The IRS recently released Chief Counsel Advice (“CCA”) 201436049. CCA are memoranda prepared by the IRS National Office that respond to a question from the IRS field. In this case, the advice was requested by IRS Counsel in Philadelphia.
The simplified facts in CCA 201436049 have Management Co., LLC (Management Co.) as a general partner of Managed Funds, which is an investment partnership with outside investors. Management Co.’s gross receipts come solely from management fees paid by Managed Funds.
Management Co. has several members (partners), who perform various services for Management Co., and in some instances, Managed Funds. Each partner receives three types of income from Management Co.:
- “Reasonable” compensation, reported on a W-2;
- Guaranteed payments, which represent health insurance premium and parking benefits paid on behalf of the partners by Management Co.; and
- Flow-through of an allocated share of income and losses from Management Co., which is reported on Schedule K-1.
Management Co. has taken the position that the flow-through amounts were not subject to self-employment tax because the partners were limited partners.
There is a long history connected with this position.
In general, Section 1401 imposes the self-employment tax on self-employment income earned by an individual. Section 1402 provides several exceptions to the self-employment tax. In particular, Section 1402(a)(13) excepts from the self-employment tax:
…the distributive share of any item of income or loss 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.
At the time that Section 1402(a)(13) was enacted (1977), limited liability companies (“LLCs”) were seldom used. Rather, there were essentially two kinds of flow-through entities taxed as partnerships: general partnerships and limited partnerships. Section 1402(a)(13) was enacted to apply to limited partners who, under state law, were not typically able to participate in management of the limited partnership’s business. Section 1402(a)(13) was never intended to apply to LLC members and its application has been awkward, at best.
Exacerbating the situation is the fact that there is no definition of “limited partner” in the Code and all attempts made by the IRS to promulgate regulations met with difficulty. In 1997, Congress actually forbid the IRS from finalizing proposed regulations that would have provided a definition of “limited partner” and rules under which a limited partner would be able to meet the exception specified in Section 1402(a)(13). As a result, there have been many years in which there was no guidance by the IRS and only a few court cases, with odd fact patterns, that addressed the issue. Congress had reserved to itself the right to clarify the law, but took no steps to actually enact clarifying legislation. The IRS typically adopted the view that income earned by an LLC member in a service business was subject to self-employment tax.
It should come as no surprise, then, that in CCA 201436049, the IRS National Office rejected the taxpayer’s characterization of the flow-through amounts and determined that the flow-through amounts were subject to self-employment tax. The IRS’s arguments are based on case law (by and large, more favorable to the IRS due to bad facts) and the legislative history of Section 1402. The IRS argues in the CCA that the flow-through amounts are not in the nature of a return on capital investment, even though the partners had paid more than a nominal amount for their partnership units.
The IRS has said that it will issue guidance on the application of self-employment tax to LLC members in the coming year or two. The CCA is likely the first volley from the IRS on what will be a contentious issue.
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