing this disparity, the Treasury, in the administration’s 2016 budget, has proposed that income from a professional service business be subject to SECA taxes in the same manner, regardless of the form of the business. Such a change may eventually provide a certain degree of equity among entities, as well as removing the challenge of figuring out where to slot limited liability companies into the SECA framework. Nevertheless, it should not be lost on taxpayers that the Treasury proposal resides within a section called “Loophole Closers” and is scored to raise almost $75 billion over 10 years. Furthermore, without some accommodation to separate reasonable compensation from what may be considered a return on investment, a degree of uncertainty is likely to remain.
Code Sec. 1401(a) and (b) impose a tax on self-employment income of 12.4 percent, plus a hospital insurance tax of 2.9 percent, for a combined rate of 15.3 percent. Under Sec. 1402, the tax applies to net earnings from self-employment, defined as the gross income derived by an individual from any trade or business carried on by the individual.
Reg. Sec. 1.1402(a)-1(a)(2) and 1.1402(a)-2(d) impose the tax on a member’s distributive share of partnership income from a trade or business. However, Code Sec. 1402(a)(13) excludes from SECA tax the distributive share of partnership income allocated to a limited partner. Interestingly, Reg. Sec. 1.402(a)-2(g) treats partnership income as net earnings from self-employment “irrespective of the nature of [the partner’s] interest” and even if the member is a “limited or inactive partner,” but this provision as interpreted over the last several years apparently does not affect the basic exclusion for limited partners.
While the code and regs do not discuss S corp earnings, the IRS early on in Rev. Rul. 59-221 concluded that an S corp shareholder’s distributed and undistributed dividends are not derived from a trade or business carried on by the shareholder. Accordingly, amounts included in income are not net earnings from self-employment for SECA taxes. The IRS and the courts have affirmed this treatment. See, for example, Ding v. Commissioner (9th Cir., December 30, 1999, 2000-1 USTC ¶50,137, affg TC Memo. 1997-435), where the taxpayer sought to deduct S corp losses from the self-employment earnings. The court specifically “recognized the continuing validity” of the 1959 revenue ruling. Of course, a shareholder can also be an employee, which is often the case, and compensation for those efforts must be “reasonable.”
The IRS and taxpayers have litigated the treatment of a partner’s earnings by arguing whether the partner derived the income as a limited partner or in some other manner. In the case of LLCs, the IRS has argued that owners of interests in an LLC do not hold an interest as a limited partner and therefore are subject to SECA taxes as general partners. Taxpayers, on the other hand, have argued that LLCs are different entities from limited partnerships and that interest holders should not be classified according to traditional analysis as either general or limited partners.
A recent court case demonstrates the continuing relevance of the self-employment tax issue. In Methwin v. Commissioner, T.C. Memo. 2015-81, CCH Dec. 60,295(M), the Tax Court concluded that an investor in several oil and gas ventures was subject to SECA tax on his earnings from the ventures because they were partnerships and he was a member. The investor had a small interest in the ventures (2-3 percent) and was not personally involved in any business activity. Furthermore, because the ventures had made a Code Sec. 761 election to be excluded from Subchapter K of the Tax Code (the partnership provisions), the investor argued that the venture was not a partnership.
The court stated that, based on Cokes v. Commissioner, 91 T.C. 222 (1988), CCH Dec. 44,792, a taxpayer who is not active in the management of a trade or business may still be liable for SECA tax if the business is carried out through a partnership of which he is a member. The court determined that the venture continued to be a partnership, despite its election out of Subchapter K. Again citing Cokes, the court said that “a partnership remains a partnership and other sections of the code [such as Sec. 1401] are applicable as if no exclusion [from Subchapter K] existed.”
1. IRS activity. The IRS issued proposed regs in 1997 (REG-209824-96, Jan. 13, 1997) that would treat an individual as a limited partner (not subject to SECA tax) unless the individual:
- Has personal liability as a partner for claims against the partnership;
- Has the authority to contract on behalf of the partnership under state law; or,
- Participates in the partnership’s trade or business for more than 500 hours during the partnership’s tax year.
The proposed regulations provide exceptions for certain individuals owning both general and limited interests in the partnership and certain individuals working more than 500 hours during the year.
These regulations have not been adopted or withdrawn. Commentators have suggested that the IRS unofficially follows the regulations even though they are in proposed form. In any case, in its latest business plan on potential guidance (2014-2015 Priority Guidance Plan, Third Quarter Update, released April 28, 2015), the IRS proposed to provide “Guidance on the application of Sec. 1402(a)(13) to limited liability companies.”
2. Treasury budget proposal. In discussing its FY 2016 “greenbook” proposal (“Conform Self-Employment Contributions Act (SECA) Taxes For Professional Service Businesses”), the Treasury stated that “the taxation of income earned by owners of pass-through entities is outdated, unfair and inefficient” because it treats business owners differently based on the legal form of the entity and the payment they receive. Many owners avoid payroll taxes on income that is equivalent to self-employment earnings and would otherwise be subject to employment taxes, the Treasury indicated.
The Treasury also noted that S corp owners game the system by paying themselves low salaries, which are subject to employment taxes, and inflating their dividends. Dealing with this problem, according to the Treasury, is “a challenge for the IRS to administer. The determination of reasonable compensation’ of S corporation owners generally depends on facts and circumstances and is difficult for the IRS to enforce.”
The Treasury proposal would apply to professional service businesses organized as S corps, limited partnerships, general partnerships, and LLCs taxed as partnerships. In an effort to make this change not entirely one-sided in favor of the government, a proposal earlier in 2014 by then-Ways & Means Committee Chair Dave Camp would allow partners and S shareholders to take a 30 percent deduction to account for capital and up to 100 percent for those who did not materially participate in the entities activity.
Most taxpayers are sensitive to their liability for employment taxes and prefer to avoid the application of SECA taxes of 15.3 percent on earnings from a trade or business. With the growth of limited liability companies and limited liability partnerships, traditional SECA tax rules have become even more difficult to apply. The issue awaits further action from the IRS, the Treasury, and/or Congress.
George G. Jones, JD, LL.M, is managing editor, and Mark A. Luscombe, JD, LL.M, CPA, is principal analyst, at Wolters Kluwer, CCH Tax and Accounting.
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