A Brief History of Limited Partner Self-Employment Tax

 

There is a case going through the courts that caught my eye.

It has to do with limited liability companies (LLCs). More specifically, it has to do with LLC members.

LLCs started coming into their own in the 1990s. That gives us about 35 years of tax law to work with, and in many (if not most) cases practitioners have a good idea what the answers are.

There is one question, however, that still lingers.

Let’s set it up.

Before there were LLCs there were limited partnerships (LPs). The LPs will forever be associated with the tax shelters, and much of the gnarliness of partnership taxation is the result of Congress playing whack-a-mole with the shelters.

The LPs tended to have a similar structure.

(1)  Someone set up a partnership.

(2)  There were two tiers of partners.

a.    The general partner(s) who ran the show.

b.    The limited partner(s) who provided the cash but were not otherwise involved in the show. It is very possible that the limited was a well-to-do investor placed there by a financial advisor. The limited partner was basically investing while hoping for a mild/moderate/lavish side dish of tax deduction goodness.

The liability of the limited partners in the event of disaster was capped, generally to the amount invested. They truly were limited.

A tax question at this point was:

Is a limited partner subject to self-employment tax on his/her share of the earnings?

This question was not as simple as it may sound.

Why?

Did you know there was a time when people WANTED to pay into social security?

Let’s do WAYBAC machine.

When first implemented, social security only applied to certain W-2 workers.

This was an issue. There was a significant tranche of workers, such as government employees and self-employeds, who did not qualify. Enough of these excluded workers wanted (eventual) social security benefits that Congress changed the rules in 1950, when it introduced self-employment (SE) taxes. FICA applies to a W-2 worker. SE taxes apply to a self-employed worker. Both FICA and SE are social security taxes.

Congress also made all partners subject to SE tax: general, limited, vegan, soccer fan, whatever.

This in turn prompted promoters to peddle partnerships for the primary purpose of paying self-employment tax.

It sounds crazy in 2023, but it was not crazy at the time. During the 1950s the SE rate varied between 2.25% and 3.375% and the wage base from $3,600 to $4,200. Take someone who had never paid into social security. Getting an annual partnership K-1 and paying a little bit of SE tax in return for a government-backed lifetime annuity sounded appealing. The value of those benefits likely far exceeded the cost of any SE taxes.

It was appealing enough to catch Congress’ attention.

In 1977 Section 1402(a)(13) entered the tax Code:

There shall be excluded the distributive share of any item of income or loss of a limited partner, as such, other than guaranteed payments … to that partner for services actually rendered to or on behalf of the partnership to the extent that those payments are established to be in the nature of renumeration for those services.”

You see what Congress did: they were addressing the partnerships gaming the social security system. One could earn social security benefits if one was involved in business activities, but not if one were just an investor – that is, a “limited” partner.

But things change.

Social security tax rates kept going up. The social security wage base kept climbing. Social security was becoming expensive. Rather than opt-in to social security, people were trying to opt out.

And businesses themselves kept changing.

Enter the LLCs.

Every member in an LLC could have “limited” liability for the entity’s debts. How would that play with a tax Code built on the existence of general and limited partners? LLCs introduced a hybrid.

Taxwise, it was problematic.

In 1994 the IRS took its first shot. It proposed Regulations that would respect an LLC member as a limited partner if:

(1) The member was not a manager of the LLC, and

(2) The LLC could have been formed as a limited partnership, and, if so, the member would have been classified as a limited partner.

It was a decent try, but the tax side was relying very heavily on the state law side. Throw in 50 states with 50 laws and this approach was unwieldy.

The IRS revisited in 1997. It had a new proposal:

         An individual was a limited partner unless

(1) He/she was personally liable for partnership debt, or

(2)  He/she could sign contracts for the partnership, or

(3) He/she participated in partnership activities for more than 500 hours during the year.

Got it. The IRS was focusing more on functional tests and less on state law.

I was in practice in 1997. I remember the reaction to the IRS proposal.

It was intense enough that the politicians got involved. Congress slapped a moratorium on further IRS action in this area. This was also in 1997.

The moratorium is still there, BTW, 26 years later.

And now there is a case (Soroban Capital Partners LP v Commissioner) coming through and returning attention to this issue.

Why?

Sure, there have been cases testing the SE tax waters, but most times the numbers have been modest. There has been no need to call out the National Guard or foam the runways.

Soroban upped the ante.

Soroban is challenging whether approximately $140 million (over several years) is subject to SE tax.

Soroban also brings a twist to the issue:

Can a partner/member wear both hats? That is, can the same person be a general partner/member (and subject to SE tax) and a limited partner/member (and not subject to SE tax)?

It is not a new issue, but it is a neglected issue.

We’ll return to Soroban in the future.

Does An LLC Member Pay Self-Employment Tax?

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.

Why is Kinder Morgan Buying Its Own Master Limited Partnerships?

I am reading that Kinder Morgan, Inc (KMI) is restructuring, bringing its master limited partnerships (MLPs) under one corporate structure. We have not spoken about MLPs in a while, and this gives us an opportunity to discuss what these entities are. We will also discuss why a company would reconsolidate, especially in an environment which has seen passthrough entities as the structure of choice for so many business owners.

As a refresher, a plain–vanilla corporation (which we call a “C” corporation) pays tax at the corporate level. The United States has the unenviable position of having one of the highest corporate tax rates in the world, which is certainly a strike against organizing a business as a C corporation. Couple this with the tax Code’s insistence on taxing the worldwide income of a C corporation (with certain exceptions), and there is a second strike for businesses with substantial overseas presence.

A passthrough on the other hand generally does not pay tax at the entity level. It instead passes its income through to its owners, who then combine that income with their personal income and deductions (for example, salary, interest and dividends, as well as mortgage interest and real estate taxes) and pay taxes on their individual tax returns. This is a key reason that many tax professionals are opposed to ever-higher individual tax rates. The business owner’s personal income is artificially boosted by that business income, pushing - if not shoving - him/her into ever-higher tax rates. This is not generally interpreted as an admonition from our government to go forth and prosper. 

MLPs are relatively recent creations, entering the tax Code in 1986. They can be the size of publicly-traded corporations, but they are organized instead as publicly-traded partnerships. They are required to generate at least 90% of their revenues from “qualifying sources,” commonly meaning oil, natural gas or coal. The stock market values MLPs on their cash flow, so the sponsor (in this case, KMI) has great incentive to maximize distributions to the unitholders. MLPs have consequently become legitimate competitors to bonds and dividend-paying stocks. You could, for example, purchase a certificate of deposit paying 1.4%, or you could instead purchase a MLP paying 7%. Introduce a low interest rate environment, couple it with expanded activity in shale and natural gas, and MLPs have been in a very favorable investment environment for a while.

One of the granddaddies of MLPs is Kinder Morgan Inc, which placed its operating activities in three principal MLPs: Kinder Morgan Energy Partners, Kinder Morgan Management and El Paso Pipeline Partners. To say that they have done well is to understate.

There is a tax downside to MLP investing, however. A MLP does not pay dividends, as Proctor & Gamble would. Instead it pays distributions, which may or may not be taxable. You do not pay tax on the distributions per se. You instead pay tax on your distributable income from the MLP, reported on a Schedule K-1. A partner pays tax on his/her income on that K-1; by investing in a MLP you are a partner. To the extent that the K-1 numbers approximate the distribution amount, your tax would be about the same as if you had received a dividend. That, however, almost never happens. Why? Let’s look at one common reason: depreciation. As a partner, you are entitled to your share of the entity’s depreciation expense. Depreciation reduces your share of the distributable income. To the extent that there is heavy depreciation, less and less of your distribution would be taxable. What type of entity would rack up heavy depreciation? How about a pipeline, with hundreds of millions of dollars tied-up in its infrastructure? 

This leads to an (almost) win:win situation for the investor. To the extent there is outsized depreciation, or perhaps depletion or tax credits, you can receive generous distributions but pay tax on a considerably smaller number. There is a tax downside however. To the extent that the distributions exceed the K-1 income, you are deemed to have received a return of your capital. This means that you are getting back part of your investment. This matters later, when you sell the MLP units. Your “basis” in the MLP would now be less (as your investment has been returned to you bit by bit), meaning that any gain on a subsequent sale would be larger by the same amount. Many MLP investors have no intention of ever selling, so they do not fear this contingency. No later sale equals no later tax.

Almost all MLPs pay someone to actually manage the business, whether it is a pipeline or timberland. That someone would be the sponsor or general partner (GP). The general partner receives a base percentage to manage the operations, and many MLPs also further pay an incentive distribution right (IDR) to the general partner, which amount increases as the MLP becomes more and more profitable. For example:

·        A GP receives 2% base to manage the business

·        Then there is an IDR at certain steps

o   At step one, the GP receives 15% of the increment over the first step,

o   At step two, the GP receives 25% of the increment over the second step

o   At step three, he GP receives 35% of the increment over the third step

How high can this go? Well, KMI and its MLPs have done so well that approximately 50% is going to an IDR payment.

This means that KMI is receiving up to 50% of the MLP income it is managing, so 50% comes back to the KMI (a C corporation) anyway. One really has not accomplished much tax-wise as far as that 50% goes.

But that leaves the other 50%, right?

MLPs can have difficulty borrowing money because they pay-out such an outsized percentage of their income, whether as IDRs or distributions. A banker wants to see a profitable business, as well as see the business retain some of that profit, if only to repay the bank. This leads to complicated bank loans, as the GP has to step in as a borrower or a guarantor on any loan. Banks also like to have collateral. Problem: the GP does not have the assets; instead the MLP has the assets. This causes banking headaches. The headache may be small, if the MLP is small.  Let the MLP grow, and headaches increase in intensity. 

Remember what we said about KMI? It is one of the granddaddies of MLPs. Banking and deal making have become a problem.

So KMI Inc has decided to do away with its MLP structure. It has proposed to buy back its MLPs in a $44 billion deal, bringing everything under the corporate roof. It now becomes the third largest energy company in the United States, behind only Exxon Mobil and Chevron.

The stock market seemed to like the deal, as KMI’s stock popped approximately 10% in one day.

What is the tax consequence to all this? Ah, now we have a problem. Let us use Kinder Morgan Energy Partners as an example. These investors will have a sale, meaning they will have to report and pay taxes on their gains. Remember that they have been reducing their initial investment by excess distributions. I have seen estimates of up to $18 tax per KMEP MLP unit owned. Granted, investors will also receive almost $11 in cash per unit, but this is a nasty April 15th surprise waiting to happen.

The restructuring should reduce KMI’s taxable income as much as $20 billion over the next dozen years or so, as KMI will now be able to claim the depreciation on its corporate tax return. In addition, KMI will be able to use its own stock in future acquisitions, as C corporations can utilize their stock to structure tax-free mergers. Standard & Poor’s has said it would upgrade KMI’s credit rating, as its organizational chart will be easier to understand and its cash flow easier to forecast. KMI has already said it would increase its dividend by approximately 10% annually for the rest of the decade.

By the way, are you wondering what the secret is to the tax voodoo used here? Kinder Morgan is bringing its MLPs onto its depreciation schedule, meaning that it will have massive depreciation deductions for years to come. There is a price to pay for this, though: someone has to report gain and pay tax. The IRS is not giving away this step-up in depreciable basis for free. It is however the MLP investors that are paying tax, although KMI is distributing cash to help out. To the extent that KMI optimized the proportion between the tax and the cash, the tax planners hit a home run.