What’s Fair Got To Do With It?

I am reading a tax case with an unfortunate result.

It does not seem that difficult to me to have planned for a better outcome.

I have to wonder: why didn’t they?

Let’s set it up.

We have a law firm in New York. There is a “heavy” partner and the other partners, which we will call “everybody else.” The firm faced hard times, and “everyone else” kept-up their bleed rate (the rate at which they withdraw cash), with the result that their capital accounts went negative.

COMMENT: A capital account is increased by the partner’s share of the income and reduced by cash withdrawn by said partner. When income goes down but the cash withdrawn does not, the capital account can (and eventually will) go negative. 

Let’s return to our heavy partner.

He was concerned about the viability of the firm. He was further concerned that New York law imposed on him a fiduciary responsibility to assure that the firm be able to pay its bills. I applaud his sense of responsibility, but I have to point out that any increased uncertainty over the firm’s capacity to pay its bills might have something to do with “everybody else” taking out too much cash.

Just sayin’.

Our partner’s share of firm income was almost $500 grand.

Problem is that the cash did not follow the income. His “share” of the income may have been $500 grand, but he left around $400 grand in the firm to make-up for the slack of his partners.

And you have one of those things about partnership taxation:   

·      The allocation of income does not have to follow the allocation of cash.

There are limits to how far one can push this, of course.

Sometimes the effect is beneficial to the partner:

·      A partner tales out more cash than his/her share of the income because the partnership owns something with big-time depreciation. Depreciation is a non-cash expense, so it doesn’t affect his/her distribution of cash.

Sometimes the effect is deleterious to the partner:

·      Our guy took out considerably less cash than the $500K income.

Our guy did not draw enough cash to even pay the taxes on his share of the income.

OBSERVATION: That’s cra-cra.

What did he do?

He reported $75K of income on his tax return. Seeing how did not receive the cash, he thought the reduction was “fair.”

Remember: his partnership K-1 reported almost half a million.

The number on his personal return did not match what the partnership reported.

COMMENT: By the way, there is yet one more form to your tax return when you do not use a number reported by a partnership. The IRS wants to know. He might as well just have booked the audit.

Sure enough, the IRS sent him a notice for over $140,000 tax and $28,000 in penalties.

Off to Tax Court they went.

And he had … absolutely … no … chance.

Partnerships have incredibly flexible tax law. There is a reason why the notorious tax shelters of days past were structured around partnerships. One could send income here, losses there, money somewhere else and muddy the waters so much that you could not see the bottom.

In response, Congress and the IRS tightened up, then tightened some more. This area is now one of the most horrifying, unintelligible stretches in the tax Code.  It can – with little exaggeration – be said that all the practitioners who truly understand partnership tax law can fit into your family room.

Back to our guy.

The Court did not have to decide about New York law and fiduciary responsibility to one’s law firm or any of that. It just looked at tax law and said:

Your income did not match your cash. You set this scheme up, and – if you did not like it – you could have changed it. Once decided, however, live with your decision.

Those are my words, by the way, and not a quote.

Our law partner owed the tax and penalties.

Ouch and ouch.

I must point out, however, that the law firm’s tax advisors warned our guy that his “fiduciary” theory carried no water and would be disregarded by the IRS, but he decided to proceed nonetheless. He brought much of this upon himself.

What would I have recommended?

For goodness’ sake, people, change the partnership agreement so that the “everybody else” partners reported more income and our guy reported less. It is fairly common in more complex partnerships to “tier” (think steps in a ladder or the cascade of a fountain) the distribution of income, with cash being the second – if not the first – step in the ladder. The IRS is familiar with this structure and less likely to challenge it, as the movement of income would make sense.

Another option of course would be to close down the law firm and allow “everybody else” to fend for themselves.

I would argue that my recommendation is less harsh.

LLC Members and W-2s

There is a tax issue that has dogged advisors for years. 

It has to do with limited liability companies.

What sets it up is tax law from general partnerships.

A general partnership is the Gunsmoke of partnerships. The “general” does not means everybody participates. It does mean that everyone is liable if the partnership gets sued.

Whoa. There is clearly a huge downside here.

Which leads us to limited partnerships. Here only a general partner takes on that liability thing. A limited partner put his/her capital account at risk, but nothing more. Forget about signing on that bank debt.

Let’s present the granddaddy of self-employment tax law:

·        A general partner is considered self-employed and pays self-employment tax on his/her distributable income, irrespective of his/her own involvement in the trade or business.

·        A limited partner is presumed to not be involved in the trade or business of the partnership; therefore, he/she does not pay self-employment (SE)  tax on his/her distributable income.

o   There is an exception for “guaranteed payments, which is akin to a salary. Those are subject to SE tax.

How can we differentiate a general partner from a limited partner?

It is that liability thing. The entity is likely being formed under state “limited partnership” law rather than “general partnership” law. In addition, the partnership agreement will normally include a section specifying in detail that the generals run the show and the limiteds are not to speak until spoken to.

Then came the limited liability companies (LLCs).

These caused tax planners to swoon because they allowed a member to actually participate in the business without forfeiting that liability protection.

COMMENT: BTW the banks are quite aware of this. That is why the bank will likely request the member to also sign personally. Still that is preferable to being a general, where receipt of the partnership interest immediately makes you liable.

Did you catch the use of the word “member?” Equity participants in an LLC are referred to as “members,” not “partners.”

So how are LLCs taxed?

Like a partnership. 

COMMENT: I know. All we did was take that car around the block.

Let’s return to that self-employment issue: is a “member” subject to self-employment tax because he/she participates (like a general) or not subject because he/she has limited liability (like a limited)?

It would help if the IRS had published guidance in this area since the days of the Rockford Files. Many advisors, including me, reason that once the LLC is income-taxable as a partnership then it is also self-employment taxable as a partnership. That is what “like a” means. If you work there, it is self-employment income to you.

But I do not have to go far to find another accountant who disagrees with me.

What to do?

Some advisors allow their LLC member-clients to draw W-2s.

Some do not.

There is a problem, however: a member is not considered an employee. And one has to be an employee to receive a W-2.

The fallback reasoning for a long time has been that a member “is like” an employee, in the same sense that I am “like” LeBron James.

It is not technically-vigorous reasoning, and I could not guard LeBron with a squad of Marines by my side.

Then the IRS said that it would respect a single-member LLC as the employer of record, rather than going up the ownership chain to whoever the sole owner is. The IRS would henceforth treat the single-member as a corporate employer for employment taxes, although the single-member would continue to be disregarded for income tax purposes (it is confusing, I know).  The IRS included exceptions, examples and what-nots, but they did not include one that addressed LLC members directly.

The members-want-W-2s school used this notice to further argue their position. You have the LLC set-up a single-member subsidiary LLC and have the subsidiary – now considered a corporate employer – issue W-2s to the members. Voila!    

Let’s be clear why people care about this issue: estimated taxes. People do not like paying estimated taxes. It requires a chunk of money every three months. Members pay estimated taxes. Members would prefer withholding. Withholding comes out of every check, which is less painful, and don’t even talk about that three-month thing.    

The IRS has backed-off the member/W-2 issue for a long time.

However the IRS recently issued guidance that the above “parent-subsidiary” structure will not work, and taxpayers have until August 1 to comply. The IRS did this by firing its big guns: it issued Regulations. There are enhanced disclosure requirements when one takes a position contrary to Regulations, and very few practitioners care to do that. It is considered a “call me to book the audit” disclosure.

The IRS has given these advisors little more than two whole months to rope-in their errant LLC clients. 

Although the window is tight, I agree with the IRS on this one, except for that two-month thing. They feel they have floated the change long enough to alert practitioners. I would have made it effective January 1, 2017, if only for administrative ease. 

Still this is an area that needs improvement. While the IRS is concerned that member W-2s may lead to members inappropriately participating in benefit plans, there is also mounting demand for member withholding. 

Perhaps the answer is to allow withholding but to use something other than a W-2. One could design yet another 1099, and the member would attach it to his/her tax return to document the withholding. Any additional paperwork is a bother at the LLC level, but it would just join the list of bothersome things. The members wanting withholding would have to employ their powers of persuasion.

Sounds like the beginning of a compromise.

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.