In the weeks preceding the introduction of the bill that was just enacted as the Tax Cuts and Jobs Act (the “Act”), my colleagues teased me, “Lou, what are you going to do when Congress simplifies the Code?”

“Simplify?” I responded as I reached for the Merriam-Webster’s Dictionary that I have used since 1980 – it resides next to the HP scientific calculator that I have used since 1987 – change is not always a good thing – “Congress is incapable of simplifying anything.”

Tax Cuts and Jobs Act

“The word ‘simplify’,” I continued, “is defined as follows: to make simple or simpler; to reduce to basic essentials; to diminish in scope or complexity; to make more intelligible.”

After reviewing the final version of the legislation, two thoughts came to mind: first, Congress must not have a dictionary and, second, the most influential lobbying organization in Washington must be comprised entirely of tax professionals.

In order to better appreciate – if not fully understand – the changes wrought by the Act regarding the Federal taxation of trade or business income that is recognized, “directly or indirectly,” by non-corporate taxpayers, the reader should be reminded of the existing rules, and should also be made aware of the policy underlying the changes.

Pre-2018

A business that is conducted by an individual as a sole proprietorship (whether directly or through a single-member LLC that is disregarded for tax purposes) is not treated as an entity separate from its owner. Rather, the owner is taxed directly on the income of the business.

A business that is conducted by two or more individuals as a general partnership, a state law limited partnership, or a state law limited liability company, is treated as a pass-through entity for tax purposes – a partnership. The partnership is not itself taxable on the income of the business. Rather, each partner/member is taxed on their distributive share of the partnership’s business income.

A corporation that is formed under state law to conduct a business is not itself taxable on the income of the business if it is a “small business corporation” and its shareholders elect to treat it as an S corporation. In that case, the corporation is treated as a pass-through entity for tax purposes. In general, it is not taxable on its business income; rather, its shareholders are taxed on their pro rata share of the S corporation’s business income.

In each of the foregoing situations, the business income of an individual owner of a sole proprietorship, a partnership, or an S corporation (each a “Pass-Through Entity” or “PTE”) is treated for tax purposes as though the owner had realized such income directly from the source from which it was realized by the PTE.

In determining the taxable business income generated by a PTE, the Code allows certain deductions that are “related” to the production of such income, including a deduction for the ordinary and necessary expenses that are paid or incurred by the PTE in carrying on the business.

Because business income is treated as ordinary income (as opposed to capital gain) for tax purposes, the taxable business income of the PTE is taxed to its individual owner(s) at the regular income tax rates.[1]

What’s Behind the Change?

The vast majority of closely-held businesses are organized as PTEs, and the vast majority of newly-formed closely-held businesses are organized as limited liability companies that are treated as partnerships or that are disregarded for tax purposes.[2]

In light of this reality, Congress sought to bestow some unique economic benefit or incentive upon the non-corporate owners of PTEs in the form of a new deduction, and reduced taxes.[3]

However, Congress restricted this benefit or incentive in several ways that reflect a bias in favor of businesses that invest in machinery, equipment, and other tangible assets:[4]

  • in general, it is limited to PTEs that do not involve only the performance of services;
  • it benefits only the net business income of the PTE that flows through to the taxpayer; it does not apply to any amount paid by the PTE to the taxpayer in respect of any services rendered by the taxpayer to the PTE;
  • it does not apply to the PTE’s investment income; it is limited to the PTE’s business income; and
  • the benefit is capped, based upon how much the PTE pays in wages or invests in machinery, equipment, and other tangible property.

Beginning in 2018: New Sec. 199A of the Code

For taxable years beginning after December 31, 2017 and before January 1, 2026, an individual taxpayer[5] (a “Taxpayer”) who owns an equity interest in a PTE that is engaged in a qualified trade or business may deduct up to 20% of the qualified business income allocated to him from the PTE.

Qualified Trade or Business

Taxpayer’s qualified business income (“QBI”) is determined by each qualified trade or business (“QTB”) in which Taxpayer is an owner.[6] A QTB includes any trade or business conducted by a PTE other than a specified service trade or business.[7]

A “specified service trade or business” means any trade or business involving the performance of services in the fields of health, law, accounting, consulting, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees, or which involves the performance of services that consist of investing and investment management, or trading or dealing in securities.[8] However, a trade or business that involves the performance of engineering or architectural services is not a “specified service.”

Qualified Business Income

Taxpayer’s QBI from a QTB for a taxable year means Taxpayer’s share of the net amount of qualified items of income, gain, deduction, and loss that are taken into account in determining the taxable income of the QTB for that year.[9]

Items of income, gain, deduction, and loss are “qualified items” only to the extent they are effectively connected with the PTE’s conduct of a QTB within the U.S.[10]

“Qualified items” do not include specified investment-related income, gain, deductions, or loss; for example, items of gain taken into account in determining net long-term capital gain, dividends, and interest income (other than that which is properly allocable to a trade or business) are not included[11]; nor are items of deduction or loss allocable to such income.

Taxpayer’s QBI also does not include any amount paid to Taxpayer by an S corporation that is treated as reasonable compensation for services rendered by Taxpayer. Similarly, Taxpayer’s QBI does not include any “guaranteed payment” made by a partnership to Taxpayer for services rendered by Taxpayer.[12]

The Deduction

In general, Taxpayer is allowed a deduction for any taxable year of an amount equal to the lesser of:

(a) Taxpayer’s “combined QBI amount” for the taxable year, or

(b) an amount equal to 20% of the excess (if any) of

(i) Taxpayer’s taxable income for the taxable year, over

(ii) any net capital gain for the taxable year.

The combined QBI amount for the taxable year is equal to the sum of the “deductible amounts” determined for each QTB “carried on” by Taxpayer through a PTE.[13]

Taxpayer’s deductible amount for each QTB is the lesser of:

(a) 20% of the Taxpayer’s share of QBI with respect to the QTB, or

(b) the greater of:

(i) 50% of the “W-2 wages” with respect to the QTB, or

(ii) the sum of:

(A) 25% of the W-2 wages with respect to the QTB, plus

(B) 2.5% of the unadjusted basis, immediately after acquisition, of all “qualified property”.[14]

In general, the W-2 wages with respect to a QTB for a taxable year are the total wages subject to wage withholding, plus any elective deferrals, plus any deferred compensation paid by the QTB with respect to the employment of its employees during the calendar year ending during the taxable year of Taxpayer.[15]

“Qualified property” means, with respect to any QTB for a taxable year, tangible property of a character subject to depreciation that is held by, and available for use in, the QTB at the close of the taxable year, which is used at any point during the taxable year in the production of QBI, and for which the depreciable period[16] has not ended before the close of the taxable year.

Example

The taxpayer is single. She is a member of an LLC (“Company”) that is treated as a partnership for tax purposes (a PTE). The company is engaged in a QTB that is not a specified service trade or business.

Taxpayer’s taxable income for 2018 is $500,000 (i.e., gross income of $520,000 less itemized deductions of $20,000), which includes a guaranteed payment from Company of $120,000, for services rendered to Company during 2018, and her allocable share of QBI from Company for 2018 of $400,000. She has no investment income for 2018.

Her allocable share of W-2 wages with respect to Company’s business for 2018 is $300,000.

During 2018, Company purchases machinery and immediately places it into service in its QTB (the machinery is “qualified property”). Taxpayer’s allocable share of the purchase price is $750,000.

The taxpayer is allowed a deduction for the taxable year of an amount equal to the lesser of:

(a) her “combined QBI amount” for the taxable year (the guaranteed payment of $120,000 is not included in QBI), or

(b) 20% of her taxable income of $500,000 for the taxable year, or $100,000.

Taxpayer’s combined QBI amount for 2018 is equal to her “deductible amount” with respect to Company. The deductible amount is the lesser of:

(a) 20% of Taxpayer’s QBI (20% of $400,000 = $80,000), or

(b) the greater of:

(i) 50% of the W-2 wages with respect to the QTB (50% of $300,000 = $150,000), or

(ii) the sum of: 25% of the W-2 wages with respect to the QTB ($75,000), plus (B) 2.5% of the unadjusted basis, immediately after acquisition, of all qualified property (2.5% of $750,000 = $18,750): $75,000 + $18,750 = $93,750.

Thus, Taxpayer’s deductible amount is $80,000. Because this amount is less than $100,000 (20% of her taxable income of $500,000 for the taxable year), Taxpayer will be allowed to deduct $80,000 in determining her taxable income for 2018.

Looking Ahead

It remains to be seen whether the “20% deduction” based upon the QBI of a PTE will be a “game changer” for the individual owners of the PTE.

After all, the deduction is subject to several limitations that may dampen its effect. For example, QBI does not include the amount paid by the PTE to Taxpayer in respect of services rendered by Taxpayer. In addition, the losses realized in one QTB may offset the income realized in another, thereby reducing the amount of the deduction. Finally, the deduction is subject to limits based upon the wages paid and the capital investments made by the QTB.

Maximizing the Deduction?

Might an S corporation shareholder or a partner in a partnership reduce the amount paid to them by the entity for their services so as to increase the amount of their QBI and, so the amount of the deduction? In the case of an S corporation, this may result in the IRS’s questioning the reasonableness (i.e., insufficiency) of the compensation paid to the shareholder-employee.[17]

Or might a PTE decide to invest in more tangible property than it otherwise would have in order to set a greater cap on the deduction?

In any case, the business must first be guided by what makes the most sense from a business perspective.

Becoming a Pass-Through?

What if a business is already organized as a C corporation? Should the QBI-based deduction tip the scales toward PTE status?

Before taking any action with respect to changing its status for tax purposes, a C corporation will have to consider much more than the effect of the deduction for PTEs.

For example, does it even qualify as a small business corporation? If not, what must it do to qualify? Must it redeem the stock owned by an ineligible shareholder, or must it recapitalize so as to eliminate the second class of stock? Either option may prove to be economically expensive for the corporation and the remaining shareholders.

If the corporation does qualify, what assurances are there that all of its shareholders will elect to treat the corporation as an S corporation? Even if the election is made, will the presence of earnings and profits from “C” taxable years implicate the “excess passive income” rules?

In any case, a C corporation that is not otherwise contemplating a change in its tax status, should probably not become an S corporation solely because of the PTE-related changes under the Act, especially if the corporation does not contemplate a sale of its business in the foreseeable future.

Wait and See?

The deduction based on the QBI of a PTE will expire at the end of 2025 unless it is extended before then. It is also possible that it may be eliminated by Congress after 2020.

An existing PTE and its owners should continue to operate in accordance with good business practice while they and their tax advisers determine the economic effect resulting from the application of the new deduction to the PTE.

They should also await the release of additional guidance from the IRS regarding “abusive” situations, tiered entities, and other items.[18]


*This post is the first of several that will be dedicated to those portions of the Tax Cuts and Jobs Act of 2017 (H.R. 1) that are most relevant to the closely-held business and it owners.

[1] The Act reduces the highest income tax rate applicable to the individual owner of a PTE to 37% (from 39.6%) for taxable years beginning after December 31, 2017 and before January 1, 2026. Note that the 3.8% surtax continues to apply to the distributive or pro rata share of an individual partnership or shareholder who does not materially participate in the trade or business conducted by the PTE.

[2] Though occasionally, the owner(s) will elect to treat the LLC as a corporation for tax purposes; for example, to reduce employment taxes.

[3] The Act includes a number of business-related benefits that are applicable to both corporate and non-corporate taxpayers. It also includes some that are unique to corporations, such as the reduction of the corporate income tax rate from a maximum of 35% to a flat 21%.

[4] As we will see in the coming weeks, that Act contains a number of such provisions.

[5] More accurately, the benefit is available to non-corporate owners; basically, individual taxpayers, though trusts and estates are also eligible for the deduction.

[6] A PTE may conduct more than one QTB – different lines of business – or Taxpayer may own equity is more than one PTE.

[7] Also excluded is the trade or business of being an employee.

[8] The exclusion from the definition of a qualified business for specified service trades or businesses is phased in for a taxpayer with taxable income in excess of a “threshold amount” of $157,500 ($315,000 in the case of a joint return). The exclusion is fully phased in for a taxpayer with taxable income at least equal to the threshold amount plus $50,000 ($100,000 in the case of a joint return).

[9] If the net amount of the QBI is a loss (negative), it is treated as a loss from a QTB in the succeeding taxable year.

[10] Generally, when a person engages in a trade or business in the U.S., all income from sources within the U.S. connected with the conduct of that trade or business is considered to be effectively connected income.

[11] Qualified items should include the gain recognized on the sale of business assets.

[12] The IRS is authorized to issue regulations that would exclude any amount paid or incurred by the partnership to Taxpayer for services provided by Taxpayer to the partnership other than in his capacity as a partner.

[13] Taxpayer does not need to be active in the business in order to qualify for the deduction.

[14] This “wage limit” is phased in for a taxpayer with taxable income in excess of the threshold amount. The limit is fully applicable for a taxpayer with taxable income equal to the threshold amount plus $50,000 ($100,000 in the case of a joint return).

[15] In the case of a partnership or S corporation, the provision applies at the partner or shareholder level. Each partner or shareholder, as the case may be, takes into account his allocable or pro rata share of each qualified item of income, gain, deduction, and loss, and is treated as having W-2 wages and unadjusted basis for the taxable year equal to his allocable or pro rata share of the W-2 wages and unadjusted basis of the partnership or S corporation, as the case may be.

[16] The “depreciable period” is the period beginning with the date the qualified property is first placed in service and ending on the later of the date that is 10 years after such date, or the last day of the last full year in the applicable recovery period for the property.

[17] State and local taxes also need to be considered; for example, NYC’s unincorporated business income tax and its general corporation tax.

[18] “What we do in haste, we regret at leisure?”

Ah, December

As we near the end of the taxable year ending December 31, 2017, the thoughts of most people turn to holidays and family gatherings, feasting and celebrations, and reflecting, perhaps, on another year gone-by.

Not so for tax professionals.

Instead of “visions of sugar plums” dancing in their heads, these poor folk dream of proposed legislation, obsess over the effective dates of regulations, struggle to close year-end transactions and to implement last-minute tax planning, and prepare for the upcoming tax filing season.

Speaking of tax filings, there is a new filing obligation that should be of interest to U.S. tax professionals who advise foreigners with U.S. investments or U.S. business interests. This filing requirement went into effect for taxable years beginning on or after January 1st of 2017; thus, the first returns to be filed under the new requirement will be due in early 2018.

Specifically, if a domestic LLC is wholly-owned by one foreign person, and it is otherwise treated as a disregarded entity for tax purposes, then the LLC must comply with certain reporting and record maintenance requirements that were previously limited to foreign-owned U.S. corporations.

Entity Classification

In general, a business entity with two or more members is treated, for tax purposes, as either a corporation or a partnership, and a business entity with a single owner is treated as either a corporation or an entity disregarded as separate from its owner (“disregarded entity”).

Certain domestic business entities, such as LLCs, are classified by default as partnerships (if they have more than one owner) or as disregarded entities (if they have only one owner), but are eligible to elect for federal tax purposes to be classified as corporations.

Some disregarded entities are not obligated to file a return or to obtain an employer identification number. According to the IRS, the absence of a return filing obligation (and the associated record maintenance requirements), made it difficult for the IRS to implement and enforce the tax laws applicable to foreigners that invest, or operate a business, in the U.S. through as disregarded entity.

Information Reporting

Under the Code, a domestic corporation that is at least 25% foreign-owned (a “reporting corporation”) is subject to specific information reporting and record maintenance requirements.

A reporting corporation is required to file an annual return on IRS Form 5472, Information Return of a 25% Foreign-Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business, with respect to each “related party” (including, among others, the 25%-foreign shareholder) with which the reporting corporation has had any “reportable transactions” including, for example, sales, leases, services, rentals, licenses, and loans.

The Form 5472 for a tax year must be attached to the reporting corporation’s income tax return for such year by the due date (including extensions) of the return. A separate Form 5472 must be filed for each foreign or domestic related party with which the reporting corporation had a reportable transaction during the tax year.

The reporting corporation must also keep books and records that are sufficient to establish the accuracy of the federal income tax return of the corporation, including information, documents, or records to the extent they may be relevant to determine the correct U.S. tax treatment of its transactions with related parties.

An Issue for the IRS

When a foreign-owned entity, such as an LLC, was classified as a corporation or a partnership for tax purposes, general ownership and accounting information was available to the IRS through the return filing and EIN application requirements.

Before 2017, however, when a single-member, foreign-owned, domestic LLC was treated as a disregarded entity for tax purposes, it was generally not subject to a separate income or information return filing requirement. Its owner was treated as owning directly the entity’s assets and liabilities, and the information available with respect to the disregarded entity depended on the foreign owner’s own return filings, if any were required.

Thus, if the LLC was wholly-owned by a foreign corporation, foreign partnership, or nonresident alien individual, generally no U.S. income or information return would have been required if neither the disregarded LLC nor its owner received any U.S. source income or was engaged in a U.S. trade or business.

Moreover, if the disregarded entity only received certain types of U.S. source income, such as portfolio interest or U.S. source income that was fully withheld upon at source, its foreign owner would not have had a U.S. return filing requirement.

The IRS found that even in cases when the disregarded entity had an EIN, as well as in cases when income earned through a disregarded entity had to be reported on its owner’s return (for example, income from a U.S. trade or business), it could be difficult for the IRS to associate the income with the disregarded entity based solely on the owner’s return.

The absence of specific return filing, and associated recordkeeping, requirements for foreign-owned, single-member domestic entities, and the resulting lack of ready access to information on ownership of, and transactions involving, these entities, made it difficult for the IRS to ascertain whether the entity or its owner was liable for any federal tax.

New Reporting Obligation

Thus, at the end of 2016, the IRS adopted a new regulation under which a domestic LLC, that is wholly-owned (directly, or indirectly through one or more other disregarded entities) by one foreign person, is treated as a domestic corporation (i.e., as an entity that is separate from its owner) for the limited purposes of the reporting and record maintenance requirements (including the associated procedural compliance requirements) described above. Importantly, it does not alter the framework of the existing entity classification regulations, including the treatment of certain LLCs as disregarded for income tax purposes.

By treating an affected LLC as a foreign-owned domestic corporation, the LLC becomes a “reporting corporation.” Consequently, it is required to file a Form 5472 information return with respect to any “reportable transactions” between the LLC and its foreign owner or other foreign “related parties” (transactions that would have been regarded under general U.S. tax principles if the entity had been, in fact, a corporation for U.S. tax purposes) including, for example, sales, leases, services, rentals, licenses, and loans. It is also required to maintain records sufficient to establish the accuracy of the information return and the correct U.S. tax treatment of such transactions. In addition, because the foreign-owned LLC has a filing obligation, it is required to obtain an EIN.

To ensure that a wholly-owned LLC reports all of its transactions with its foreign owner and other related parties, even if its foreign owner already has an obligation to report the income resulting from those transactions (for example, transactions resulting in income effectively connected with the conduct of a U.S. trade or business), the regulations specify, as an additional reportable category of transaction, any transaction to the extent not already covered by another reportable category. Thus, for example, contributions and distributions (both current and liquidating) are considered reportable transactions with respect to a “reporting LLC.”

Accordingly, any transaction between such an LLC and its foreign owner (or another disregarded entity of the same owner) would be considered a reportable transaction for purposes of the reporting and record maintenance requirements, even though, because the transaction involves a disregarded entity, it generally would not be considered a transaction for other tax purposes.

In order to facilitate the implementation of this reporting requirement, the reporting LLC is treated as having the same taxable year as its foreign owner, if the foreign owner has a U.S. return filing obligation. If the foreign owner has no U.S. return filing obligation, then the LLC is treated as having the calendar year as its taxable year.

Penalties

The penalty provisions associated with the failure to file the Form 5472 and the failure to maintain records will apply to reporting LLCs. For example, a penalty of $10,000 will be assessed against any reporting LLC that fails to file Form 5472 when due. The penalty also applies for a failure to maintain records as required. If the failure continues for more than 90 days after notification by the IRS, additional penalties will apply.

What Does It Mean?

Ah, the beginning of a new taxable year, and of a new era of transparency for many foreign-owned LLCs. What is one to do?

For starters, the U.S. professionals who advise these entities and their owners should alert them of the new reporting requirements, if they haven’t already done so. They should also be on the lookout for new Form 5472 instructions.

If a reporting LLC does not already have one, it must obtain an EIN as soon as possible. In connection therewith, the LLC will have to identify its “responsible party” (basically, the individual who controls the disposition of the LLC’s funds and assets), which means that the responsible party will itself have to obtain its own U.S. identification number (for example, an ITIN).

In addition, the LLC, its foreign owner, and their U.S. advisers will have to make certain that they have properly documented their 2017 reportable transactions, have maintained sufficient records to substantiate the accuracy of the information return to be filed by the LLC, and have implemented the appropriate internal procedures to ensure future compliance with the new reporting requirement.

Some Days Are Stones[1]

It’s not always easy to find a topic about which to write a weekly blog post. I usually look for a ruling or decision that illustrates one of the recurring themes of the tax law, and then develop a lesson or message around it. Sometimes I’ll use a project on which I’m working.

Some weeks are more fruitful than others. This week was a relatively lean one.

That being said, I did come across a recent letter ruling issued by the IRS that was short on facts and legal analysis, and the outcome of which would be obvious to most, but which I thought might serve my purpose.

The taxpayer to which the ruling was issued asked the IRS to consider whether the conversion of a State law limited liability company (“LLC”) into a State law limited partnership would cause the LLC or its members to recognize taxable income or gain.

Now, some of you may say, “big whoop.” (I did say the result was obvious.)

Nevertheless, the ruling does offer an opportunity for some fruitful discussion based upon the significance of the factual representations on which the ruling was based.

Basic Facts

LLC-1 was classified as a partnership for federal tax purposes. It had two managing members:

  • Corp-1 was a state law limited liability company that was classified as a corporation for tax purposes;
  • LLC-2 was a limited liability company that was disregarded as an entity separate from its owner for tax purposes;
    • Corp-2 was classified as a corporation for tax purposes, and was the sole member of LLC-2; thus, Corp-2 was treated as the second member of LLC-1 for tax purposes.

The other membership interests in LLC-1 were non-managing member interests owned either indirectly by Corp-2 (including through subsidiaries of LLC-2), or by other investors.

LLC-1 planned to convert to a limited partnership in accordance with State law (the “Conversion”), after which it would continue to carry on the business operations it previously conducted as a limited liability company before the Conversion.

Creation of Disregarded Entities

Before the Conversion, Corp-1, LLC-2, and one of LLC-2’s wholly-owned subsidiaries (we are not told whether this subsidiary was itself a disregarded entity – i.e., a limited liability company – or a corporation) would each form a single-member limited liability company (three in all) that would be disregarded as an entity separate from its respective owner for federal tax purposes (the “Disregarded Entities”).

In connection with the Conversion, LLC-2 and LLC-2’s subsidiary would each contribute all of its interest in LLC-1 (including its managing-member interest) to its respective Disregarded Entity. Corp-1 would contribute a portion of its interest in LLC-1 to its Disregarded Entity.

As part of the Conversion, the three Disregarded Entities would become the State law general partners of LLC-1; for tax purposes, their “regarded” owners (Corp-1, LLC-2 and LLC-2’s subsidiary) would be treated as the general partners of post-Conversion LLC-1 (as compared to the two State law managing members of pre-Conversion LLC-1).

(The ruling did not give the business reason for the Disregarded Entities. There are several possibilities, including planning for creditors upon the conversion of the managing member interests into general partner interests.)

The Representations

According to LLC-1, the limited partnership agreement that would replace its operating agreement would be substantively identical to the operating agreement; in other words, the economic arrangement among the members/partners, including the allocation of income, gain, loss, deduction, and credit among them would not be changed by virtue of the Conversion.

Consistent therewith, it was represented in the ruling that:

  • the balances in each partner’s (formerly member’s) capital account immediately after the Conversion would be the same as they were immediately before the Conversion
  • each partner’s total percentage interest in X’s profits, losses, and capital after the Conversion will be the same as that partner’s percentage interest in X’s profits, losses and capital before the Conversion, and the allocation of tax items will also remain unchanged
    • there would be no change in how they shared these tax items after the Conversion;
  • each partner’s share of liabilities of LLC-1 immediately after the Conversion would be the same as it was immediately before the Conversion
    • there would be no deemed distribution or deemed contribution of cash to any partner, or any deemed sale of partnership interests between any partners; there would be no change in any partner’s share of value, gain, or loss associated with the partnership’s unrealized receivables or inventory items in connection with the Conversion
    • thus, no partner would be treated as having exchanged an interest in so-called “hot assets” for a greater interest in other assets of the partnership, or vice versa, which could result in income or gain to such partner; and
  • LLC-1 would retain the same method of accounting and accounting period.

Interestingly, LLC-1 represented to the IRS that it had not issued any profits interest in the two years preceding the date of the Conversion. You may recall that a person’s receipt of a profits interest in a partnership will generally not be treated as a taxable event; this result will not follow, however, if the partner disposes of the profits interest within two years of receipt.

LLC-1 also represented that the “Sec. 704(b) book basis” of its property (the fair market value of the property at the time of its contribution to LLC-1, adjusted for subsequent book depreciation) that secured nonrecourse debt exceeded the amount of such debt; in other words, there was no “partnership minimum gain” – the gain that the partnership would realize if it disposed of the property for no consideration other than full satisfaction of the liability.

The IRS’s “Analysis”

According to the Code, an existing partnership is considered as continuing if it is not terminated. A partnership is considered as terminated only if: (1) no part of any business, financial operation, or venture of the partnership continues to be carried on by any of its partners in a partnership; or (2) within a 12-month period, there is a sale or exchange of 50 percent or more of the total interest in partnership capital and profits (a “technical termination”).

The IRS has, on several occasions, published rulings in which it examined the federal income tax consequences of a conversion of one form of partnership interest into another form of partnership interest in the same partnership. In general, provided each partner’s total percentage interest in the partnership’s profits, losses, and capital would remain the same after the conversion, and the partnership’s business would continue, no gain or loss would be recognized by the partners as a result of their exchanging their interests in the partnership.

Similarly, the IRS has previously ruled that the conversion of a domestic partnership into a domestic limited liability company classified as a partnership for tax purposes is treated as a partnership-to-partnership conversion that is subject to the same principles as an exchange of interests within the same partnership. It has also stated that the same holdings would apply if the conversion had been of an interest in a domestic limited liability company that is classified as a partnership for tax purposes into an interest in a domestic partnership.

IRS regulations provide that a business entity that is not classified as a corporation per se (a so-called “eligible entity”) can elect its classification for federal tax purposes. An eligible entity with at least two members can elect to be classified as either an association or a partnership, and an eligible entity with a single owner can elect to be classified as an association or to be disregarded as an entity separate from its owner. The regulations also provide that unless the entity elects otherwise, a domestic eligible entity will be treated as a partnership if it has two or more members.

Without further discussion, the IRS concluded that the Conversion would not cause a “technical termination” of LLC-1’s status as a partnership for tax purposes, and that neither LLC-1 nor its members would recognize taxable income, gain, or loss upon the Conversion.

Although not stated in the ruling, the IRS could have added that: the taxable year of the pre-Conversion limited liability company did not close as a result of the Conversion, the post-Conversion partnership would continue to use the EIN of the converted limited liability company, the tax elections made by the converted limited liability company would remain in effect as would its depreciation methods, and the members’ bases in their membership interests would carry over to their partnership interests.

So What? Is That It?

Pretty much.

The point is that there is a lot of thought and planning that goes into securing a “duh” ruling. The ruling becomes a foregone conclusion only because of the analysis, structuring and drafting that preceded it.

In the case of the ruling described herein, the failure of any of the representations set forth above may have resulted in a taxable event to one or more of the partners.

For that reason, it would behoove anyone who advises taxpayers and their business entities to become familiar with the kinds of representations that are made in connection with a “successful” ruling on a specific kind of transaction.

These representations highlight many of the issues that others have encountered in similar transactions over the years, and on which the IRS may be focusing. As such, they may provide a good starting point for an adviser’s consideration of, and planning for, his or her own client’s transaction.

 

[1] From “Some Days Are Diamonds” by Dick Feller, sung by John Denver.

Last week’s post explored the federal income tax consequences to a taxpayer who failed to timely file an election for the classification of his wholly-owned business entity.

Today’s post considers how one taxpayer sought to utilize the IRS’s business entity classification rules to reduce his estate’s exposure for NY estate tax. Individuals who are not domiciled in NY (“nonresidents”), but who operate a NY business, should familiarize themselves with NY’s response to the taxpayer’s proposed plan.

Situs of an LLC Interest
NY had previously ruled in an advisory opinion that a membership interest in a single-member LLC (“SMLLC”) that owned NY real property, and that was disregarded for federal income tax purposes, would be treated as real property – not as an intangible – for NY estate tax purposes.

The opinion also held that when a SMLLC makes an election to be treated as an association (taxable as a corporation) pursuant to the IRS’s “check-the-box” rules, the membership interest in the SMLLC would be treated as intangible property.

It concluded that the election that is in place on the date of the single member’s death is the election that will be used to determine whether the interest in the SMLLC is treated as real property or as intangible property for purposes of NY’s estate tax.

A recent NY advisory opinion addressed Taxpayer’s question whether a membership interest in a SMLLC would be treated as intangible property for NY estate tax purposes where the SMLLC initially elects to be disregarded for income tax purposes but, immediately upon the single member’s death, retroactively elects to be treated as an association taxable as a corporation.

Electing to Change Tax Status – and Situs?
Taxpayer represented that he was currently a NY resident, but that he planned to move to another state. At that time, Taxpayer would transfer his NY real property into a SMLLC, of which he would be the sole member. This SMLLC would not elect to be treated as an association for federal income tax purposes. Thus, it would be treated as a disregarded entity, and Taxpayer would continue to be treated as the owner of the real property.

Taxpayer also represented that he intended to remain the sole owner of the LLC for the remainder of his life, and to continue to have the SMLLC treated as a disregarded entity until his death. This would enable Taxpayer to claim on his personal income tax return the income and deductions associated with the real property.

Upon his death, Taxpayer’s Last Will and Testament would direct his executor to elect that the SMLLC be taxed as an association, and as an S-corporation, for income tax purposes. These elections would have retroactive effect to at least one day prior to the date of Taxpayer’s death.

Before we consider NY’s response to Taxpayer’s proposal, let’s first review the application of NY’s estate tax to nonresident decedents, as well as the IRS’s entity classification rules, the interplay of which is key to NY’s opinion.

The NY Estate Tax
NY imposes an estate tax on the transfer by the estate of a nonresident decedent of real property located in NY.

However, where the real property is held by a corporation or partnership, an interest in such entity has been held to constitute intangible property.

The NY Constitution prohibits the imposition of an estate tax on a nonresident’s intangible property, even if such property is located in NY. For example, securities and other intangible personal property within the state, that are not used in carrying on any business within the state by the owner, are considered to be located at the domicile of the owner for purposes of taxation.

NY’s tax law likewise provides that the NY taxable estate of a nonresident decedent does not include the value of any intangible personal property otherwise includible in the decedent’s gross estate.

The Entity Classification (“check-the-box”) Rules
Pursuant to the IRS’s entity classification rules, an entity that has a single owner, such as a SMLLC, is disregarded as an entity separate from its owner unless it elects to be classified as an association taxable as a corporation.

In other words, where no election is filed, the default classification of the SMLLC is that of a disregarded entity, one that is not deemed to be an entity separate from its owner. The SMLLC will retain this default classification until it makes an election to change its classification.

If the SMLLC is disregarded for tax purposes, its assets and activities are treated in the same manner as those of a sole proprietorship, branch, or division of the owner – the sole member is treated as the direct owner of the LLC’s assets, and is treated as conducting the LLC’s activities himself, for tax purposes.

A SMLLC may elect to be classified as other than its default classification by filing an entity classification election with the IRS. Specifically, a SMLLC may elect to be classified as an association, and thus treated as a corporation for tax purposes, by making such an entity classification election.

Such an election would be effective on the date specified by the entity on the election form, or on the date the form was filed if no such date is specified on the form. The effective date specified on the form cannot be more than 75 days prior to the date on which the election is filed, or more than 12 months after the date on which the election is filed.

NY’s Opinion
“A membership interest in a SMLLC owning New York real property, which is disregarded for income tax purposes, is not treated as ‘intangible property’ for purposes of New York State estate tax purposes. However, where a SMLLC makes an election to be treated as a corporation pursuant to [the ‘check-the-box’ rules], rather than being treated as a disregarded entity, such ownership interest would be considered intangible property for New York State estate tax purposes.”

The opinion noted that there is no provision in NY law applicable to the estate tax that provides for retroactively changing an entity’s classification, in this case to be treated as an association/corporation, after the death of its sole owner. Consequently, any post-mortem, retroactive classification election would be disregarded and not treated as a valid election for NY estate tax purposes.

Based on the above analysis, the advisory opinion stated that where a SMLLC is disregarded for Federal income tax purposes, the assets and activities of the SMLLC are treated as those of the deceased nonresident sole member without regard to any post-mortem election directed by his Last Will and Testament.

Therefore, under the circumstances described above, the interest in the SMLLC owned by Taxpayer would not be treated, for NY estate tax purposes, as an intangible asset. Instead, the NY real property held by the SMLLC would continue to be treated as real property held by the Taxpayer for NY estate tax purposes, even after the retroactive classification election was filed.

The Right Answer
Although an advisory opinion is limited to the facts set forth therein, and is binding on NY only with respect to the person to whom it is issued, it is pretty clear that NY’s position regarding Taxpayer’s proposed gambit stands on fairly solid ground.

The proposal described above is premised on the fact that Taxpayer has no idea of when he will die. He wants to enjoy the flexibility of operating through a SMLLC during his life and, upon his demise, take advantage of the opportunity afforded by the entity classification rules to make a retroactive change to the LLC’s tax status and, thereby, to change the situs of his membership interest in the LLC.

Although there are several statutorily-approved post-mortem planning opportunities (for example, the 6-month alternate valuation rule), the ability to elect to change the situs of a nonresident decedent’s property for NY estate tax purposes is definitely not one of them.

A nonresident business owner who operates in NY through a SMLLC certainly should not rely upon his executor’s making a post-mortem entity classification election to “remove” his tangible assets from the reach of the NY estate tax.

An S-corporation is a viable alternative, though it is more restrictive than a SMLLC, and the S-corporation election would have to be made while the owner was still alive.

Alternatively, the owner could choose to admit a second member to the LLC – perhaps an S-corporation, wholly-owned by him, that would hold a de minimis membership interest. The LLC would be treated as a partnership for tax purposes, thereby affording the owner the desired flexibility and pass-through treatment. The LLC interest would also be treated as an intangible in the hands of the nonresident owner under the NY estate tax.

Fortunately, Taxpayer sought professional guidance, as well as NY’s opinion, before implementing the proposed gambit. It’s a lesson to be remembered.

Whose Tax Liability?

In order to properly assess and collect a tax, the IRS first needs to identify the taxpayer that is responsible for reporting the income, and for collecting and remitting the tax, at issue. This is not always a simple proposition. In the case of a business entity, it may depend, in part, upon the entity’s classification for tax purposes.

Tax LiabilityFor example, a business entity that was incorporated under State law will be treated as a taxable C corporation for tax purposes. The same corporation may file an election with the IRS to be treated as a pass-through small business (“S”) corporation, and it may subsequently elect to revoke its “S” election.

In the case of every other business entity, however, the classification is more “fluid.” In order to provide certainty both to the IRS and to taxpayers, the IRS has issued entity classification regulations. These regulations provide certain “default” classifications that coincide with what most taxpayers would desire for the entity in question. Where the taxpayer wants to elect a classification other than the “preferred” default status, it must affirmatively notify the IRS of its decision.

Thus, an LLC that has only one member is ignored for income tax purposes; it is treated as partnership if it has at least two members; regardless of how many members it has, it may elect to be treated as an association that is taxable as a corporation.

The importance of properly making and filing an election so as to change the classification of a business entity for tax purposes cannot be understated.

An Illustration

Taxpayer was the sole shareholder of Corp., a “C” corporation on behalf of which he consistently filed Form 1120, U.S. Corporation Income Tax Return.

Taxpayer formed LLC at the end of Year 1 and became LLC’s sole member. Immediately after the formation of LLC, Corp. merged with and into LLC, with LLC as the surviving entity, and Corp. ceased to exist. LLC continued to own Corp.’s assets and to operate Corp’s business. Since the merger, LLC filed Forms 1120 using Corp’s employer identification number (“EIN”). However, LLC did not file IRS Form 8832, Entity Classification Election.

Taxpayer filed Forms 940 and 941 on behalf of LLC, but did not make sufficient tax deposits or pay the tax due for its employment tax liabilities for several taxable periods after the merger (but before 2009 – see later).

The IRS issued a Notice of Intent to Levy for these periods and filed a Notice of Federal Tax Lien.

Taxpayer argued that LLC, and not Taxpayer individually, was liable for the employment tax liabilities due from LLC.

The only issue for consideration by the Tax Court was whether Taxpayer, as the sole member of LLC, was personally liable for the payment of the employment tax liabilities of LLC for the taxable periods in question.

Entity Classification

The so-called “check-the-box” regulations allow an “eligible business entity” to elect its classification for federal tax purposes. An eligible business entity is one that is not treated as a corporation, per se, under the regulations.

An eligible entity with a single owner, such as the LLC and Taxpayer in the present case, may elect to be classified as an association – i.e., as a corporation – for tax purposes, or it may choose to be disregarded as an entity separate from its owner.

An eligible entity with a single owner that does not file an election is disregarded as an entity separate from its owner; its default status is that of a disregarded entity.
An election is necessary only when an eligible entity chooses to be classified initially as something other than its default classification, or when an eligible entity chooses to changes its classification.

The tax treatment of a change in the classification of an entity for federal tax purposes by election is determined under all relevant provisions of the Code and general principles of tax law, including the step transaction doctrine.

For example, if an eligible entity that is disregarded as an entity separate from its owner (the default status of a single-member LLC) elects to be classified as an association, the following is deemed to occur: the owner of the eligible entity contributes all of the assets and liabilities of the entity to the association in exchange for stock of the association.

If an eligible entity classified as an association (a business entity that elected to be treated as a corporation for tax purposes) elects to be disregarded as an entity separate from its owner, the following is deemed to occur: the association distributes all of its assets and liabilities to its owner in liquidation of the association.

Form 8832

An entity whose classification is determined under the default classification rules retains that classification until the entity makes an election to change its status by filing IRS Form 8832, Entity Classification Election.

An election will not be accepted unless all of the information required by Form 8832 and its instructions is provided. Further, to avoid penalties, an eligible entity that is required to file a federal tax or information return for the taxable year in which an election is made must attach a copy of Form 8832 to its tax or information return for that year.

Under these rules, LLC was disregarded as a separate entity from Taxpayer, its owner, because it was a single-member LLC that had never filed Form 8832.

Notwithstanding this conclusion, Taxpayer made a number of arguments as to why Form 8832 was not the only method by which an eligible entity could elect to change its classification.

The Taxpayer’s Position

First, Taxpayer argued that the merger of Corp. and LLC was a valid reorganization under Section 368(a)(1)(F) of the Code (an “F reorganization,” or “mere change” in corporate identity or form) and, as a result, LLC should be treated as a corporation for federal tax purposes.

Second, Taxpayer argued that the filing of Forms 1120 for the first year after the merger of Corp. and LLC constituted a valid election for LLC to be taxed as a corporation.

Third, Taxpayer argued that the doctrine of equitable estoppel prevented the IRS from contending that LLC was not a corporation because the IRS had “tacitly acquiesced” to the filings of Forms 1120 for the year of the merger and subsequent years.

The Tax Court’s Response

The Court responded that regardless of whether the merger of Corp. and LLC qualified as a valid F reorganization, LLC never filed Form 8832 electing its classification for federal tax purposes as an association and, thus, was not a corporation but, rather, was disregarded as an entity separate from its owner. (Incidentally, this would have caused the merger to be treated as a taxable liquidation of Corp.)

Next, the Court stated that an eligible entity could not elect its entity classification by filing any particular tax return it wished; it had to do so by filing Form 8832 and following the instructions within the regulations. Thus, LLC could not elect to be treated as an association/corporation merely by filing corporate income tax returns.

Finally, according to the Court, equitable estoppel did not bar the IRS from treating LLC as a disregarded entity. The Court noted that equitable estoppel was to be applied against the IRS with the utmost restraint. The elements of estoppel, it stated, are: “(1) * * * a false representation or wrongful misleading silence; (2) the error must be in a statement of fact and not in an opinion or a statement of law; (3) the person claiming the benefits of estoppel must be ignorant of the true facts; and (4) he must be adversely affected by the acts or statements of the person against whom an estoppel is claimed.” The IRS made no false statement to Taxpayer, and the Court did not agree that the IRS’s failure to reject LLC’s filed Forms 1120 was a wrongful misleading silence. Moreover, Taxpayer knew that LLC had never filed a Form 8832 to elect to be treated as anything other than a disregarded entity.

For the foregoing reasons, the Court rejected Taxpayer’s arguments, and found that LLC was disregarded as an entity separate from Taxpayer.

The Taxes At Issue

The Code requires employers to pay employment taxes imposed on employers and to withhold from employees’ wages certain taxes imposed on employees. Employers are required to withhold from employees’ wages the amounts of federal income tax owed by those employees. The Code also imposes a tax on every employer with respect to individuals in his employ.

For employment taxes related to wages paid before January 1, 2009, a disregarded entity’s activities were treated in the same manner as those of a sole proprietorship, branch, or division of the owner.

Accordingly, the sole member of a limited liability company and the limited liability company itself were treated as a single taxpayer who is personally liable for purposes of the employment tax reporting and wages paid before January 1, 2009. Taxpayer was, therefore, liable for LLC’s unpaid employment tax liabilities arising during the tax periods at issue since they related to wages paid before 2009.

Did the Court Get it Right?

On a strict reading of the regulations, yes, it did.

However, the Court’s decision seems harsh. Taxpayer clearly intended to treat LLC as an association taxable as a corporation for tax purposes. He caused LLC and Corp. to merge as part of a transaction that was reported as a tax-free corporate reorganization, not as a taxable liquidation. He treated LLC as the continuation of Corp. for tax purposes, causing LLC to file income tax returns as a “C” corporation, using Corp.’s EIN, after the merger.

What Taxpayer failed to do was file a Form 8832 to elect to be treated as an association.

Interestingly, an eligible entity, including a single-member LLC, that timely elects to be an S corporation, by filing IRS Form 2553, is treated as having made an election under the regulations to be classified as an association, provided that (as of the effective date of the “S” election) the entity meets all other requirements to qualify as a small business corporation. The deemed election to be classified as an association will apply as of the effective date of the S corporation election and will remain in effect until the entity makes a valid election to be classified as other than an association.

When this provision of the check-the-box regulations was adopted, the IRS explained that requiring eligible entities to file two elections in order to be classified as S corporations – Form 8832 and Form 2553 – creates a burden on those entities and on the IRS. The regulations sought to simplify these paperwork requirements by eliminating the requirement that the entity also elect to be classified as an association by filing Form 8832. Instead, an eligible entity that makes a timely and valid election to be classified as an S corporation by filing Form 2553 will be deemed to have elected to be classified as an association taxable as a corporation.

The regulation also provides that, if the eligible entity’s “S” election is not timely and valid, the default classification rules will apply to the entity unless the IRS provides late S corporation election relief or inadvertent invalid S corporation election relief.

Unless the IRS amends the regulations to expand the relief available thereunder beyond “S” elections, to cover eligible business entities in general, a taxpayer seeking a particular entity classification for tax purposes must file Form 8832. It will not be enough that the taxpayer has otherwise acted consistently with the desired status.

Partner or Employee?

It has long been the position of the IRS that a bona fide member of a partnership is not an employee of the partnership. Such a partner, who devotes his or her time and energies to the conduct of the trade or business of the partnership, or in providing services to the partnership, is a self-employed individual.

According to the IRS, however, it appears that some taxpayers have been misreading the so-called “entity classification” rules so as to permit the treatment of individual partners, in a partnership that owns a disregarded entity, as employees of the disregarded entity. Under this reading, some partnerships have permitted partners to participate in certain tax-favored employee benefit plans.

In order to address this issue, the IRS recently proposed regulations to clarify that such partners are subject to the same self-employment tax rules as partners in a partnership that does not own a disregarded entity. [TD 9766]

Before reviewing the proposed regulations, it may be helpful to describe the tax treatment of “partner compensation.”

Payments for Services

The rules that govern the tax treatment of transactions between partners and their partnerships are among the most complex rules in the Code. The treatment of a particular transaction will depend, in part, upon the capacity in which the partner is acting and upon the nature of the transaction.

For example, payments made by a partnership to a partner for services rendered in his or capacity as such, are considered as made to a person who is not a partner, if such payments are determined without regard to the income of the partnership. [IRC Sec. 707(c)]

However, such a “guaranteed payment” is considered as made to a non-partner only for certain enumerated purposes.

Specifically, the partner must include the amount of the payment in his or her gross income [IRC Sec. 61; https://www.law.cornell.edu/uscode/text/26/61 ], even if the partnership has a loss for the year in which the payment is made. Moreover, because the payment is made in respect of services rendered, the income is taxed as ordinary income regardless of the character of the income, if any, realized by the partnership.

Similarly, the partnership may deduct the payment [IRC Sec. 162], provided it constitutes an ordinary and necessary trade or business expense , is reasonable for the services rendered, and does not have to be capitalized under the rules relating to capital expenditures. [IRC Sec. 263]

The impact of this rule is limited to these enumerated purposes. For purposes of other provisions of the tax law, guaranteed payments are regarded as a partner’s share of the partnership’s income. Thus, as in the case of a partner’s distributive share of partnership income, the partner must include such payments in gross income for his or her taxable year within or with which ends the partnership taxable year in which the partnership deducted such payments under its method of accounting. [Reg. Sec. 1.707-1(c)]

For purposes of other provisions of the Code, guaranteed payments are regarded as a partner’s distributive share of ordinary income. Thus, a partner who receives guaranteed payments for a period during which he or she is absent from work because of personal injuries or sickness is not entitled to exclude such payments from his gross income. [IRC Sec. 105] Similarly, a partner who receives guaranteed payments is not regarded as an employee of the partnership for the purposes of income or employment tax withholding, deferred compensation plans, etc. [Reg. Sec. 1.707-1(c)] Instead, guaranteed payments received by a partner, from a partnership that is engaged in a trade or business, for services rendered to the partnership are treated as “net earnings from self-employment” and are subject to self-employment tax. [1.1402(a)-1(b)]

The Entity Classification Rules

A business entity (typically, an LLC) that has a single owner, and that is not a corporation, is disregarded as an entity separate from its owner for purposes of the income tax. The single owner is treated, for example, as owning all of the entity’s assets and as receiving all of its income.

However, such a “disregarded entity” is treated as a corporation for purposes of the employment taxes imposed under the Code. Therefore, the disregarded entity, rather than the owner, is considered to be the employer of the entity’s employees for purposes of the employment taxes.

While a disregarded entity is, thus, treated as a corporation for employment tax purposes, this rule does not apply for self-employment tax purposes. Rather, the general rule applies, and the entity will be disregarded as an entity separate from its owner for purposes of the self-employment tax.

The applicable regulation illustrates this rule in the context of a single individual owner (not a partnership) by stating that the owner of an entity that is treated in the same manner as a sole proprietorship is subject to tax on self-employment income. However, the regulation includes an example in which the disregarded entity is subject to employment tax with respect to employees of the disregarded entity, while the individual owner is subject to self-employment tax on the net earnings from self-employment resulting from the disregarded entity’s activities.

Because the regulation does not include a specific example applying the general rule in the context of a partnership, many taxpayers believed – unreasonably, you might say – that an individual partner, in a partnership that owns a disregarded entity, could be treated as an employee of the disregarded entity. Consequently, they decided to pay wages to partners through a disregarded entity, like a wholly-owned LLC, in order to qualify the partners as “employees” for purposes of certain tax-advantaged benefit plans.

The Proposed Regulation

The IRS noted that the regulation did not create a distinction between a disregarded entity owned by an individual (that is, a sole proprietorship) and a disregarded entity owned by a partnership in the application of the self-employment tax rules. Rather, the regulation applies for self-employment tax purposes for any owner of a disregarded entity without carving out an exception regarding a partnership that owns such a disregarded entity.

The regulations proposed by the IRS apply the existing general rule to illustrate that, if a partnership is the owner of a disregarded entity, the partners are subject to the same self-employment tax rules as partners in a partnership that does not own a disregarded entity. In other words, the rule that treats the entity as disregarded for self-employment tax purposes applies to partners in the same way that it applies to a sole proprietor owner. A disregarded entity that is treated as a corporation for purposes of employment taxes is not treated as a corporation for purposes of employing its individual owner, or for purposes of employing an individual that is a partner in a partnership that owns the disregarded entity.

Where Is This Leading?

In order to allow adequate time for partnerships to make necessary payroll and benefit plan adjustments, the proposed regulations, which were also issued as temporary regulations, will apply no earlier than August 1, 2016.

Between now and then, any partnership that has been treating its partners as employees of an LLC wholly-owned by the partnership will have to stop doing so.

A the same time, however, it should be noted that the IRS has indicated that it will consider whether it should allow partnerships to treat partners as employees in certain circumstances; for example, in the case of employees of a partnership who obtain a small ownership interest in the partnership as a compensatory award or incentive.

In connection therewith, the IRS will have to analyze, among other things, the impact on employee benefit plans (including, but not limited to, qualified retirement plans, health and welfare plans, and fringe benefit plans) and on employment taxes if partners were to be treated as employees in certain circumstances.

Stay tuned – the IRS may eventually change its position.