Many of our clients, most of which are closely-held U.S. businesses, are looking to expand their operations overseas. Some are venturing into foreign markets on their own, while others are joint-venturing with established foreign businesses.

In structuring a joint venture, the parties will often form a foreign business entity that affords a significant degree of limited liability protection, such as a corporation.

As a matter of U.S. Federal tax law, however, it may be advisable that the form of foreign entity not be treated as a corporation per se. Rather, the better choice may be that the foreign entity qualify as a so-called “eligible entity” under U.S. tax law – one that provides limited liability protection to its members but that may elect to be treated as a partnership.

If the foreign eligible entity is treated as a partnership for U.S. tax purposes, a share of the losses that may be generated by the entity in the early stages of its operation may flow through to the U.S. business to be used in determining its taxable income.

The IRS recently considered an interesting version of this scenario.

Joint Venture

In Year 1, US Parent corporation and Foreign Parent corporation formed JV, as a foreign limited liability company, to carry out a joint venture. As a matter of Foreign Law, JV had two equity owners: foreign corporations FC-1 and FC-2, each of which contributed funds to JV. US Parent and Foreign Parent owned the equity of FC-2; Foreign Parent was the sole owner of FC-1.

US Parent also provided funds to JV through its U.S. subsidiary, US Partner, and Foreign Parent did so directly. The amounts provided were treated as loans under Foreign Law. Thus, under Foreign Law, JV was treated as having two owners: FC-1 and FC-2.

Check the Box

US Parent elected to treat JV as a partnership for U.S. Federal tax purposes. US Parent also treated the amounts provided to JV by US Partner and Foreign Parent as equity, rather than debt. As a result, for US tax purposes, JV was treated as having four partners: FC-1, FC-2, US Partner, and Foreign Parent. Thus, the partnership allocation rules became applicable for purposes of determining US Partner’s share of JV’s tax items.

The joint venture agreement for JV did not set forth any of the “economic effect test” provisions regarding capital account maintenance, liquidation in accordance with positive capital accounts, or deficit restoration obligations; nor did it specify the allocation of JV/partnership tax items among the partners.

Additional Funding

Foreign Law required that, in order for an entity to maintain its legal status as a limited liability company, it should have net assets greater than or equal to its charter capital.

If an entity’s net assets were less than its charter capital, then the entity must either (1) decrease its charter capital, or (2) obtain additional contributions from its owners. If the entity’s owners do not take steps to improve its negative net asset position, the Foreign governmental authority may seek the liquidation of the entity. Furthermore, where an entity improves its net asset position by reducing its charter capital, in lieu of obtaining contributions from its owners, Foreign Law allows any creditor to seek the liquidation of the entity.

The JV Agreement required the owners of JV to lend additional funds pro-rata to their respective ownership interests in JV whenever JV lacked sufficient assets to meet these funding requirements.

Guaranteed Payments

According to the JV Agreement, US Partner and Foreign Parent would receive fixed payments related to their contribution amounts. The fixed payments were computed without regard to the income and cash flow of JV.

US Parent characterized these payments by JV to US Partner as guaranteed payments (for U.S. tax purposes) for the use of capital. From Year 2 to Year 5, JV deducted its payments to US Partner as guaranteed payments. JV had cumulative operating losses from Year 2 to Year 6. The guaranteed payments generated much of these losses. The loss deductions were allocated by JV solely to FC-2 and FC-1.

End of the Joint Venture

After several years of disappointing results, Foreign Parent and US Parent reached an agreement for US Parent to sell its indirect interest in JV to Foreign Parent. Because no JV loss deductions had been allocated to US Partner, US Partner’s basis in JV at the time of the sale was not insignificant and, as a result, US Parent reported a loss of on its U.S. return attributable to the sale of US Partner’s interest in JV.

The IRS’s Analysis

After examining the U.S. Parent’s tax return, the IRS field office asked the National Office to consider the proper allocation of JV’s losses. The IRS examiner believed that part of the loss allocated to FC-2 should have been allocated to US Partner, while US Parent argued that FC-2 bore the economic risk of JV’s operating losses.

Allocation Rules

Under the Code, a partner’s distributive share of income, gain, loss deduction, or credit (or item thereof) is determined in accordance with the partner’s interest in the partnership (taking into account all facts and circumstances), if:

  • the partnership agreement does not provide as to the partner’s distributive share of the partnership’s income, gain, loss, deduction, or credit (or item thereof), or
  • the allocation of such items to a partner under the agreement does not have substantial economic effect.

The IRS applies a two-part analysis for determining substantial economic effect:

  • the allocation must have economic effect; and
  • the economic effect of the allocation must be substantial.

An allocation of partnership income, gain, loss, or deduction to a partner will have economic effect if the partnership agreement provides that:

  • the partnership will maintain a capital account for each partner;
  • the partnership will liquidate according to positive capital account balances; and
  • the partners are obligated to restore any deficit balances in their capital accounts following a liquidating distribution.

If an allocation lacks substantial economic effect, the IRS requires that the item be allocated in accordance with the partners’ interest in the partnership.

“Partner’s Interest”

A partner’s “interest in the partnership” signifies the manner in which the partners have agreed to share with that partner the economic benefits or burdens corresponding to the income, gain, loss, deduction, or credit of the partnership. The determination of a partner’s interest in a partnership is made by taking into account all facts and circumstances relating to the economic arrangement of the partners.

The IRS explained that a partner receives income, not a distributive share, from a guaranteed payment for the use of capital, and the partnership receives a corresponding business deduction. The income from the guaranteed payment does not affect the recipient’s basis in its partnership interest or its capital account. The partnership’s deduction for the guaranteed payment reduces the partnership’s income (or increases the partnership’s loss) to be allocated among its partners.

Because they were determined without regard to the income of the JV-partnership, the fixed payments made by JV to US Partner and Foreign Parent from Year 2 to Year 5 were guaranteed payments for the use of capital. The guaranteed payments generated ordinary income for US Partner and Foreign Parent and deductions for JV.

During this period, JV incurred operating losses, primarily as a result of the guaranteed payment deductions. These losses were allocated entirely to FC-2 and FC-1. US Partner and Foreign Parent received no allocation of loss.

The IRS found that the allocation of JV’s operating loss did not have economic effect because JV did not maintain capital accounts, it did not provide for the liquidation of its partners’ interests in accordance with positive capital account balances, nor did it provide a deficit restoration obligation.

Thus, the IRS continued, JV’s operating loss had to be reallocated in accordance with the partners’ interests in the partnership, reflecting the manner in which the partners agreed to share the economic burden corresponding to that loss.

US Parent argued that Foreign Law effectively subjected FC-2 to a deficit restoration obligation because, if JV’s capitalization fell below a certain threshold, the equity holders of JV (FC-1 and FC-2 under Foreign Law; not US Partner and Foreign Parent) would need to contribute additional capital to JV to avoid its liquidation.

The IRS rejected this argument, finding that these additional capital contributions were not required by Foreign Law, as JV’s partners could allow JV to liquidate rather than make these additional contributions. While FC-2 and FC-1 did contribute additional amounts to JV after Year 2, these amounts were minimal compared with the substantial additional amounts contributed to JV by US Partner and Foreign Parent.

As creditors under Foreign Law, US Partner and Foreign Parent had priority over FC-2 and FC-1 if JV was liquidated. However, FC-2 and FC-1 had no obligation to restore any shortfall in payments to US Partner and Foreign Parent upon liquidation. Consequently, JV would not have the assets to repay US Partner and Foreign Parent their positive capital account balances upon liquidation, thus placing the economic burden for the operating loss allocations to FC-2 and FC-1 on US Partner and Foreign Parent. Any capital contributions by FC-2 and FC-1 would be necessary only to keep JV a going concern and avoid liquidation in the event JV became undercapitalized. Whether to keep JV a going concern would be up to US Parent and Foreign Parent, and was not mandated by Foreign Law.

Based on the foregoing, the IRS concluded that the allocation of JV’s loss to FC-2 and FC-1 should be limited to the amount of their positive capital account balances. They bore the burden of the economic loss of their capital contributions on liquidation up to this amount.

In addition, the IRS concluded that US Partner and Foreign Parent bore the economic burden of JV’s losses in excess of those positive capital accounts.

Don’t Forget

U.S. persons are subject to U.S. income tax on their worldwide income. Thus, before selecting the form of foreign entity through which to begin its foreign operations, a U.S. person should consider the options available.

The form of foreign entity ultimately chosen must be optimal from a business perspective, and it should afford the U.S. person limited liability protection.

However, as always, the tax consequences of a business structure may have a significant effect on the net economic benefit of a transaction, including the foreign operations of a U.S. business. Therefore, the U.S. person should consider how the applicable foreign law will affect the foreign entity’s tax status from a U.S. perspective.

The U.S. person should also examine how each option would be treated for U.S. tax purposes – as a corporation, partnership, or disregarded entity, and whether a check-the-box election would be advisable – and how the tax items attributable to the foreign business may impact the U.S. person’s overall tax liability.

The choice of foreign business entity should be approached with an eye toward maximizing the U.S. person’s overall foreign and U.S. tax benefits, including the use of foreign losses and foreign tax credits, and the deferral of foreign income.

The process is far from simple, but it is absolutely necessary.

“When will they ever learn?”

No, I am not channeling Seeger. I am referring to those individuals[i] who continue to acquire real property (“RP”) in, or who contribute RP to, corporations. In just the last couple of months, I have encountered taxpayers who want to remove RP from the closely held corporations in which they are shareholders. Of course, they want to do so on a “tax efficient” basis. Their reasons for removing the property are varied.

In one case, for example, the shareholders want to dispose of the business that also resides in the corporation; they want to do so by selling their shares of stock in the corporation, so as to avoid the two levels of tax that would result from a sale of the corporation’s assets; however, they also want to retain ownership of the RP.

In another, the shareholders want to withdraw some of their equity from the RP in the form of a distribution from the corporation.

In yet another, the two shareholders want to go their separate ways, each of them taking one of the RPs owned by the corporation.

There are others. In each case, the shareholders have come to realize – for the reasons set forth below – that they should not have used a corporation to hold their RP.

In the Beginning

A taxpayer who contributes RP to a corporation in exchange for shares of stock in the corporation will be taxable on the gain realized in such exchange unless the taxpayer – alone, or in conjunction with others are also contributing a not insignificant amount of money or other property to the corporation in exchange for shares – owns at least 80% of the total combined voting power of all classes of stock entitled to vote and at least 80% of the total number of other all other classes of stock of the corporation immediately after the exchange. It may not be possible for a taxpayer to attain this level of control – and the desired tax deferral –when he is seeking to become a shareholder of an established corporation.

This should be contrasted with a contribution of property to a partnership (or to an LLC that is treated as a partnership for tax purposes). In that case, the contributor is not required to attain a specific level of ownership in order to avoid gain recognition on the contribution of the RP to the partnership in exchange for a partnership interest.

However, the contributor must be attuned to the partnership “disguised sale” rules, which may treat the contributor as having sold all or some of the RP to the partnership; for example, where he mortgages the RP to withdraw equity therefrom just prior to contributing the RP (subject to the indebtedness) to the partnership.

The contributor must also be careful of “shifting” liabilities, as where he contributes mortgaged property to a partnership; if the contributor is not personally liable for the indebtedness, it will be “re-allocated” among all the partners, and he will be treated as receiving a distribution of money that may be taxable to him. .

“Day by Day” Operations

Where the RP is held in a C corporation, the corporation, of course, enjoys the benefits and burdens of ownership. If the property is leased to another, the corporation includes the rent in its gross income; it also claims the associated depreciation and other expenses in determining its taxable income. After satisfying its tax liability, the corporation may pay a dividend to its shareholders, which will be taxable to them.

If the shareholders elect to treat the corporation as an S corporation, the corporate-level tax may be avoided, the corporation’s taxable income will be passed through and taxed to its shareholders, the basis for their shares will be adjusted upward to reflect this income, and the distribution of the corporation’s net income should not generate additional tax to the shareholders.

In order to qualify as an S corporation, however, the corporation will be limited as to who may have hold its stock; for example, another corporation, a partnership, and a nonresident alien cannot own shares of stock in an S corporation.

In addition, an S corporation may have only one class of stock, meaning that each outstanding share must have the same rights to current and liquidating distributions as every other share; no preferred interests are permitted.

Thus, an S corporation is severely limited in its capitalization choices.

Finally, if an S corporation was formerly a C corporation, and has accumulated earnings and profits from its C corporation tax years, the S corporation will be subject to a 35% corporate-level excise tax on a portion of its rental income if the gross receipts from such rental activity constitute “passive investment income” and they exceed 25% of the S corporation’s total gross receipts. The corporation will even lose its “S” election if this situation continues for three consecutive tax years, in which case the corporation will generally not be eligible to re-elect “S” status for a period of five years.

In contrast, a partnership is not subject to an entity-level income tax, its profits are taxed directly to its owners and may be withdrawn by them without additional tax (to the extent the money withdrawn does exceeds a partner’s adjusted basis for his partnership interest), the partnership is not limited as to the nature or the number of its owners, and it can provide for any manner of profit allocation among its partners, including preferred and carried (“promote”) interests, provided such allocation has substantial economic effect.

Refinancing

Once a RP has reached a certain level of equity (fair market value over mortgage balance), it is not uncommon for the owner of the RP to access the increased equity – without having to sell the RP – by refinancing the existing indebtedness; the owner borrows more than the amount of the existing indebtedness, replaces that indebtedness, and withdraws the balance. Because the money that the owner has “cashed out” must eventually be repaid, the owner do not have a taxable event.

As we saw a few weeks ago, this approach to withdrawing equity from RP on a tax efficient basis works well when the property is held by a partnership. Unfortunately, the same cannot be said when a corporation owns the property.

Of course, the corporation, itself, can withdraw the increased equity from its RP through a refinancing without tax consequences. However, what happens when the corporation then distributes this cash to its shareholders? In the case of a C corporation, the amount distributed is treated as a dividend to the extent of the corporation’s current and accumulated earnings and profits; the balance is then treated as a tax-free return of capital to the extent of each shareholder’s basis for his shares of stock; any remaining portion of the distribution is taxable to the shareholders as gain from the sale of their stock.

In the case of an S corporation with no C corporation earnings and profits, the amount distributed is first applied against a shareholder’s adjusted basis for his shares, and any excess is treated as gain from the sale of such shares. Unlike the partners of a partnership, the S corporation shareholders do not receive an increased basis in their shares of corporate stock as a result of the refinancing, even if they personally guarantee the corporation’s indebtedness.

Disposition of the Property

There may come a time when the RP is sold. In the case of a C corporation, that means a corporate-level tax followed by a taxable liquidating distribution to its shareholders.

There is also a corporate-level tax where an S corporation that is subject to the built-in gain rules sells its RP within the recognition period (the 5-year period beginning with the first day of the first taxable year for which the corporation was an S corporation).

Where the S corporation was always an S corporation, and did not acquire the RP from a C corporation in a tax-free exchange, there is no corporate-level tax, and the gain from the sale is taxed to its shareholders. The subsequent distribution of the net proceeds from the sale may be taxable to a shareholder to the extent it exceeds his stock basis (as adjusted for his pro rata share of the gain from the sale of the property).

Again, in the case of a partnership, there is no entity-level tax, its partners are taxed on their pro rata share of the gain recognized on the sale (though the partner who contributed the disposed-of RP may receive a special allocation of taxable gain based upon the gain inherent in the RP at the time it was contributed to the partnership), and a partner may recognize additional taxable gain to the extent the amount of cash distributed to the partner exceeds his basis for his partnership interest (as adjusted for his pro rata share of the gain from the sale of the property).

What if the disposition is to take the form of a like kind exchange? In that case, the taxpayer that sells the “relinquished property” must also acquire the “replacement property;” thus, a corporation-seller must acquire the replacement property – there is no opportunity for a single shareholder to participate in such an exchange if most of the shareholders have no interest in doing so.

In the case a partnership, however, the partnership and one or more partners may be able to engage in a so-called “drop and swap” – by making a non-taxable in-kind distribution of a tenancy-in-common interest in the RP to one or more partners – thus enabling either the partnership or the distributee partners to participate in a like kind exchange.

Distribution of the Property

What if the RP is not to be sold? What if it is to be distributed by the entity to one or more of its owners?

In general, a corporation’s distribution of appreciated RP to its shareholders is treated as a sale of the property by the corporation, with the usual corporate tax consequences. In addition, the shareholders will be taxed upon their receipt of the property, either as a dividend or as an exchange, depending on the circumstances.

Where the corporation is an S corporation, and the RP will be depreciable in the hands of the shareholders, the gain realized on the deemed sale of the RP may be treated as ordinary income and taxed to the shareholders as such.

There is an exception where the corporation’s activity with respect to the RP rises to the level of an “active trade or business.” In that case, the actively-conducted RP business, or another active business being conducted by the corporation, may be contributed to a subsidiary corporation, the stock of which may then be distributed to one or more shareholders on a tax-deferred basis. Unfortunately, if the RP is owner-occupied, the corporation will generally not be able to establish the existence of such an active business. Moreover, the corporation will have to be engaged in a second active business.

In general, a distribution of property by a partnership to its partners will not be treated as a taxable disposition; thus, the partnership may be able to distribute a RP to a partner in liquidation of his interest, or it may split up into two or more partnerships with each taking a different property, without adverse tax consequences. There are some exceptions.

For example, if RP is distributed within seven years of its having been contributed to the partnership, its distribution to a partner other than the contributor will be treated as a taxable event as to the contributor-partner. If a contributor- partner receives a distribution of RP within seven years of his in-kind contribution of other property to the partnership, the distribution will be treated as a taxable event as to the contributor-partner.

In addition, the so-called “disguised sale” rules may cause a distribution of RP to be treated as a sale of the property; for example, where the partnership encumbers the RP with a mortgage (a “non-qualified liability”) just before distributing the RP to the partner who assumes or takes subject to the mortgage.

Even where the disguised sale rules do not apply, a distribution of RP may be treated, for tax purposes, as including a cash component where the distributee partner is “relieved” of an amount of partnership debt that is greater than the amount of debt encumbering the RP.

“Choose Wisely You Must” – Yoda

The foregoing represents a simple outline of the tax consequences that must be considered before a taxpayer decides to acquire or place RP in a corporation or in a partnership.

There may be other, non-tax, considerations that also have to be factored into the taxpayer’s thinking, and that may even outweigh the tax benefits.

All-in-all, however, a closely held partnership is a much more tax efficient vehicle than a corporation for holding, operating, and disposing of real property.

Yes, some of the tax rules applicable to partnerships are complicated, but that should not be the decisive factor. Indeed, with proper planning, these rules can negotiated without adverse effects, and may even be turned to one’s advantage.

 

 

[i] This post focuses on U.S. persons. Different considerations may apply to foreign persons. See https://www.taxlawforchb.com/?s=foreign

Choice of Entity

One of the first decisions – and certainly among the most important – that the owner of a new business must make is the form of legal entity through which the business will be operated. This seemingly simple choice, which is too often made without adequate reflection, can have far-reaching tax and, therefore, economic consequences for the owner.

The well-advised owner will choose a form of entity for his business only after having considered a number of tax-related factors, including the income taxation of the entity itself, the income taxation of the entity’s owners, and the imposition of other taxes that may be determined by reference to the income generated by, or withdrawn from, the entity.

In addition to taxes, the owner will have considered the rights given to her, the protections afforded her (the most important being that of limited exposure for the debts and liabilities of the entity), and the responsibilities imposed upon her, pursuant to the state laws under which a business entity may be formed.

The challenge presented for the owner and her advisers is to identify the relevant tax and non-tax factors, analyze and (to the extent possible) quantify them, weigh them against one another, and then see if the best tax and business options may be reconciled within a single form of legal or business entity.

The foregoing may be interpreted as requiring a business owner, in all instances, to select one form of business entity over another; specifically, the creation of a corporation (taxable as a “C” or as an “S” corporation) over an LLC (taxable as a partnership or as a disregarded entity) as a matter of state law. Fortunately, that is not always the case. In order to understand why this is so, a brief review of the IRS’s entity classification rules is in order.

The Classification Regulations

A business entity that is formed as a “corporation” under a state’s corporate law – for example, under New York’s business corporation law – is classified as a corporation per se for tax purposes.

In general, a business entity that is not thereby classified as a corporation – such as an LLC – can elect its classification for federal tax purposes.

An entity with at least two members can elect to be classified as either a corporation (“association” is the term used by the IRS) or a partnership, and an entity with a single owner can elect to be classified as a corporation or to be disregarded as an entity separate from its owner.

Default Classification

Unless the entity elects otherwise, a domestic entity is classified as a partnership for tax purposes if it has two or more members; or it is disregarded as an entity separate from its owner if it has a single owner. Thus, an LLC with at least two members is treated as a partnership for tax purposes, while an LLC with only one member is disregarded for tax purposes, and its sole member is treated as owning all of the LLC’s assets, liabilities, and items of income, deduction, and credit.

Election to Change Tax Status

If a business entity classified as a partnership elects to be classified as a corporation, the partnership is treated, for tax purposes, as contributing all of its assets and liabilities to the corporation in exchange for stock in the corporation, and immediately thereafter, the partnership liquidates by distributing the stock of the corporation to its partners.

If an entity that is disregarded as an entity separate from its owner elects to be classified as a corporation, the owner of the entity is treated as contributing all of the assets and liabilities of the entity to the corporation in exchange for stock of the corporation.

An election is necessary only when an entity chooses to be classified initially (upon it creation) as other than its default classification, or when an entity chooses to change its classification. An entity whose classification is determined under the default classification retains that classification until the entity makes an election to change that classification.

In order to change its classification, a business entity must file IRS Form 8832, Entity Classification Election. Thus, an entity that is formed as an LLC or as a partnership under state law may file Form 8832 to elect to be treated as a corporation for tax purposes.

Alternatively, an LLC or a partnership that timely elects to be an S corporation (by filing IRS Form 2553) is treated as having made an election to be classified as a corporation, provided that it meets all other requirements to qualify as a small business corporation as of the effective date of the election.

Electing S Corporation Status – Why?

Most tax advisers will recommend that a new business be formed as an LLC that is taxable as a pass-through entity (either a partnership or a disregarded entity). The LLC does not pay entity level tax; its net income is taxed only to its members; in general, it may distribute in-kind property to its members without triggering recognition of gain; it may pass through to its members any deductions or losses attributable to entity-level indebtedness; it can provide for many classes of equity participation; it is not limited in the types of person who may own interests in the LLC; and it provides limited liability protection for its owners.

In light of these positive traits, why would an LLC elect to be treated as an S corporation? Yes, an S corporation, like an LLC, is not subject to entity-level income tax (in most cases), but what about the restrictive criteria for qualifying as an S corporation? An S corporation is defined as a domestic corporation that does not: have more than 100 shareholders, have as a shareholder a person who is not an individual (other than an estate, or certain trusts), have a nonresident alien as a shareholder, and have more than one class of stock.

The answer lies, in no small part, in the application of the self-employment tax.

Self-Employment Tax

The Code imposes a tax on the “self-employment income” of every individual for a taxable year (self-employment tax). In general, self-employment income is defined as “the net earnings from self-employment derived by an individual.”

“Net earnings from self-employment” is defined as the gross income derived by an individual from any trade or business carried on by such individual, less allowable deductions which are attributable to such trade or business, plus his distributive share (whether or not distributed) of income or loss from any trade or business carried on by a partnership of which he is a member . . . .”

Certain items are excluded from self-employment income, including “the distributive share of any item of income . . . of a limited partner.”

That being said, any guaranteed payments made to a limited 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 remuneration for those services . . . ,” are subject to the tax.

In creating the exclusion for limited partners, Congress recognized that certain earnings were basically in the nature of a return on investment. The “limited partner exclusion” was intended to apply to those partners who “merely invest” in, rather than those who actively participate in and perform services for, a partnership in their capacity as partners.

A partnership cannot change the character of a partner’s distributive share for purposes of the self-employment tax simply by making guaranteed payments to the partner for his services. A partnership is not a corporation and the “wage” and “reasonable compensation” rules which are applicable to corporations do not apply to partnerships.

Instead, a partner who is not a “limited partner” within the meaning of the exclusion is subject to self-employment tax on his full distributive share of the partnership’s income, even in cases involving a capital-intensive business.

Thus, individual partners who are not limited partners are subject to self-employment tax on their distributive share of partnership income regardless of their participation in the partnership’s business or the capital-intensive nature of the partnership’s business.

Unfortunately, the Code does not define the term “limited partner,” though the IRS and the courts have, on occasion, interpreted the term as applied to the members of an LLC; specifically, based upon these interpretations, the level of a member’s involvement in the management and operation of the LLC will be determinative of her status as a “limited partner” and, consequently, of her liability for self-employment tax.

S Corporations

The shareholders of an S corporation, on the other hand, are not subject to employment taxes in respect of any return on their investment in the corporation – i.e., on their pro rata share of S corporation income – though they are subject to employment taxes as to any wages paid to them by the corporation.

For that reason, the IRS has sought to compel S corporations to pay their shareholder-employees a reasonable wage for services rendered to the corporation. In that way, the IRS hopes to prevent an S corporation from “converting” what is actually compensation for services into a distribution of investment income that is not subject to employment taxes.

Why Not Incorporate?

If the self-employment tax on an owner’s share of business income can be legitimately avoided by operating through an S corporation – except to the extent it is paid out as reasonable compensation for services rendered by the owner to the corporation – why wouldn’t the owner just form a corporation through which to operate the business?

The answer is rather straightforward: because tax planning, although a very important consideration, is not necessarily the determinative factor in the choice-of-entity decision.

There may be other, non-tax business reasons, including factors under state law, for establishing a business entity other than a corporation.

For example, in the absence of a shareholders’ agreement – which under the circumstances may not be attainable – shares of stock in a corporation will generally be freely transferable, as a matter of state law; on the other hand, the ability of a transferee of an ownership interest in an LLC to become a full member will generally be limited under state law – in most cases, the transferee of a membership interest in an LLC will, in the absence of a contrary provision in the LLC’s operating agreement, become a mere assignee of the economic benefits associated with the membership interest, with none of the rights attendant on full membership in the LLC.

With that in mind – along with other favorable default rules under a state’s LLC law, as opposed to its corporate law – and recognizing the limitations imposed under the Code for qualification as an S corporation, a business owner may decide to form her entity as an LLC in order to take advantage of the “benefits” provided under state law; but she will also elect to treat the LLC as an S corporation for tax purposes so as to avoid entity-level income tax and to limit her exposure to self-employment tax.

In this way, the business owner may be able to reconcile her tax and non-tax business preferences within a single legal entity. The key, of course, will be for both the owner and her tax advisers to remain vigilant in the treatment of the LLC as an S corporation. The pass-through treatment for tax purposes will be easy to remember, but other tax rules applicable to corporations (such as the treatment of in-kind distributions as sales by the corporation), and to S corporations in particular (such as the single class of stock rule), will require greater attention, lest the owner inadvertently cause a taxable event or cause the LLC to lose its “S” status.

Business Owners & Employment Taxes

In general, self-employed individuals are subject to employment taxes on their net earnings from self-employment.

The wages paid to individuals who are non-owner-employees of a business are subject to employment taxes regardless of how the business is organized.

The shareholders of a corporation are not subject to employment taxes in respect of any return on their investment in the corporation, though they are subject to employment taxes as to any wages paid to them by the corporation.

In the case of an S corporation, the IRS has sought to compel the corporation to pay its shareholder-employees a reasonable wage for services rendered to the corporation, so as to prevent its “conversion” into a distribution of investment income that is not subject to employment taxes.

In the case of a partnership, its “limited partners” are generally not subject to employment taxes in respect of their distributive share of the partnership’s income, while the shares of its “general partners” are subject to such taxes, regardless of whether or not they receive a distribution from the partnership.

The IRS recently considered whether a portion of an individual partner’s distributive share of partnership income could properly be treated as a return on his investment in the partnership and, thus, not subject to employment taxes.

Background

Taxpayer owned several franchise restaurants and contributed them to LLC, a limited liability company treated as a partnership for tax purposes.

During the years at issue, LLC’s gross receipts and net ordinary business income were almost entirely attributable to food sales.

Taxpayer owned the majority of LLC. The remaining interests in LLC were owned by Taxpayer’s spouse and an irrevocable trust. LLC’s operating agreement provided for only one class of ownership. Neither Taxpayer’s spouse nor the trust were involved with LLC’s business operations.

Taxpayer’s franchise agreements required him to personally work full-time on, and to devote his best efforts to, the operation of the restaurants. LLC’s operating agreement provided that Taxpayer was LLC’s Operating Manager, President, and CEO, and required him to conduct its day-to-day business affairs. In particular, Taxpayer had authority to manage LLC, make all decisions, and do anything reasonably necessary in light of its business and objectives.

Taxpayer directed the operations of LLC, held regular meetings and discussions with his management team and staff, made strategic, investment management and planning decisions, and was involved in the franchisor’s regional board and in its strategic planning.

LLC employed a number of individuals, many of whom had some level of management or supervisory responsibility. Pursuant to his authority under LLC’s Operating Agreement, Taxpayer appointed an executive management team consisting of financial and operations executive employees who did not have an ownership interest in LLC, but were given the responsibility of managing certain of LLC’s day-to-day business affairs, including making certain key management decisions.

Taxpayer had ultimate responsibility for hiring, firing, and overseeing all LLC’s employees, including members of the executive management team.

During the years at issue, LLC made “guaranteed payments” to Taxpayer for his services rendered to LLC.

Taxpayer as Limited Partner?

LLC treated Taxpayer as a limited partner for purposes of the employment tax rules, and included only the guaranteed payments in Taxpayer’s net earnings from self-employment, not his full distributive share of LLC’s net income.

LLC’s position was that Taxpayer’s income from LLC should be bifurcated for employment tax purposes between his (1) income attributable to capital invested or the efforts of others, which was not subject to employment tax, and (2) compensation for services rendered to LLC, which was subject to employment tax.

LLC asserted that, as a retail operation, it required capital investment for buildings, equipment, working capital and employees. LLC noted that Taxpayer and LLC made significant capital outlays to acquire and maintain the restaurants, and argued that LLC derived its income from the preparation and sale of food products by its employees, not the personal services of Taxpayer.

LLC asserted that Taxpayer had a reasonable expectation for a return on his investment beyond his compensation from LLC. It argued that Taxpayer’s guaranteed payments represented “reasonable compensation” for his services, and that his earnings beyond his guaranteed payments were earnings which were basically of an investment nature.

Therefore, LLC concluded that Taxpayer was a limited partner for employment tax purposes with respect to his distributive share of LLC’s net income.

Self-Employment Tax – In General

The Code imposes self-employment taxes on the self-employment income of every individual. The term “self-employment income” means the net earnings from self-employment derived by an individual during any taxable year.

In general, the term “net earnings from self-employment” means the net income derived by an individual from any trade or business carried on by such individual, plus his distributive share (whether or not distributed) of net income from any trade or business carried on by a partnership of which he is a member, with certain enumerated exclusions.

Among these exclusions, the Code provides that there shall be excluded any gain from the sale or exchange of property if such property is neither (i) stock-in-trade or other property of a kind which would properly be includible in inventory, nor (ii) property held primarily for sale to customers in the ordinary course of the trade or business. Thus, the exclusion does not apply to gains from the sale of stock in trade, inventory, or property held primarily for sale to customers in the ordinary course of a trade or business.

Partnerships & Self-Employment Tax

The Code also provides another exclusion:

there shall be excluded the distributive share of any item of income . . .
of a limited partner, as such, other than guaranteed payments . . .
to that partner for services actually rendered to . . . the partnership to the extent that those payments are established to be in the nature of remuneration for those services.

Unfortunately, the Code does not define “limited partner,” and the exclusion was enacted before LLCs became widely used.

Prior to the enactment of the exclusion, the Code provided that each partner’s share of partnership income was includable in his net earnings from self-employment for tax purposes, regardless of the nature of his membership in the partnership.

In creating the exclusion for limited partners, Congress recognized that certain earnings were basically of an investment nature. However, the exclusion was not extended to guaranteed payments, such as salary, received for services actually performed by the limited partner to or for the partnership.

Thus, individual partners who are not limited partners are subject to self-employment tax on their distributive share of partnership income regardless of their participation in the partnership’s business or the capital-intensive nature of the partnership’s business.

The Once-Proposed Regulations

In 1997, the IRS issued proposed regulations defining “limited partner” for these purposes. They generally provided that an individual would be treated as a limited partner unless the individual: (1) had personal liability for the debts of or claims against the partnership by reason of being a partner; (2) had authority to contract on behalf of the partnership; or (3) participated in the partnership’s trade or business for more than 500 hours.

In response to criticism from the business community, Congress immediately imposed a temporary moratorium on finalizing the proposed regulations, which expired in 1998; however, the 1997 proposed regulations were never finalized.

Subsequently, however, some Courts had the opportunity to shed light on the issue in the context of cases in which taxpayers attempted to distinguish between a partner’s wages and his share of partnership income. The Courts explained that a limited partnership has two fundamental classes of partners, general and limited. General partners typically have management power and unlimited personal liability. Limited partners lack management powers but enjoy immunity from liability for debts of the partnership. Indeed, a limited partner could lose his limited liability protection were he to engage in the business operations of the partnership. Consequently, the interest of a limited partner in a limited partnership is akin to that of a passive investor.

According to these Courts, the intent of the “limited partner exclusion” was to ensure that individuals who merely invested in a partnership and who were not actively participating in the partnership’s business operations would not receive credits toward Social Security coverage. In addition, the Courts noted that the legislative history of the “limited partner exclusion” did not support the conclusion that Congress contemplated excluding partners who performed services for a partnership in their capacity as partners (i.e., acting in the manner of self-employed persons) from liability for self-employment taxes. In addition, the Courts stated that “members of a partnership are not employees of the partnership” for purposes of self-employment taxes. Instead, a partner who participates in the partnership business is “a self-employed individual.” Thus, such a partner should treat all of his partnership income as self-employment income, rather than characterizing some of it as wages.

The IRS’s Analysis . . .

The IRS stated that, in general, a partner must include his distributive share of partnership income in calculating his net earnings from self-employment.

While the Code excludes from self-employment tax the gain on the disposition of certain property, the exclusion does not apply to a restaurant or retail operation’s sales of food or inventory. Thus, the IRS noted, the Code contemplates that a capital-intensive business such as a retail operation with stock in trade or inventory may generate income subject to self-employment tax. Because LLC earned its income from food sales in the ordinary course of its trade or business, the exclusion in the Code does not apply to LLC’s income.

Therefore, unless Taxpayer was a limited partner, he was subject to self-employment tax on his share of LLC’s income, notwithstanding the capital investments made, the capital-intensive nature of the business, or the fact that LLC had many employees.

Surprisingly, LLC did, in fact, take the position that Taxpayer was a limited partner for purposes of the “limited partner exclusion”.

The IRS disagreed. Relying upon the legislative history of the “limited partner exclusion,” the IRS explained that it was intended to apply to those who “merely invested ” rather than those who “actively participated” and “performed services for a partnership in their capacity as partners (i.e., acting in the manner of self-employed persons).”

The IRS further explained that “the interest of a limited partner in a limited partnership is generally akin to that of a passive investor,” and stated that limited partners are those who “lack management powers but enjoy immunity from liability for debts of the partnership.”

. . . And Conclusion

Taxpayer had sole authority over LLC, and was the majority owner, with ultimate authority over every employee and each aspect of LLC’s business. Even though LLC had many employees, including several executive level employees, Taxpayer was the only partner of LLC involved with the business and was not a mere investor, but rather actively participated in the partnership’s operations and performed extensive executive and operational management services for LLC in his capacity as a partner (i.e., acting in the manner of a self-employed person). Thus, the income Taxpayer earned through LLC was not income of a mere passive investor that Congress sought to exclude from self-employment tax.

LLC conceded that “service partners in a service partnership acting in the manner of self-employed persons” were not limited partners. However, LLC argued that a different analysis should apply to partners who: (1) derived their income from the sale of products, (2) made substantial capital investments, and (3) delegated significant management responsibilities to executive-level employees. LLC asserted that in these cases the IRS should apply “substance over form” principles to exclude from self-employment tax a reasonable return on the capital invested.

LLC interpreted the legislative history to mean that the “limited partner exclusion” applied to exclude a partner’s reasonable return on his capital investment in a capital-intensive partnership, regardless of the extent of the partner’s involvement with the partnership’s business.

Essentially, LLC argued that the self-employment tax rules for capital-intensive businesses carried on by partnerships were identical to the employment tax rules for corporate shareholder-employees: only reasonable compensation should be subject to employment tax.

Under this analysis, LLC argued that (1) LLC’s guaranteed payments to Taxpayer were reasonable compensation for his services, and (2) Taxpayer’s distributive share represented a reasonable return on capital investments in LLC’s business, and, therefore, Taxpayer was not subject to self-employment tax on his distributive share.

The IRS rejected these arguments, pointing out that they “inappropriately conflate the separate statutory self-employment tax rules for partners and the statutory employment tax rules for corporate shareholder employees.” The Code, it said, provides an exclusion for limited partners, not for a reasonable return on capital, and it does not indicate that a partner’s status as a limited partner depends on the presence of a guaranteed payment or the capital-intensive nature of the partnership’s business.

Lessons?

A partnership cannot change the character of a partner’s distributive share for tax purposes simply by making guaranteed payments to the partner for his services. A partnership is not a corporation and the “wage” and “reasonable compensation” rules which are applicable to corporations do not apply to partnerships.

The “limited partner exclusion” was intended to apply to those partners who “merely invest” rather than those who actively participate in and perform services for a partnership in their capacity as partners.

Instead, a partner who is not a “limited partner” within the meaning of the exclusion is subject to self-employment tax on his full distributive share of the partnership’s income, even in cases involving a capital-intensive business.

However, it should be noted that there remain other transactions involving payments from a partnership to a partner that do not generate self-employment income, including interest on loans from the partner to the partnership, and rental payments for the partnership’s use of the partner’s property. Not only are such payments excluded from the partner’s self-employment income, they also reduce the partnership’s net operating income, the partner’s distributive share of which is subject to self-employment tax.