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Proposed Regulations on Self-Employment Taxes
DEPARTMENT OF THE TREASURY 26 CFR Part 1 [REG-209824-96] RIN 1545-AU24 Definition of Limited Partner for Self-Employment Tax Purposes AGENCY: Internal Revenue Service (IRS), Treasury. ACTION: Notice of proposed rulemaking and notice of public hearing. ----------------------------------------------------------------------- SUMMARY: This document contains proposed amendments to the regulations relating to the self-employment income tax imposed under section 1402 of the Internal Revenue Code of 1986. These regulations permit individuals to determine whether they are limited partners for purposes of section 1402(a)(13), eliminating the uncertainty in calculating an individual's net earnings from self-employment under existing law. This document also contains a notice of public hearing on the proposed regulations. DATES: Written comments must be received by April 14, 1997. Requests to speak and outlines of oral comments to be discussed at the public hearing scheduled for May 21, 1997, at 10 a.m. must be received by April 30, 1997. ADDRESSES: Send submissions to: CC:DOM:CORP:R (REG-209824-96), room 5226, Internal Revenue Service, POB 7604, Ben Franklin Station, Washington, DC 20044. Submissions may be hand delivered between the hours of 8 a.m. and 5 p.m. to: CC:DOM:CORP:R (REG-209824-96), Courier's Desk, Internal Revenue Service, 1111 Constitution Avenue, NW, Washington, DC. Alternatively, taxpayers may submit comments electronically via the Internet by selecting the ``Tax Regs'' option on the IRS Home Page, or by submitting comments directly to the IRS Internet site at http://www.irs.ustreas.gov/prod/tax__regs/ comments.html. The public hearing will be held in the Auditorium, Internal Revenue Service building, 1111 Constitution Avenue, NW, Washington, DC. FOR FURTHER INFORMATION CONTACT: Concerning the regulation, Robert Honigman, (202) 622-3050; concerning submissions and the hearing, Christina Vasquez, (202) 622-6808 (not toll-free numbers). SUPPLEMENTARY INFORMATION: Background This document contains proposed amendments to the Income Tax Regulations (26 CFR part 1) under section 1402 of the Internal Revenue Code and replaces the notice of proposed rulemaking published in the Federal Register on December 29, 1994, at 59 FR 67253, that treated certain members of a limited liability company (LLC) as limited partners for self-employment tax purposes. Written comments responding to the proposed regulations were received, and a public hearing was held on June 23, 1995. Under the 1994 proposed regulations, an individual owning an interest in an LLC was treated as a limited partner if (1) the individual lacked the authority to make management decisions necessary to conduct the LLC's business (the management test), and (2) the LLC could have been formed as a limited partnership rather than an LLC in the same jurisdiction, and the member could have qualified as a limited partner in the limited partnership under applicable law (the limited partner equivalence test). The intent of the 1994 proposed regulations was to treat owners of an LLC interest in the same manner as similarly situated partners in a state law partnership. Public comments on the 1994 proposed regulations were mixed. While some commentators were pleased with the proposed regulations for attempting to conform the treatment of LLCs with state law partnerships, others criticized the 1994 proposed regulations based on a variety of arguments. A number of commentators discussed administrative and compliance problems with the 1994 proposed regulations. For example, it was noted that both the management test and the limited partner equivalence test depend upon legal or factual determinations that may be difficult for taxpayers or the IRS to make with certainty. Another commentator pointed out that basing the self-employment tax treatment of LLC members on state law limited partnership rules would lead to disparate treatment between members of different LLCs with identical rights based solely on differences in the limited partnership statutes of the states in which the members form their LLC. For example, State A's limited partnership act may allow a limited partner to participate in a partnership's business while State B's limited partnership act may not. Thus, an LLC member, who is not a manager, that participates in the LLC's business would be a limited partner under the proposed regulations if the LLC is formed in State A, but not if the LLC is formed in State B. Commentators asserted that this disparate treatment is inherently unfair for federal tax purposes. Some commentators argued for a ``material participation'' test to determine whether an LLC member's distributive share is included in the individual's net earnings from self-employment. The proposed regulations did not contain a participation test. Commentators advocating a participation test stressed that such a test would eliminate uncertainty concerning many LLC members' limited partner status and would better implement the self-employment tax goal of taxing compensation for services. Other commentators argued for a more uniform approach, stating that a single test should govern all business entities i.e., partnerships, LLCs, LLPs, sole proprietorships, et al.) whose members may be subject to self-employment tax. These commentators generally recognized, however, that a change in the treatment of a sole proprietorship or an entity that is not characterized as a partnership for federal tax purposes would be beyond the scope of regulations to be issued under section 1402(a)(13). Finally, some commentators focused on whether the Service would respect the ownership of more than one class of partnership interest for self-employment tax purposes (bifurcation of interests). The proposed regulations treated an LLC member as a limited partner with respect to his or her entire interest (if the member was not a manager and satisfied the limited partner equivalence test), or not at all (if either the management test or limited partner equivalence test was not satisfied). Commentators, however, pointed to the legislative history of section 1402(a)(13) to support their argument that Congress only intended to tax a partner's distributive share attributable to a general partner interest. Under this argument, a partner that holds both a general partner interest and a limited partner interest is only subject to self-employment tax on the distributive share attributable to the partner's general partner interest. This intent also may be inferred from the statutory language of section 1402(a)(13) that the self-employment tax does not apply to ``* * * the distributive share of any item of income or loss of a limited partner, as such * * *.'' Based on this evidence, these commentators requested that the proposed regulations be revised to allow the bifurcation of interests for self- employment tax purposes. After considering the comments received, the IRS and Treasury have decided to withdraw the 1994 notice of proposed rulemaking and to re- propose amendments to the Income Tax [[Page 1703]] Regulations (26 CFR part 1) under section 1402 of the Code.