Tuesday, November 28, 2017
Sometimes farmers and ranchers operate in the partnership form without any formal documentation of their business association. Other times, there is a formalized agreement that really isn’t paid much attention to. But, the details of partnership law and the associated tax rules can produce some surprises if those details are not properly understood.
Today’s post takes a look at some key tax features, and surprises, surrounding the partnership form of doing business.
A major tax consideration for farmers and ranchers (and others) when deciding the appropriate form of business structure is self-employment tax. This year, the tax rate is 15.3 percent on the first $127,200 of an individual’s self-employment income. The rate then goes to 2.9 percent up to self-employment income of $250,000 (for a married person that files jointly). Then, thanks to the health care law, the rate jumps another 31 percent to 3.8 percent on any additional amount of self-employment income. For the 3.8 percent amount, the combined earned income of spouses is measured against the $250,000 threshold.
But, self-employment tax is treated differently in a partnership – at least for limited partners. A limited partner, under the tax law, is treated like an owner of an S corporation. A limited partner’s compensation income is subject to self-employment tax, but the limited partner’s share of partnership income is not net earnings from self-employment. Accordingly, it is not subject to self-employment tax. For a limited liability company (LLC) that is treated as a partnership for tax purposes, the self-employment tax burden depends on the structure of the LLC and whether it is member-managed or manager-managed. In other posts, I have written on that structure and the associated self-employment tax issues. Basically, however, if a member does not have management authority under the agreement, the member is viewed under the tax law as a limited partner.
Recent cases. A couple of recent cases illustrate the self-employment tax treatment of members of partnerships. In Hardy v. Comr., T.C. Memo. 2017-17, the petitioner was a plastic surgeon who purchased a 12 percent manager interest in an LLC that operated a facility in which the plaintiff could conduct surgeries when necessary. The petitioner also conducted surgeries in his own office separate from the LLC facility, and owned a separate company run by his wife for his surgical practice. The court did not allow the IRS to group the two activities together based on the weight of the evidence that supported treating the two activities as separate economic units. The petitioner did not have any management responsibilities in the LLC, did not share building space, employees, billing functions or accounting services with the LLC. In addition, the petitioner’s income from the LLC was not linked to his medical practice. Thus, by looking to the petitioner’s actual conduct, the Tax Court determined that the petitioner was a limited partner in the LLC for self-employment tax purposes even though the petitioner held a manager interest in the LLC. Hardy v. Comr., T.C. Memo. 2017-17. For reasons further explained below, one should not rely on the Hardy case to avoid self-employment tax if the person may exercise management authority.
By comparison, consider Methvin v Comr., 653 Fed. Appx. 616 (10th Cir. Jun. 24, 2016), aff’g., T.C. Memo. 2015-81. In this case, 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 Subchapter 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. At least the investor’s income would not be subject to the 3.8 percent Net Investment Income Tax imposed by the health care law (I.R.C. §1411).
As for the IRS, its position on the matter was most recently announced in a Chief Counsel Advice in 2014. C.C.A. 201436049 (May 20, 2014). Citing I.R.C. §1402(a)(13), the IRS noted that a limited partner is not subject to self-employment tax on the limited partner’s share of partnership income, but an active owner is.
The cases point out several things of importance. First, even though a taxpayer may not be personally active in the management of a partnership that is carrying on a trade or business that generates self-employment income, the taxpayer can still be subject to self-employment tax on the taxpayer’s share of partnership income if the partnership business is carried out on the partner’s behalf by an agent (or employee). In addition to Methvin, the Tax Court decided similarly in a 1988 case. Cokes v. Comr., 91 T.C. 222 (1998). It doesn’t matter how large or small the taxpayer’s interest in the partnership is.
The second point is that an election out of Subchapter K (the partnership tax section of the Code) has no impact on the nature of the entity for self-employment tax purposes. That’s fundamental partnership tax law dating at least back to the Tax Court’s 1998 decision. The real question is whether the entity satisfies the definitional test set forth in I.R.C. §7701(a)(2). Likewise, a partnership’s existence turns on the parties’ intent. That’s a factual determination and numerous considerations are important to answering that question. See Luna v. Comr., 42 T.C. 1067 (1964). So, even if a taxpayer doesn’t participate in the partnership’s business activities, it may not matter from a self-employment tax standpoint. That’s why the Congress included a special “carve-out” for limited partners in I.R.C. §1402(a)(13). A taxpayer classified as a general partner (or one with a manager interest) can’t use the special provision. Viewed in this light, the Tax Court’s Hardy decision would appear incorrect. But, there were other unique issues in Hardy that may have influenced the court’s conclusion on the self-employment tax issue.
The third point is that the IRS can change its administrative position on an issue. It need not be “fair” as it applies the tax rules to a taxpayer’s situation. The simple fact is that an IRS concession of an issue for a taxpayer in one tax year does not mean it must concede the issue in other years. See, e.g., Burlington Northern Railroad Co. v. Comr., 82 T.C. 143 (1984). The same can be said for taxpayers. The American Institute of Certified Public Accountants has Statements on Standards for Tax Services. One of those Standards, No. 5, allows a CPA to argue a position that is contrary to one that the client has conceded in prior tax years.
Clarity on the type of partnership and the type of interest is important. A well-drafter partnership agreement can go a long way to ensuring that the desired tax result is achieved. Operating under an informal arrangement and/or not fully understanding the meaning of the type of ownership interest held from a tax standpoint can result in an unexpected tax result.