The recently published Green Book contains details on changes proposed by the Biden Administration that aim to rationalize the net investment income tax (NIIT) and the self-employment tax imposed under the Self-Employment Contributions Act. Broadly, these proposals would:
- Ensure that all trade or business income earned by high-income taxpayers (taxpayers with adjusted gross income in excess of $400,000) is subject to either the NIIT or self-employment tax, by treating trade or business income that is not subject to self-employment tax as net investment income subject to the NIIT;
- Eliminate the current exception from self-employment tax for limited partners who provide services to and materially participate in the partnership’s trade or business; and
- Subject S corporation owners who materially participate in the S corporation’s trade or business to self-employment tax on their distributive share of trade or business income in excess of certain threshold amounts.
The proposed change for limited partners is of particular interest, given the IRS’ increased scrutiny of the use of the limited partner self-employment tax exception.
Current Treatment of Limited Partners
Currently, the tax code provides that a distributive share of partnership income allocable to a “limited partner” is not subject to self-employment tax. Further, if the limited partner is actively involved in the partnership’s trade or business, the limited partner’s distributive share of income is not subject to the NIIT. Current law, therefore, appears to create the ability for limited partners to avoid both taxes in specific factual situations.
Unfortunately, neither the tax code nor regulations define the term limited partner. Under the plain language of the statute, any taxpayer holding a limited partnership interest in a limited partnership formed under state law could arguably be considered a limited partner for purposes of the exception, regardless of their level of activity in the partnership’s trade or business. However, based on recent examination activity and public comments, the IRS does not accept this position. Furthermore, recent court decisions that considered this issue all found in favor of the government.
Recent Court Decisions and Guidance
In Renkemeyer, Campbell, & Weaver LLP v. Commissioner, 136 T.C. 137 (2011), the Tax Court ruled that the members of a law firm formed as a Kansas limited liability partnership were not limited partners for self-employment tax purposes and, therefore, income allocated to the partners was subject to self-employment tax. According to the Tax Court, the statutory exception should only apply to individuals who merely invest in a partnership, not to partners that are actively engaged in the partnership’s activities. Similar rulings have been issued in other court cases and in internal legal memoranda issued by the IRS Office of Chief Counsel. However, in these rulings and guidance, the underlying partnerships were not organized as limited partnerships under state law.
More recently, in George E. Joseph, T.C. Memo. 2020-65, the Tax Court held that the taxpayer was subject to self-employment tax on his distributive share of partnership income, based on the taxpayer’s failure to demonstrate that he was a limited partner for purposes of self-employment tax. The taxpayer also failed to submit evidence to the court supporting the legal organization of the federal tax partnership. Consequently, the court was unable to consider the issue of whether a limited partner in a state law organized limited partnership should be considered a limited partner for self-employment tax regardless of their level of activity in the partnership’s trade or business.
Current IRS Position
Based on the existing statutory guidance, it is possible that active limited partners of state law organized limited partnerships may be able to avoid both the NIIT and self-employment tax on their distributive shares of partnership income. However, the IRS has actively disagreed with this position in examinations where this issue has been raised, and it does not appear willing to settle. The IRS’ position appears to be based on the holding in Renkemeyer, regardless of the manner of formation of the underlying tax partnership. Given recent public comments by the IRS, taxpayers should anticipate a continued focus on this issue with limited likelihood of settlement.
The proposal described in the Green Book would resolve the issue of whether a limited partner is subject to self-employment solidly in the government’s favor, by requiring limited partners who are active in the partnership’s trade or business to be subject to self-employment tax on their distributive share of partnership income. The Green Book states that the proposal would be effective for tax years beginning after December 31, 2021.
Taxpayers currently taking the position that they are an active limited partner not subject to the NIIT or self-employment tax should monitor the progress of this proposal. For taxpayers currently under examination, the proposed legislation could prove helpful. The Green Book’s discussion of this issue implies that the proposal is necessary to change the current law. This could mean that the current law exception for limited partners of state law organized limited partnerships is appropriate and should be respected by the IRS. However, whether the IRS or the courts are willing to concede the issue remains to be seen.