S.E. Tax on Passive Investment Income; Election Out of Subchapter K Doesn’t Change Entity’s Nature; and IRS Can Change Its Mind

A recent Tenth Circuit Court of Appeals opinion provides some good teaching points that tend to get forgotten or come as a surprise. The petitioner was a CEO of a computer company, and didn’t have any specialized knowledge or expertise in oil and gas ventures. In the 1970s, he acquired working interests in several oil and gas ventures of about 2-3 percent each. The ventures were not part of any business organization, but were established by a purchase and operating agreement with the actual operator of the interests. The operator managed the interests and allocated to the petitioner the income and expense from the petitioner's interests. The petitioner had no right to be involved in the daily management or operation of the ventures. Under the agreement, the owners of the interests elected to be excluded from Subchapter K via I.R.C. §761(a).

For the year at issue, the petitioner's interests generated almost $11,000 of revenue and approximately $4,000 of expenses. The operator classified the revenues as non-employee compensation and issued the petitioner a Form 1099-Misc. (as non-employee compensation). No Schedule K-1 was issued and no Form 1065 was filed. The petitioner reported the net income as "other income" on line 21 of Form 1040 where it was not subject to self-employment tax. The petitioner believed that his working interests were investments and that he was not involved in the investment activity to an extent that the income from the activity constituted a trade or business income. He also believed that he was not a partner because of the election under I.R.C. §761(a), so his distributive share was not subject to self-employment tax.

The IRS agreed with the petitioner’s position in prior years, but chose not to for 2011, the year in issue. The IRS claimed that the income was partnership income that was subject to self-employment tax. The Tax Court agreed with the IRS because a joint venture had been created with the working interest owners (of which the petitioner was one) and the operator. Thus, the petitioner's income was partnership income under the broad definition of a partnership in I.R.C. I.R.C. §7701(a)(2). Importantly, the trade or business was conducted, the court determined, by agents of the petitioner, and simply electing out of sub-chapter K did not change the nature of the entity from a partnership. Also, the fact that IRS had conceded the issue in prior years did not bar the IRS from changing its mind and prevailing on the issue for the year at issue.

On appeal, the Tenth Circuit affirmed, noting that the petitioner did not hold a limited partner interest which would not be subject to self-employment tax pursuant to I.R.C. §1402(a)(13). The Tenth Circuit also noted that the fact that the IRS had conceded the self-employment tax issue in prior years did not preclude the IRS from pursuing the issue in a subsequent tax year.

The outcome of the case is not surprising. In the oil and gas realm, operating agreements often create a joint venture between the owners of the working interests (who are otherwise passive) and the operator. That will make the income for the working interest owners self-employment taxable, and an election out of Subchapter K won’t change that result. That’s particularly the case if the court finds an agency relationship to be present, as it did in the present case. And, IRS gets a pass for inconsistency.

As a consolation prize, at least the investor’s income would not be subject to the Net Investment Income Tax imposed by the health care law (I.R.C. §1411).

The case is Methvin v. Comr., No. 15-9005, 2016 U.S. App. LEXIS 11659 (10th Cir. Jun. 24, 2016), aff’g., T.C. Memo. 2015-81.