IRS will audit more LLCs claiming self-employment tax exemption
TAX ALERT |
Taxpayers who are limited partners or members of LLCs and claim exemption from self-employment taxes may see increased examination activity from the IRS in light of President Biden’s proposals to increase IRS enforcement activity. The Made in America Tax Plan announced the administration’s proposal to increase tax enforcement among corporations and high-income Americans by increasing resources for the IRS. The FY 2022 budget requested an increase of $1.2 billion to the IRS annual budget, $900 million of which will be dedicated to enforcement activities. In addition, President Biden announced he will seek an additional $80 billion over 10 years to fund hiring, training and deploying auditors to focus on complex investigations as well as improve technology the IRS is using in its enforcement efforts. On May 11, 2021, Clifford Warren of the IRS Office of Associate Chief Counsel (Passthroughs and Special Industries) commented at a Practicing Law Institute virtual conference that audits involving LLCs claiming exemptions for self-employment taxes are both ongoing and successful, and cautioned taxpayers to be mindful of the U.S. Tax Court decision in Renkemeyer, Campbell & Weaver LLP v. Commissioner, 136 T.C. 137 (2011).
Self-employment tax exemption overview
Section 1401(a) imposes a tax on the self-employment income of individuals (self-employment tax). This tax is based on net earnings from self-employment, as defined in section 1402(a) and includes a taxpayer’s ‘distributive share’. However, section 1402(a)(13) excludes from self-employment income the distributive share of any item of income or loss of a limited partner, other than amounts constituting guaranteed payments for services. While this exemption seems to clearly apply to a limited partner in a true state law limited partnership, its application to partners in various other ‘limited’ liability state law entities, such as LLPs and LLCs, is less than clear.
In 1997, the Treasury proposed regulations (Prop. Reg. section 1.1402(a)-2) that would have denied the exemption to limited partners who provided substantial services to the partnership, or any services to certain ‘service’ partnerships like law and accounting firms – arguably addressing the perceived abuse. However, the regulations were sufficiently controversial, and were ultimately never finalized (although taxpayers may rely on them thanks to the Services’ internal policy of following its own proposed regulations). Despite this, the Tax Court and the IRS have sought to apply similar policies limiting the exemption in the case of LLCs and LLPs – enter Renkemeyer.
In Renkemeyer, the partners of a law firm claimed the limited partner exemption because the organizational documents had designated their interests as those of limited partners and the partnership benefited from limited liability under state law. In response to the first argument, the court noted that the LLP was not technically a state law limited partnership – observing that, under the Kansas Uniform Partnership Act, it was technically a general partnership that allowed limited liability for its partners. Interestingly, while the court ultimately ruled against the taxpayer, nothing in the ruling suggests it did so because the taxpayers were limited liability partners rather than limited partners in a state-law limited partnership. Instead, the court denied the taxpayers the exemption as a result of the partners very minimal capital contributions (less than $200 for each partner) coupled with the fact that most of the firm’s revenue was generated from legal services performed by the partners in their capacity as such.
Although Mr. Warren cites Renkemeyer as required reading (and validly so), other decisions may shed additional light on the issues. The Tax Court took up the issue most recently in George E. Joseph v. Commissioner (T.C. Memo. 2020-65). That case strongly supports the Renkemeyer conclusion, but notes that it only technically applies to LLCs or LLPs, and does not apply, at least yet, to partnership interests qualifying as limited partnership interests in a state-law limited partnership. Presumably, it would also not apply to an LLC or LP that satisfied the existing proposed regulations. For example, an LLC member of a non-service business that did not have the power to bind the entity, did not have unlimited liability, and did not participate in the business for more than 500 hours would ostensibly be exempt, under the IRS policy of not taking positions contrary to their proposed regulations.
At the same time, taxpayers considering planning for the future should also be aware that the Biden Administration has proposed to eliminate the exception from the 3.8% net investment income tax for certain active partners in certain businesses, which together with a properly structured limited partnership or S corporation, enabled some taxpayers to avoid both SE tax, and the net investment income tax.
For LLCs and their owners who have been relying on the section 1402(a)(13) exemption, the IRS has a very strong case. Those concerned about possible penalties might consider remedial action – such as starting to pay, or filing a qualified amended return for past open years.
For true, state law limited partnerships (LPs) and their partners, the position is much stronger. However, LPs and their partners may find it prudent to review their overall structure, as not all structures afford the same level of strength against scrutiny (size of GP interest, nature of GP powers, nature of LP authority, etc.).
Alternatively, LLCs and their owners might want to consider restructuring as an LP with as good a structure as possible — at least to minimize risk going forward. That is complicated by a number of President Biden’s proposals — some of which would make it more attractive to qualify as an LP, and others less attractive. For example, the President has proposed to apply a 15.3% SE tax (or FICA tax split between employer and employee) for income above $400,000 — not just 2.9% or 3.8%. On the other hand, he has proposed to require NIIT taxes of 3.8% for anyone that would be exempt because they have a ‘good’ LP structure.
Mr. Warren’s comments followed those of other IRS executives, who announced new IRS audit initiatives last year, including examination of high-income individuals with interests in pass-through entities. The IRS also expects to announce a new program for large partnership audits and will continue its campaigns to address Large Business and International tax compliance issues. Taxpayers should consider consulting their tax advisers to better understand these IRS exam initiatives and, in appropriate cases, to be ‘audit—ready’ if, and when, the IRS selects them for audit.