Pass-throughs should review self-employment and NII taxes
New law may lead to increased IRS scrutiny
TAX ALERT |
The 2017 tax changes will lead many partnerships, LLCs, and S corporations to reconsider their choice of entity – possibly becoming C corporations or possibly retaining their pass-through status. For taxpayers continuing to operate as pass-through entities it may be equally appropriate to reconsider the impact of their entity choice on their potential liability for self-employment and net investment income taxes, in light of recent developments. The 2017 law briefly considered repealing the statutory exemption from self-employment taxes for ‘limited partners’ but in the final analysis retained the provisions of current law. Nevertheless, with increased IRS attention on pass-through entities qualifying for the new 20 percent deduction, the IRS may also take a closer look at compliance with the self-employment (SE) and net investment income (NII) tax rules.
In particular, some LLCs or LLPs may wish to consider reorganizing as limited partnerships, or confirming that they qualify for exclusion under the literal terms of the outstanding proposed regulations. Here is a more detailed overview of the current state of the law and potential planning opportunities.
First, there are the relatively clear cases where the SE tax applies – and the NII tax does not apply but only because the SE tax applies instead:
Sole proprietors – including individuals owning a business in the form of a single-member LLC – are subject to self-employment tax on all of their income from the business – whether it is derived from their personal services or from capital investments.
General partners are subject to self-employment tax on all of their income from the partnership – whether it is derived from their personal services or from capital investments.
Partners in partnerships of any type, or LLC members, that receive guaranteed payments for services provided to a partnership or LLC are subject to self-employment tax liability on such payments.
Next, there is the hybrid situation of an S corporation:
S corporation shareholders are exempt from self-employment tax on their share of S corporation income, but may have a portion of that income recast as a disguised wage – subject to FICA taxes imposed on the deemed employer and the deemed employee – if they perform services for the corporation without being paid ‘reasonable compensation.’
While this theoretically makes S corporations attractive for passive investors, a purely passive investor will be subject to the net investment income tax on their S corporation income above the applicable ‘high income’ limits for that tax.
Dual-capacity S corporation shareholders – who have capital invested but also provide sufficient services to qualify for exemption from the net investment income tax – typically more than 100 hours – are in a better situation. As long as they are paid reasonable compensation subject to FICA taxes for their actual services, their S corporation income will be exempt from both self-employment taxes and net investment income taxes. For example, the CEO and owner of an S corporation may have $100 million invested in the company generating $10 million of S corporation income exempt from both SE and NII taxes, while receiving a salary of $1 million for working full time as the CEO, which would be subject to FICA taxes.
The Limited Partner Exclusion – Different Rules For Different Entities
The greatest area of uncertainty surrounds the treatment of partners and LLC members who may try to qualify for the best of all worlds – exemption from the net investment income tax (like active shareholders in S corporations) because they are minimally active in the business (generally requiring more than 100 hours of services) – and exemption from self-employment tax liability under a statutory rule contained in section 1402(a)(13) of the Internal Revenue Code of 1986 (‘IRC’ or ‘Code’).
Unfortunately, the IRS and the courts have been trying to limit the SE benefits for LLCs and LLPs. See, Renkemeyer, Campbell & Weave, LLP v. Commissioner, 136 TC 137 (2011), Howell v. Commissioner, 104 TCM 519 (2012), CCA 201436049, Reither v. United States, 919 F. Supp. 2d 1140 (D. NM 2012), ILM 201640014, Hardy v. Commissioner, TC Memo 2017-16, 113 TCM 1070 , Castigliola v. Commissioner, TC Memo 2017-62, 113 TCM 1296.
As far as the IRS is concerned, partners or members in LLCs and LLPs may be considered subject to SE taxes if they cannot show – using the strict, mechanical rules of the government’s outstanding proposed regulations – that their income represents a return on capital and not personal services income. Where such a showing is made, the IRS will generally honor the proposed regulations even though they are not final. For example, the proposed regulations would apply the exclusion to the income on an ‘investor class’ of membership interests in an LLC, even though the taxpayer was also active, and enjoyed the ability to manage the entity, as a member-manager also holding an interest in a separate class of interests. To qualify as such an ‘investor class,’ the proposed regulations require that, immediately after the taxpayer acquires her interest in that investor class, there are also non-active, non-controlling partners enjoying limited liability that own “a substantial, continuing interest” in that class and whose rights and obligations with respect to that class are identical to those of the taxpayer. In addition, this exception does not apply to ‘service partners’ in certain designated ‘service partnerships.’ There is also a similar rule where there is only one class of generally passive, investor-type interests where an active investor is compensated for his services with a guaranteed payment.
It is important to note, however, that strict compliance with all of the particulars of these proposed regulations may be required, since the IRS is only honoring them as a matter of its internal policy. Thus, a general policy argument that, even though some of the details of the proposed regulations are not satisfied, the law should not reach income that is demonstrably a return on capital but does not strictly satisfy the mechanical tests of the proposed regulations may be greeted with skepticism by the IRS. That may be the case even though such a policy argument finds support in some Tax Court decisions, such as Renkemeyer v. Commissioner, where the Tax Court held that the partners in a law firm operated as an LLP could not avail themselves of the exclusion for their personal services income in the legal profession, but suggested that a different answer might have been obtained with respect to demonstrated returns on capital investments in the business.
The difficulties posed for LLCs or LLPs may lead many taxpayers to consider converting from LLP or LLC form to the form of a true, state law limited partnership. That could include transferring assets to a new LP and liquidating the LLC or LLP, or converting an existing multiple-member LLC into a single-member LLC owned by a limited partnership holding company. Both approaches have their advantages and disadvantages. It appears that the IRS and the courts have not yet challenged the applicability of the ‘limited partner’ exclusion to the distributive share of a limited partner in a limited partnership. Moreover, they would appear to have difficulty doing so for a properly structured entity.
In particular, the recent Tax Court memorandum decision in Castigliola v. Commissioner, TC Memo 2017-62, 113 TCM 1296, suggests that taxpayers should pay careful attention to ensuring that there is a bona fide general partner, who could be an entity owned by some of the limited partners. In addition, taxpayers should ensure that the limited partners, who may provide services for the partnership, do so in such a manner as not to exercise ‘managerial control’ over the partnership in their capacity as limited partners, as might cause them to lose their limited liability shield under state law, which of course would be problematic quite apart from taxes. Generally speaking, an active limited partner may also hold a general partnership interest, through which she may exercise control as an agent or employee of the general partner, consistent with the statutory language and legislative history of the code provisions, but care should be taken in reviewing the applicable partnership agreement and its underlying authorizing law.