There is an issue concerning LLCs
that has existed for approximately as long as I have been in the profession. I
am thinking about it because I recently finished a research memo which included
this issue.
This time we are talking about
limited liability companies (LLCs) and self-employment income. One pays
self-employment tax on self-employment income, and the dollars can add up
rather quickly.
The offending party is the following enchanting
prose from Code section 1402(a)(13) addressing self-employment income:
… there shall be excluded the distributive share of any item
of income or loss of a limited partner, as such, other than
guaranteed payments described in … "
We do not need degrees in taxation to
zero in on the term “limited partner” as being the key to this car. If you are
a limited partner you get to exclude “the distributive share” of something.
Since the IRS wants you to pay tax on something, the less of that something is
probably a good thing.
So what is a limited partner in this
conversation?
We don’t know.
The above wording came from an IRS
proposed Regulation in 1977. The IRS stirred such a hornet’s nest that Congress
put a hold on the Regulation. The hold has long since expired, but the IRS has
not wanted to walk back onto that hill. It has been 37 years.
To be fair, the playing field changed on the
IRS.
Have you ever heard of the Estate of Ellsasser? Don’t worry if you
haven’t, as I suspect that many tax CPAs have not. Let’s time travel back to
1976. In addition to Bob Newhart and the Carol Burnett Show, people were buying
tax shelters. The shelters worked pretty well back then, long before the
passive activity rules entered the game. One of those shelters used to provide
one with self-employment income, on which one would pay self-employment – also
known as social security – tax.
Doesn’t sound like much of a shelter,
doesn’t it?
The purpose was to get social
security credits for someone who had not worked, had not earned enough credits,
or had not earned enough to maximize their social security benefits.
The IRS did not like this at all,
because at the time it was concerned with people taking advantage of social
security. That was before our government decided to bankrupt us all, which act has
now switched to the IRS demanding money from anyone foolish enough to make eye
contact.
You see, in those days, there were
entities known as “limited partnerships” in which a general partner made all
the decisions and in return the limited partners got regular checks. A limited partner had little or
no sway over the management of the place. It was an investment, like buying IBM
or Xerox stock. There was no way the IRS was going to let a limited partner buy
social security credits on the back of a limited partnership investment. No
sir. Go get a job.
Fast forward about twenty years.
There is a new sheriff in town, and that sheriff is the limited liability
company (LLC). The states had created these new toys, and their claim to fame
is that one could both work there and limit one’s liability at the same time.
Unheard of! A limited partnership could not do that. In fact, if a limited
partner started working at the place he/she would lose the protection from partnership
liabilities. No limited partner was going to do that voluntarily.
And there you have a tax Regulation
written in the 1970s referencing a “limited” partner. Twenty years later
something new appears “limiting” one’s exposure to entity liabilities, but not
being at all what the IRS had in mind two decades before.
And so the question became: does an
LLC member have to pay self-employment tax?
And the issue has recently compounded,
because there is also a new ObamaCare tax (the additional Medicare tax of 0.9%)
which applies to …. wait on it… self-employment income. Yep, it applies to
something the IRS cannot even define.
And then you have tax professionals
trying to work with this nonsense. We do not have the option of putting the
issue on the shelf until the baby is old enough to go to college. We have to
prepare tax returns annually.
So I was looking at something titled
“CCA 201436049.” It is nowhere as interesting as the final season of Sons of
Anarchy, but it does touch upon our magic two words from the 1970s.
BTW, a “CCA” is a “Chief Counsel
Advice” and represents an internal IRS document. It cannot be cited or used as
precedence, but it gives you a VERY GOOD idea of what the IRS is thinking.
In our CCA, there is company that
manages mutual funds. The management company used to be an S corporation and is
now an LLC. The members of the management company pretty much do all the
investment activity for the mutual funds, and the management company gets paid
big bucks. The management company in turn pays its members via a W-2 and then
“distributes” the remaining profit to them. The members pay social security on
the W-2 (same as you or I) but not on the distributive share.
OBSERVATION: For the tax purist, a partnership is not allowed
to pay its partner a W-2. The reason is that a partner in a partnership is
considered to be self-employed, and self-employed people do not receive W-2s. LLCs
have thrown a wrench into practice, however, and it is not uncommon to see an
LLC member receive a W-2.
To get a CCA, the taxpayer has to be
in examination. An IRS person in the field requests
direction on how to handle an issue. The issue here is whether that
distributive share should be subject to self-employment tax or not. A CCA is
therefore like giving instructions to IRS examiners in the field.
The IRS goes through the same tax history
we talked about above, and it is very skeptical that just “limiting” someone’s
liability was the intent of the 1970s Regulation. It goes on to take a look at
two recent cases.
In Renkemeyer, the Tax Court determined that lawyers within a law
practice did not fit the “limited partner” exception, especially since they
were actively working, something a 1970s “limited partner” could not do. They
had to pay self-employment taxes on their distributive income.
In Reither the taxpayer issued W-2s and argued that that was
sufficient to keep the rest of the distributive income from being subject to
self-employment tax. The District Court made short work of the argument, primarily
because there is no statutory support for it.
So … surprise, surprise… the CCA
determined that the management company’s distributive share was subject to
self-employment tax.
By itself, this is not surprising.
What I did notice is that the IRS is paying more attention to this issue, and
it is winning its cases. How much longer can it be before Congress finds this
“new” source of tax revenue?
Granted, I think the odds of any
meaningful tax legislation between Congress and this White House to be close to
zero. There will be at least a couple of years. That said, I suspect that tax planners have
only so many years left to ramp this car onto the interstate before Congress
takes our keys away.
