Skirting Employment Tax?

The Code imposes the self-employment tax on 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.

The shareholders of an S corporation are not subject to self-employment taxes on their distributive share of the corporation’s net income, though they and the corporation are subject to employment taxes on any wages paid to them by the corporation.

Over the years, many taxpayers have sought to reduce the exposure of their business income to employment tax.

Many taxpayers, for example, have organized their business as an S corporation, rather than as a partnership: they avoid entity-level tax; the corporation pays them a salary that is subject to employment tax but that may be considered low relative to the value of the services rendered; because the shareholders’ distributive share of S corporation income (after being reduced by their salary) is not subject to employment tax (in contrast to a partner’s share of partnership income), the shareholders are able to reduce their employment tax liability.

Of course, the IRS seeks to compel S corporations to pay their shareholder-employees a reasonable salary for services rendered to the corporation, so as to prevent the “conversion” of taxable income into investment income that is not subject to employment tax.

There are other items of income that are excluded from the reach of the employment tax, and which may be “manipulated” by some taxpayers in a manner similar to the payment of wages by some S corporations.

Among these exclusions is the rental income from real estate.

In contrast to wages, however, where the IRS’s concern is that the S corporation-employer may be paying an unreasonably low salary for the services rendered, thereby leaving the shareholder-employee with more “distributive share income” that is exempt from employment taxes, the concern as to rental payments is that a taxpayer-owner’s business may be paying an unreasonably large amount for the use of the owner’s separately-owned property, thereby reducing the taxpayer-owner’s net earnings from self-employment and the resulting employment tax.

The Tax Court recently considered a variation on the rental situation. The question presented was whether rent payments received by Taxpayer were subject to self-employment tax.

Well Life on a Farm is Kinda Laid-Back?

Taxpayer owned a farm, and performed the farm’s bookkeeping, other management services, and a portion of the physical labor.

During the years at issue, Taxpayer entered into an agreement (“Agreement’) with an unrelated party (“Chicken-Co”) pursuant to which Chicken-Co would deliver poultry to Taxpayer to be cared for in accordance with detailed instructions. Taxpayer was allowed to hire additional laborers or employees; however, Taxpayer’s discretion ended there.

Shortly thereafter, Taxpayer organized Corp as an S corporation. Using a recent appraisal which analyzed the cost of “performing” the Agreement purely as an investment (and not as an active business), Taxpayer entered into an employment agreement with Corp, and set his salary accordingly. Taxpayer agreed to provide bookkeeping services to Corp and, along with any hired laborers or employees, would provide the requisite labor and management services.

Chicken-Co approved Taxpayer’s assignment of the Agreement to Corp; nothing in the Agreement required Taxpayer to personally perform the duties required thereunder.

Taxpayer entered into a lease agreement with Corp by which Corp would rent the farm and various structures and equipment from Taxpayer. Corp agreed to pay rent to Taxpayer; Corp was required to remit each rent payment regardless of whether it had fulfilled its requirements under the Agreement or had received sufficient income. The rental amount represented fair market rent.

Corp fulfilled its duties under the lease, making all of the necessary rent payments to Taxpayer. At no point during the years in issue did Taxpayer believe that he was obligated to render farm-related services as a condition to Corp’s obligation pursuant to the lease to pay rent to Taxpayer. Corp also fulfilled its duties to Chicken-Co under the Agreement; Taxpayer was not obligated to perform farm-related services under the Agreement. Although Taxpayer participated in Corp’s activity, Corp consistently hired numerous laborers and professionals to carry out its obligations.

Trouble in the Henhouse?

Taxpayer reported: (i) rental income from Corp, which was excluded from self-employment tax; (ii) wages on which employment taxes had been paid; and (iii) a distributive share of Corp’s net income, which was not subject to self-employment tax.

The IRS determined that the “rental income” was subject to self-employment tax because, according to the IRS, it actually constituted net earnings from self-employment.

Taxpayer sought redetermination of the resulting deficiencies in the Tax Court, where the sole issue was whether the rent payments Taxpayer received were subject to self-employment tax; in other words, whether they represented something other than rental income.

Under the Code, the term “net earnings from self-employment” means the gross income derived by an individual from any trade or business carried on by such individual, less any allowable deductions. In computing such gross income and deductions, rental income from real estate is excluded.

The IRS contended that the rent payments Taxpayer received were subject to self-employment tax because, taking into account all the facts and circumstances, there existed an “arrangement” between Taxpayer and both Corp and Chicken-Co that required Taxpayer to materially participate in Corp’s farming activities under the Agreement.

Conversely, Taxpayer contended that the rent payments were not subject to self-employment tax because the rent payments were consistent with market rates, there was no nexus between the lease agreement, on the one hand, and either the Agreement or Taxpayer’s employment agreement with Corp, on the other, and neither of these agreements required Taxpayer’s material participation in Corp’s business.

“What’s It All About, Boy? Elucidate.” – Foghorn Leghorn 

The Court agreed with Taxpayer, stating that a rental agreement may stand on its own in certain circumstances, even despite the existence of a separate employment agreement requiring a taxpayer’s material services.

The fact that the rents in question, the Court stated, were consistent with market rates for farmland “very strongly” suggested that the rental arrangement stood “on its own as an independent transaction” and could not be said to be part of an “arrangement” for participation in the farming business activity. The same could be said where the rents in question were at, or below, fair market value.

The Court explained that Congress intended to apply the self-employment tax so as to provide benefits for individuals “based upon the receipt of income from labor, which old age, death, or disability would interrupt; and not upon the receipt of income from the investment of capital, which these events would presumably not affect.”

Therefore, Congress was careful, the Court continued, to exclude from self-employment income any amounts received as “rentals from real estate”; accordingly, the courts have interpreted this intent “to exclude only payments for use of space, and, by implication, such services as are required to maintain the space in condition for occupancy.”

However, when the tenant’s payment includes compensation for substantial additional services – and when the compensation for those services constitutes a material part of the payment – the “rent” consists partially of income attributable to the performance of labor not incidental to the realization of return from passive investment. In these circumstances, the Court stated, the entire payment is included in “net earnings from self-employment.”

The issue, then, becomes one of separating return of investment from compensation for services performed.

Did the Rent Stand on its Own?

Self-employment income generally is defined as “the net earnings from self-employment derived by an individual”. The Code defines “earnings from self-employment” as “the gross income derived by an individual from any trade or business carried on by such individual.”

The term “derived” necessitates a “nexus,” the Court stated, “between the income and the trade or business actually carried on by the taxpayer.” Under the “nexus” standard, according to the Court, income must arise from some income-producing activity of the taxpayer before that income is subject to self-employment tax.

The Code generally excludes rental real estate income from the computation of a taxpayer’s earnings from self-employment. This exclusion does not apply, however, if the income is derived under an “arrangement” pursuant to which the owner is required to, and actually does, materially participate in a farming activity (i.e., provide services in an active business activity) on his land.

In accordance with general tax concepts, the Court noted that the self-employment tax provisions are to be construed broadly in favor of treating income as earnings from self-employment, while the rental income exclusion is to be strictly construed.

Certain farming-related rental income is properly included in a taxpayer’s earnings from self-employment if the rental income is derived under an arrangement between the owner and tenant that specifies that the tenant will farm the rented land, and the owner will materially participate in the farming activity.

The Court interpreted the term “arrangement” broadly, finding that although the Taxpayer’s rental and employment agreements were separate, the Court would view the Taxpayers’ obligations within the overall scheme of the farming operations; the Court acknowledged that the income derived by one who owns and operates his own farm is often partially attributable to income of a rental character.

However, the Court added that, regardless of a taxpayer’s material participation – actual or required – if the rental income is shown to be less than or equal to fair market rental value, the rental income is presumed to be unrelated to any employment agreement or other business arrangement to which the taxpayer is a party; it does not “convert” included business income into excluded rental income. In that case, the rental agreement stands on its own, separate from the taxpayer’s farming/business activity.

As shown by the evidence, the rent payments Taxpayer received represented fair market rent. This, the Court found, was sufficient to establish that the lease agreement stood on its own. What’s more, Taxpayer had obtained a detailed analysis of the costs of operating the farm as an investment; in turn, Taxpayer priced Corp’s activities, including labor and management costs, to exceed the projected costs. The Court observed that these amounts were not merely remainder payments to Taxpayer after the rent checks were cashed. They were appropriate amounts for Corp to spend for the services required under the Agreement. The structuring of these expenses further illustrated the lengths to which Taxpayer went to operate Corp as a legitimate business, and not as a method to avoid self-employment tax.

Thus, the Court concluded that the rental agreement was separate and distinct from Taxpayer’s employment obligations and, therefore, the rental income was not includible in Taxpayer’s net self-employment income.

Observations

Where an agreement calls for rent payments that exceed what the market would bear, that excess may be evidence that there is an arrangement in which compensation for services is being disguised as rent, so that self-employment tax may be improperly avoided.

On the other hand, an agreement that calls for rent payments at fair market value, may be evidence that the arrangement does not involve disguised compensation for services, and may be relevant to the question of whether there is an arrangement linking rent and services.

The Court indicated that below-market rent is excluded from self-employment income because it does not “convert” taxable income into non-taxable income.

However, is it possible that a lower rent may act as an inducement for a larger payment elsewhere? Does the form of the transaction reflect its economic substance?

Regardless of the business, regardless of the circumstances, and regardless of the tax, the guidance is the same: if a taxpayer wants to avoid “tax surprises,” the taxpayer should treat with others on as close to an arm’s-length basis as possible. In most cases, this will in fact occur; where it doesn’t, the taxpayer has to understand the associated risks.

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.

Introduction

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

The wages paid to individuals who are non-owner-employees of a business are also 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, and thus to prevent it from “converting” into a distribution of investment income that is not subject to employment taxes.

Finally, in the case of a partnership, a “limited partner” is generally not subject to employment taxes in respect of his distributive share of the partnership’s income, while the shares of a “general partner” are subject to such taxes, regardless of whether or not the general partner receives a distribution from the partnership.

Application to LLC Members

The U.S. Tax Court recently considered whether the members of an LLC may be treated as limited partners for purposes of applying the self-employment tax to their distributive share of the LLC’s net income.

Specifically, the issue for decision was whether the three member-managers of the LLC (the “Taxpayers”) were entitled to claim the exclusion from self-employment income for limited partners for a portion of their LLC distributions.

The Taxpayers were attorneys who initially practiced law through a general partnership before reorganizing their firm as a member-managed professional limited liability company (the “PLLC”). The PLLC never had a written operating agreement, and it filed federal income tax returns as a partnership.

For the years at issue, the Taxpayers’/members’ compensation agreement required guaranteed payments (i.e., payments to a partner for services, determined without regard to the income of the partnership) to each member that were commensurate with local area legal salaries. Any net profits of the PLLC in excess of the amounts paid out as guaranteed payments were distributed among the members in accordance with the Taxpayers’ agreement.

The Taxpayers reported all of their guaranteed payments from the PLLC as self-employment income subject to self-employment tax. However, they did not remit self-employment tax on the excess of their distributive shares over the guaranteed payments they received, on the grounds that such distributive shares were attributable to the efforts of the PLLC’s other employees (in other words, they represented a return on investment).

The IRS challenged the Taxpayers’ treatment of this excess.

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, as such, other than guaranteed payments to that partner for services actually rendered to or on behalf of the partnership to the extent that those payments are established to be in the nature of remuneration for those services . . . .”

The Taxpayers contended that the above exclusion applied to their distributive shares in excess of the guaranteed payments. The IRS, however, argued that the members were not “limited partners” for purposes of this exclusion and, therefore, the distributive shares constituted self-employment income.

The Tax Court reviewed the history of the exclusion, explaining that it was enacted well before LLCs became widely used. The Court noted that no statutory or regulatory authority defines “limited partner” for purposes of the exclusion.

A “Historical” Digression

Prior to the enactment of the exclusion, the Code provided that a 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 in the nature of a return on investment. Thus, the exclusion was not extended to guaranteed payments received for services actually rendered by the limited partner to the partnership.

In 1997, in response to the proliferation of LLCs, the IRS issued proposed regulations defining “limited partner” for self-employment tax purposes. These 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 imposed a temporary moratorium on finalizing the proposed regulations, which has long since expired, yet the proposed regulations have neither been finalized nor withdrawn.

A number of courts, however, have addressed the attempts by taxpayers to distinguish between a partner’s wages and his share of partnership income. The courts have generally explained that a limited partnership has two fundamental classes of partners: general partners, who typically have management power and unlimited personal liability; and limited partners, who lack management powers but enjoy immunity from liability for debts of the partnership. A limited partner, these courts have pointed out, could lose his limited liability protection were he to engage in the business operations of the partnership. Consequently, the courts have observed that the interest of a limited partner is akin to that of a passive investor.

The Court’s Opinion

The Tax Court followed this line of this reasoning in its analysis of the Taxpayers’ position. The meaning of “limited partner,” it stated, was not confined to the limited partnership context. Therefore, the issue was whether a Taxpayer/member of the member-managed PLLC was functionally equivalent to a limited partner in a limited partnership.

In a limited partnership, the Court highlighted, a limited partner does not become liable as a general partner unless, in addition to the exercise of his rights and powers as a limited partner (e.g., the right to vote on the dissolution of the partnership or the sale of substantially all of its assets), he takes part in the control of the business.

In this case, the management power over the business of the PLLC was vested in each of the Taxpayer-members. The Taxpayers testified that each of them participated equally in all decisions and had substantially identical relationships with the PLLC, including the same rights and responsibilities: for example, they all participated in collectively making decisions regarding their distributive shares, borrowing money, hiring, firing, and rate of pay for employees, they each supervised associate attorneys, and they each signed checks for the PLLC.

There was no PLLC operating agreement or other evidence to suggest otherwise, nor was there any evidence to show that any member’s management power was limited in any way. Indeed, they had previously operated as a general partnership, and there was no evidence that organizing as a PLLC was accompanied by any change in the way they managed the business.

On the basis of the foregoing, the Court held that the respective membership interests held by the Taxpayers could not have been limited partnership interests, and the Taxpayers were not limited partners. Accordingly, the Taxpayers could not exclude any part of their distributive shares of PLLC net income from self-employment income.

Lessons & Planning

The Tax Court’s decision demonstrates that a business organization that is treated as a partnership for tax purposes cannot change the character of a partner/member’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 that are applicable to corporations do not apply to partnerships.

The “limited partner exclusion” provided by the Code 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.

Therefore, 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 (as opposed to a service-intensive) business.

If a member of an LLC truly intends to be a passive investor, his status as such should be memorialized in an operating agreement, it should be reflected in his actions, and the LLC and other members should treat him accordingly.

As always, the taxpayers must be able to support their position, and the first steps in doing so are to adopt a form of operation (and, if relevant, organization) that conforms with the intended result, to contemporaneously memorialize that intention, including the “action plan” for attaining it, and to act consistently with the foregoing.

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.

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.