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.

You Must Give The IRS Time

I understand the court’s decision, but I suspect the most interesting part is how this case even got to court.

The issue is almost prosaic:

Somona Lofton filed a 2021 Form 1040X (that is, an amended individual tax return) on May 18, 2022. She requested a refund of $5,362.

The dates strike me as odd. The 2021 return was due April 18, 2022. Lofton filed an amended return one month later. Does it happen? Sure and usually because someone left something out – maybe a W-2 or a broker’s account. That would normally increase tax though, so I am expecting a story.

The IRS did not immediately process the return.

I am not surprised. This was IRSCOVID202020212022, and you were lucky to get someone over there to even answer the phone.

Lofton filed a refund case against the IRS on September 14, 2022.

That was a waste.

Let’s talk about it.

Like any large organization, the IRS has policies and procedures to follow. I would argue that sometimes the rules approximate self-inflicted wounds, but I understand that coordinating that many people and processing that much data requires standardization.

And right there is a reason that many practitioners got upset during IRSCOVID202020212022. The system broke down. One side of the IRS was inadequately processing returns, correspondence, penalty appeals or whatnot, while the Collections side continued undeterred and unhindered.

Why was it broken? Because much of the Collections side is automated. Those notices go out without passing human eyes. If the IRS fails to match a 1099-whatever to your return, bank on receiving a CP2000 notice. Ignore it – or submit a response and then have the IRS ignore it - and you have entered automated hell. A tax practitioner can usually obtain time, allowing a break for response and processing, but the practitioner likely needs to speak with someone to obtain that time.

Yeah, no. Didn’t work when the IRS wasn’t answering the phone.

Back to Lofton.

May, September. I would have advised her to chill.

She however was not using a tax practitioner. She filed the case pro se, meaning she was representing herself. I am – frankly – impressed. Filing pro se with the Tax Court is one thing (and bad enough), but she filed pro se with the US Court of Claims. At first, I thought a tax clinic may have helped, but – no - that couldn’t be. A tax clinic would have told her to wait.

Why?

Look at this Code section:

§ 6532 Periods of limitation on suits.

(a)  Suits by taxpayers for refund.

(1)  General rule.

No suit or proceeding under section 7422(a) for the recovery of any internal revenue tax, penalty, or other sum, shall be begun before the expiration of 6 months from the date of filing the claim required under such section unless the Secretary renders a decision thereon within that time, nor after the expiration of 2 years from the date of mailing by certified mail or registered mail by the Secretary to the taxpayer of a notice of the disallowance of the part of the claim to which the suit or proceeding relates.

The IRS has six months to respond to your request for refund. Six months should be sufficient time for the IRS to adequately review a refund claim (at least in normal times). The flip side is that Congress did not want the IRS parking on a refund claim, effectively denying a refund by never processing it.  

Lofton filed suit within six months.

The Court immediately dismissed the suit. Easiest decision they made that week.

I find the rest of her story more interesting.

For example, she complained that the California Department of Social Services harassed her and withheld her benefits.

She was swinging hard.

… Civil damages for Certain Unauthorized collection action 1,000,000”

… Emotional distress $250,000”

I am not certain how that involves the Federal Court of Claims. The Court noted the same and dismissed her allegations.

Then we learn that she initially filed her 2021 federal tax return claiming a refund of $6,668. The IRS adjusted it for one of the refundable credits, reducing her refund to $3,918.

OK. She already received some of her refund as the IRS sent those monthly child tax payments.

Still, let’s do math. $3,918 plus $5,362 from the amended totals refunds of $9,280. Her original refund request was $6,668.

The woman is a tax Houdini.

Our case this time was Lofton V United States. U.S. Court of Claims, No 1:22-cv-01335.

Donating Cryptocurrency

 

I was reading something recently, and it reminded me how muddled our tax Code is.

Let’s talk about cryptocurrency. I know that there is bad odor to this topic after Sam Bankman-Fried and FTX, but cryptocurrencies and their exchanges are likely a permanent fixture in the financial landscape.

I admit that I think of cryptos – at least the main ones such as Bitcoin, Ethereum or Binance Coin – as akin to publicly traded stock. You go to www.finance.yahoo.com , enter the ticker symbol and see Bitcoin’s trading price. If you want to buy Bitcoin, you will need around $23 grand as I write this.

Sounds a lot like buying stock to me.   

The IRS reinforced that perspective in 2014 when it explained that virtual currency is to be treated as property for federal income tax purposes. The key here is that crypto is NOT considered a currency. If you buy something at Lululemon, you do not have gain or loss from the transaction. Both parties are transacting in American dollars, and there is no gain or loss from exchanging the same currency.

COMMENT: Mind you, this is different from a business transaction involving different currencies. Say that my business buys from a Norwegian supplier, and the terms require payment in krone within 20 days. Next say that the dollar appreciates against the krone (meaning that it takes fewer dollars to purchase the same amount of krone). I bought something costing XX dollars. Had I paid for it then and there, the conversation is done. But I did not. I am paying 20 days later, and I pay XX minus Y dollars. That “Y” is a currency gain, and it is taxable.

So, what happens if crypto is considered property rather than currency?

It would be like selling Proctor and Gamble stock (or a piece of P&G stock) when I pay my Norwegian supplier. I would have gain or loss. The tax Code is not concerned with the use of cash from the sale.

Let’s substitute Bitcoin for P&G. You have a Bitcoin-denominated wallet. On your way to work you pick-up and pay for dry cleaning, a cup of coffee and donuts for the office. What have you done? You just racked up more taxable trades before 9 a.m. than most people will all day, that is what you have done.

Got it. We can analogize using crypto to trading stock.

Let’s set up a tax trap involving crypto.

I donate Bitcoin.

The tax Code requires a qualified appraisal when donating property worth over $5,000.

I go to www.marketwatch.com.

I enter BTC-USD.

I see that it closed at $22,987 on January 27, 2023. I print out the screen shot and attach it to my tax return as substantiation for my donation.

Where is the trap?

The IRS has previously said crypto is property, not cash.

A donation of property worth over $5 grand generally requires an appraisal. Not all property, though. Publicly-traded securities do not require an appraisal.

So is Bitcoin a publicly-traded security?

Let’s see. It trades. There is an organized market. We can look up daily prices and volumes.

Sounds publicly-traded.

Let’s look at Section 165(g)(2), however:

    (2)  Security defined.

For purposes of this subsection, the term "security" means-

(A)  a share of stock in a corporation;

(B)  a right to subscribe for, or to receive, a share of stock in a corporation; or

(C)  a bond, debenture, note, or certificate, or other evidence of indebtedness, issued by a corporation or by a government or political subdivision thereof, with interest coupons or in registered form.

The IRS Office of Chief Counsel looked at this and concluded that it could not see crypto fitting the above categories.

Crypto could therefore not be considered a security.

As property not a security, any donation over $5 grand would require a qualified appraisal.

There was no qualified appraisal in our example. All I did was take a screen shot and include it with the return.

That means no charitable deduction.

I have not done a historical dive on Section 165(g)(2), but I know top-of-mind that it has been in the Code since at least 1986.

Do you know what did not exist in 1986?

The obvious.

Time to update the law, me thinks.

This time we were discussing CCA 202302012.

A Ghost Preparer Story

 

I came across a ghost preparer last week.

I rarely see that.

A ghost preparer is someone who prepares a tax return for compensation (me, for example) but who does not sign the return.

This is a big no-no in tax practice. The IRS requires all paid tax preparers to obtain an identification number (PTIN, pronounced “pea tin”) and disclose the same on returns. The IRS can track, for example, how many returns I signed last year via my PTIN. There are also mandates that come with the CPA license.

Why does the ghost do this?

You know why.

It started with a phone call.

Client: What do you know about the employee retention credit?

Me: Quite a bit. Why do you ask?”

Client: I had someone prepare refunds, and I want to know if they look right.”

You may have heard commercials for the ERC on the radio These credits are “for up to $26,000 per employee” but you “must act now.”

Well, yes, it can be up to $26,000 per employee. And yes, one should act soon, because the ERC involves amending tax returns. Generally, one has only three years to amend a return before the tax period closes. This is the statute of limitations, and it is both friend and foe. The IRS cannot chase you after three years, but likewise you cannot amend after the same three years.

The ERC was in place for most of 2020 and for 9 months of 2021. If you are thinking COVID stimulus, you are right. The ERC encouraged employers to retain employees by shifting some of the payroll cost onto the federal government.

Me: I thought you did not qualify for the ERC because you could not meet the revenue reduction.” 

         Client: They thought otherwise.”

         Me: Send it to me.”

He did.

I saw refunds of approximately $240,000 for 2020. I also remember our accountant telling me that the client could not meet the revenue reduction test for 2020. Revenues went down, yes, but not enough to qualify for the credit.

COMMENT: There are two ways to qualify for the ERC: revenue reduction or the mandate. The revenue reduction is more objective, and it requires a decrease in revenue from 2019 (50% decrease for the 2020 ERC; 20% decrease for the 2021 ERC). The second way – a government COVID mandate hobbling the business – does not require revenue reduction but can be more difficult to prove. A restaurant experiencing COVID mandates could prove mandate relatively easily. By contrast, a business experiencing supply-chain issues probably experienced COVID mandates indirectly. The business would likely need its suppliers’ cooperation to show how government mandates closed their (i.e., the suppliers’) doors.

I had our accountant locate the 2020 accounting records. We reviewed the revenue reduction.

The client did not make it.

I called.

Me: Did they say that you qualified under the mandate test?"

         Client: They said I qualified under revenue reduction."

         Me: But you don’t. How could they not tell?"

         Client: Because they never looked at it."

         Me: Then how ….?"

Client: They asked if I had a revenue decline and I said yes. They took my answer and ran with it."

Why would someone do this?

Because that someone works on commission.

There is incentive to maximize the refund, whether right or not.

I was looking at a refund of almost a quarter million dollars.

That would have been a nice commission.

No, the client is not filing those amended returns. He realized the con. He also realized that he had no argument upon IRS audit. He would have to return the money, plus whatever penalties they would layer on. I could no more save him than I could travel to Mars.

He now also understands why they never signed those returns.

Ghosts.

A Good Hire Can Help Prove You Are Serious About A Business

If you have gig, there is a presumption in the Code that it will be profitable.

Mind you, it may not be profitable every year. Not even Fortune 100 companies are profitable every year.  Still, the gig is expected to be profitable on a cumulative basis.

Seems obvious. Why are we talking about this?

Say that you have an internet-based business. The business itself is profitable, but you are spending so much on research, hardware, and infrastructure that - overall – the business shows a loss. You know better. You know that, soon enough, the business will turn the corner, those expenses will taper off, and you will make a fortune.

Or maybe you are funding a promising teenage boxer. Everyone sees the potential for the next Mike Tyson. You see it too.

What if your business is sitting on land that will one day be – if it is not already – absurdly valuable? Even if the business is unprofitable, the sale of the land will eventually trump those losses.

We are talking about hobby losses. You say it is a business. The IRS says it is not. It is one of the trickiest areas in the Code.  

There are several repetitive factors that the IRS looks for, such as:

(1)  You don’t treat it like a business. Little things are a tell, like not having accounting and not pivoting when it seems clear you have a loser.

(2)  You make a ton of money elsewhere, so it is financially insignificant whether that activity ever shows a profit.

(3)  You derive a high degree of personal pleasure from the activity.

Let’s look at a recent hobby loss case.

In 2004 the Wondries bought an 1,100-acre ranch in California. They borrowed at the bank, indicating in the paperwork that they would make money by selling cattle and providing guided hunting expeditions.

Mr. Wondries was a sharp cookie. He had already owned around 23 car dealerships, and he had a track record of turning losing dealerships into profitable ones.

He had no experience in ranching, though, so he hired someone (Mr. Palm) who did. Wondries hired Palm the same day he bought the ranch.

Good thing. Palm was mentoring Wondries on the fly, and they both realized that cattle raising was a no-go. They could not overcome feed prices. They thought about allowing the cattle to graze in the fields and growing their own barley, but a drought soon took away that option.

There was no money there. They sold most of the cattle.

Pivot.

Next was the guided hunting expeditions. The ranch was too small for certain (read: the desirable and profitable) hunts. We haven’t even mentioned insuring a hunting activity.

Bye to hunting.

Pivot again.

Wondries and Palm still thought they could make money by holding the land for investment. Seems that Wondries bought the land at a good price, so there was room to run.

Over three years (2016 to 2017) the ranch lost over $925 grand. You and I would have run for the hills, but Mr. Wondries’ W-2’s for the period totaled over $12 million. He could take a financial hit.

Big W-2. Substantial losses from a gig. Looks like meaningful personal pleasure is involved. The IRS caught scent and went for it.  Hobby loss. No loss deductions for you.

Off to Tax Court they went.

These cases tend to be very fact specific. While there are criteria the courts repetitively consider, that does not mean each court interprets, applies, or weights the criteria in the same manner.

Let’s go over them briefly.

(1)  The way taxpayer conducts the activity

 

The Court saw a business plan, an accounting system, and the hiring of an industry pro.

 

This went in the taxpayers’ favor.

 

(2)  Expertise of taxpayer or advisors

 

Wondries’ expertise was in dealerships, but he recognized that and hired a ranching pro. He also listened to the pro while trying to make the ranch profitable.

 

This went in the taxpayers’ favor.

 

(3)  Time and effort expended by taxpayer

 

The Wondries together spent an average of six days per month at the ranch. It was not much in the scheme of things.

 

To be fair, they had other stuff going on.

 

This still went in the taxpayers’ favor. Why? Because the manager was there full-time, and his time was imputed to the Wondries.

 

(4)  Expectation that assets used in activity will appreciate   

 This went in the taxpayers’ favor.

 

(5)  Taxpayer success in other activities

 

Wondries was a successful businessman.  

 

This went in the taxpayers’ favor.

 

(6)  History of activity income or loss

 

The ranch was a loser.

 

This went against the taxpayers.

 

(7)  The amount of profits compared to losses

 

The concept here is whether there were wee profits against huge losses.

 

This went against the taxpayers.

 

(8)  Taxpayer financial status

 

The Wondries were loaded.

 

This went against the taxpayers.

 

(9)  Elements of personal pleasure in the activity

 

The IRS pounced on this one. A ranch? Does anything say personal pleasure like a ranch?

 

The Court thought otherwise. They noted that the Wondries were working when they were there. They were hiking, biking, or boating when they visited their other properties. This lowers one’s motivation in wanting to visit the ranch.

 

The Court spotted the taxpayers this one.

 

The Tax Court decided the ranching activity was a business and not a hobby.

Not surprisingly, they also noted that:

                  This is a close case.”

What swung it for the Wondries?

Two things stand out to me:

(1)  The Court did not see significant personal pleasure in owning the ranch. In fact, it sounded like any pleasure from showing- off the ranch was more than offset by working every time the Wondries visited.

(2)  Hiring an industry pro to run the place. By my count, the ranch manager swung the Court’s decision in at least three of the above criteria

Hobby loss cases are fickle. What can tax advisors take away from this case?

Hire a pro to run the thing. Give the pro authority. Listen to the pro. Pivot upon that advice.

To say it differently, don’t be this:

Our case this time was Wondries v Commissioner, T.C. Memo 2023-5.

A 1099 Reporting Rule Is Delayed

 

You may have heard that the IRS recently delayed a 1099 reporting rule that was going to otherwise affect a lot of people this filing season.

We are talking about payments apps such as Venmo, PayPal, Square and Cash App. Use Lyft or Uber, purchase something on Etsy or buy lunch at a food truck and you are likely paying cash or using one of these payment platforms.

For years and years, the tax rules require a payment processor to issue a 1099 to a business if two things happened:

(1)  The business received payments exceeding $20,000 and

(2)  There were more than 200 transactions.

This flavor of 1099 is a “1099-K.” It basically means that one received payment for a business transaction by accepting a credit card or mobile payment app. Mind you, this is not the same flavor of 1099 as those for interest or dividend income, rent or stock sales. A 1099-K is issued to a business, not to an individual. However, an individual having a business – think a side gig – can receive a 1099-K for that gig. Think Uber or Etsy – or a teenage babysitter – and you get the distinction.  

I remember when the $20,000/200 rule came in. There was one year when the IRS wanted taxpayers to separate business revenues on their tax return between those reported on a 1099 and those not. Clients were not amused with locating and providing those 1099 forms. Preparers quickly adjusted by reporting all revenues as reported on a 1099, despite IRS protestations that it would render their computer matching superfluous. True, but preparers cannot spend a lifetime preparing one tax return because Congress and the IRS want a DNA match on any economic activity during the year.   

Congress changed the $20,000/200 law. The American Rescue Plan of 2021 reduced the dollar threshold to $600 in the aggregate, with no threshold on the number of transactions.

Fortunately, some of the business apps are trying to minimize the damage. PayPal and Venmo, for example, are allowing users to distinguish whether a payment is personal - think a birthday gift – or a payment for goods and services. Personal payments do not require 1099-K reporting.   

Many tax professionals were concerned how this expanded reporting would mesh with an IRS that is just barely getting itself off the floor from COVID202020212022. The IRS still has unprocessed tax returns and correspondence to wade through – the same IRS that recently destroyed millions of tax documents because they relinquished hope of ever processing them.

The 1099-K reporting has not gone away completely, though. The IRS delayed the $600 rule, but the old rule - $20,000 and 200 transactions – is still in effect. Yeah, it can be confusing.

Have you wondered why that $600 limit has never changed? The $600 has been around since the Internal Revenue Code of 1954, and prior to 1954 there was comparable reporting for certain payments exceeding $1,000. Mind you, average annual U.S. income in 1954 was less than $4,000. You could buy a house for twice that amount.  

Had that $600 been pegged for inflation – not an unreasonable request to make of Congress, which caused the inflation - it would be almost $6,700 today.

And Congress would not be burdening everybody with 1099 reporting at dollar thresholds less than you spend monthly on groceries.

 

Happy New Year