NYSBA Tax Section Submits Report on Application of Employment Taxes to Partners

The subject of "payroll" taxes in relation to members of entities classified as tax partnerships drew much attention this year, mostly in reaction to the Tax Court's decision in Renkemeyer, Campbell & Weaver LLP v. Commissioner.² As discussed in the attached report, however, this issue is not new. Many years have passed since regulations were first proposed under Section 1402(a)(13) (the "Proposed Regulations") -- those Proposed Regulations were never finalized and were the subject of a temporary moratorium. Though the moratorium expired over fourteen years ago, the Proposed Regulations have not been finalized, or withdrawn, and open questions remain under Section 1402(a)(13) in terms of the scope of the exclusion from self-employment taxes for "limited partners". At the same time, limited liability companies and limited liability partnerships have proliferated -- allowing members to retain a limited liability shield while participating in a very active way in the operation, and often in the management, of an enterprise formed as a tax partnership.

The recently-enacted provisions of Section 1411 will impose a 3.8% tax on income that represents a "return on invested capital" for individuals who meet a certain income threshold. This statutory provision was designed to parallel the Medicare tax imposed on "earned" income. We believe that the need for guidance in respect of Section 1402(a)(13) has been heightened, given the adoption of Section 1411.

As reflected in the attached report, in our view the term "limited partner" for purposes of Section 1402 should be divorced from state law classifications. We recommend that in order to best reflect the Congressional intent underlying the Section 1402(a)(13) exclusion, the term "limited partner" should be defined by reference to the level of participation of an individual in relevant partnership activities. A test that is analogous to the material participation test that applies under Section 469 of the Code would in our view further the intent of the self-employment tax provisions of the Code, and would be consistent with Congress' goal in enacting the statutory provisions contained in Section 1411. The attached report takes the Proposed Regulations as a starting point and makes a number of specific recommendations in respect of a "material participation" standard, special rules for service partnerships, the manner in which "service partnership" should be defined, and the extent to which a partner who holds interests denominated (under state law) as both "general" and "limited" partner interests should be allowed to bifurcate their interest in the relevant partnership for purposes of the self-employment tax provisions of Section 1401.

In relation to Section 1411, we ask that consideration be given to the issuance of some form of guidance that will address the application of the new statutory provision in the context of investment partnerships, especially where there an individual derives income through more than one partnership tier. We make this observation because we have noted certain ambiguities that could arguably be read into the statutory provisions, particularly in relation to investment partnerships and the carried interest.

We appreciate your consideration of our recommendations. If you have any questions or comments regarding this report, please feel free to contact us and we will be glad to discuss or assist in any way.

²Renkemever, Campbell & Weaver LLP v. Commissioner, 136 T.C. No. 7 (Feb. 9, 2011

The general topic of how the Section 1401 self-employment taxes apply to members of entities classified as partnerships for federal income tax purposes (including limited partnerships ("LP"s), limited liability partnerships ("LLP"s) and limited liability companies ("LLC"s)) has received much attention this year due to the Tax Court's decision in Renkemeyer, Campbell & Weaver LLP v. Commissioner.⁴ While the Renkemeyer decision renewed focus on the subject of how these taxes apply to individual members and partners who are not "general partners" under State law, the issue is not new; in fact, for many years there has been a lack of definitional clarity as to the meaning of the term "limited partner" in Section 1402(a)(13), as well as a lack of guidance regarding how this definition relates, if at all, to the determination of whether one is a "material participant" for purposes of Section 469 (the applicable provisions of which limit the deductibility of losses from passive activities).

The matter has become more complicated as a result of the recently-adopted statutory provisions contained in Section 1411 of the Code. Under Section 1411, certain passive or "unearned" income of individuals will be subject to a 3.8% "Medicare contribution" tax beginning in January 2013 (the "Section 1411 Tax").⁵ The Section 1411 Tax was specifically designed to parallel the uncapped Medicare hospital insurance portion of FICA and SECA taxes⁶ which apply to "earned" income. When the legislation was proposed and passed, it was observed that people who earn a salary or who earn "self employment income" must pay the Medicare hospital insurance tax on that earned income; one of the Administration's goals, in proposing Section 1411, was to provide for increased fairness.⁷ The passage of Section 1411 thus reflects an intention to impose the 3.8% Medicare tax on both earned and unearned income of individuals, assuming a certain income threshold is met. This evolution in the law further underscores the need for clarification regarding the application of Section 1401 (including its application to a "limited partner").

As things currently stand, application of the Section 1401 tax to an individual's share of business income derived by an entity classified as a partnership for tax purposes can vary greatly based upon the state law form of entity that is selected and the state law classification of the individual's interest; this variation is, in our view, not appropriate.⁸ We believe that the Section 1401 tax imposed on individual partners performing similar activities should be similar and should not vary based upon state law classifications. We believe that if the principles underlying the FICA and SECA Medicare tax on salaries and self-employment income are to be properly reflected, the Section 1401 tax must be applied in a consistent fashion to all partners in LPs, LLPs and LLCs.

We see these issues as being closely linked to certain open questions concerning the application of the Section 1411 Tax. The statutory text of Section 1411 may raise questions of interpretation, particularly in the context of partnerships that are principally engaged in investment activities (including investing in stocks, securities, and other financial instruments). Some of these interpretive questions might allow room for an interpretation whereby certain passive income derived through a partnership would avoid taxation under both Section 1401 and Section 1411, a result that we do not believe was intended. We believe it would be helpful if clarifying guidance were issued under Section 1411 making the operative provisions of the statute clearer in the context of investment partnerships and tiered ownership structures.

In terms of the Treasury Department's authority to issue regulations defining the meaning of the term "limited partner" for purposes of Section 1402(a)(13), taking the regulations that were proposed by the Service in 1997 as a starting point,⁹ we believe that the Treasury Department clearly has the authority to issue interpretive regulations that would include analogous provisions to the 1997 Proposed Regulations, particularly in light of the decision of the Supreme Court in Mayo Foundation for Medical Education vs. United States.¹⁰ In particular, we believe the Treasury Department unquestionably has the authority to issue regulations addressing the circumstances where a member of an entity formed as other than a "limited partnership" under state law could nevertheless be treated as a "limited partner" for purposes of Section 1402(a)(13), since there are categories of interests a person might hold that are exactly what was envisioned when the exception in Section 1402(a)(13) was adopted. Similarly and by extension, we believe the Treasury Department has clear authority to exclude certain persons from "limited partner" treatment for this purpose, regardless of the manner in which their interest is denominated under applicable state law, because there are cases where a person's level of involvement and/or participation in a partnership goes beyond what Congress was referring to and had contemplated when drafting the exclusion now contained in Section 1402(a)(13). We address the subject of the Treasury Department's authority to issue interpretive regulations in greater detail in the section at the end of this Report.

For individuals who are partners, the relevant tax under current law is SECA. (FICA does not apply to a partner's partnership income because, as the Service has ruled, a partner cannot be an employee of her own partnership.¹⁵) NESE is defined in Section 1402(a) and generally includes an individual's distributive share of income from any trade or business carried on by a partnership in which she is a partner. An important exception to this general rule is set forth in Section 1402(a)(13), excluding from NESE "the distributive share of any item of income or loss of a limited partner, as such, other than guaranteed payments described in Section 707(c) . . . 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."

Congress enacted Section 1402(a)(13) in 1976 in order to prevent individuals not otherwise covered by Social Security from obtaining such coverage by purchasing limited partnership interests in partnerships which they had no other connection to.¹⁶ Thus, Section 1402(a)(13) carves out from NESE (and thus from the scope of SECA) a limited partner's distributive share of partnership income. It has remained open to interpretation for years whether the (a)(13) exclusion applies to LLC members, who are neither general nor limited partners, but who benefit from the protection of limited liability under state laws; given the statutory reference to "limited partner," it is unclear what criteria are to be applied when making this determination.

In January 1997, the Service proposed regulations (the "1997 Proposed Regulations") that would have clarified the intended scope of Section 1402(a)(13); these proposed regulations would generally have prevented any partners (including LLC members) providing more than 500 hours of service to the partnership (and, in the case of service partnerships, more than a de minimis amount of services) from being treated as "limited partners" for Section 1402(a)(13) purposes. However, following the release of the 1997 Proposed Regulations, Congress imposed a one-year moratorium, in August 1997, preventing the Treasury from adopting regulations dealing with the employment tax treatment of limited partners (the "1997 Moratorium").¹⁷ The moratorium expired on July 1, 1998. The 1997 Proposed Regulations were never adopted, even after the 1997 Moratorium expired.

Accordingly, taxpayers have lacked guidance regarding the scope of subsection (a)(13). We do not believe Congress intended the application of the self employment tax to depend upon formalistic differences in the choice of entity selected, but the current statutory framework, read alone, allows for such distinctions. We recommend now, as we have previously, that all individuals who perform services for flow-through entities should be treated consistently under the SECA rules. We believe this is consistent with Congressional intent (as discussed in more detail below). Accordingly, we recommend that regulatory guidance be issued providing that SECA treatment of partners depends upon whether they perform services for the "partnership," and not on whether they hold an interest denominated as a LP, LLC member, or GP interest.

To some degree, a complete rationalization of the FICA/SECA tax treatment of owners of flow-through entities would require some legislative changes to the S corporation rules. Currently, a n S corporation shareholder is subject to FICA only on the shareholder's wages from the S corporation, and not on amounts received in the form of dividends. This dichotomy puts pressure on the question of whether the shareholder/service-provider was reasonably compensated in the form of wages (an inquiry that is not relevant in the SECA-partnership context). In this Report, we are not addressing S corporations, other than to reiterate that last year we endorsed the proposed reform of the SECA rules as applied to S corporation and certain other flow through entities (included in HR 4213).¹⁸

We believe the time is ripe for regulatory guidance under Section 1402. Section 1402(a)(13) was enacted (in 1976) in reaction to the result of Estate of Ellsasser.¹⁹ The new section was intended to prevent "purely passive" limited partners from attempting to come within the social security tax system. In fact, the House Report at the time expressed concern, when the provision was first enacted, over "situations in which certain business organizations solicit investments in limited partnerships as a means for an investor to become insured for social security benefits. In these situations the investor limited partner performs no services for the partnership and the social security coverage which results is, in fact, based on income from an investment. This situation is . . . inconsistent with the basic principle of the social security program that benefits are designed to partially replace lost earnings from work." (emphasis supplied).²⁰ The legislative history thus reflects a clear intention on Congress' part to have the self employment tax apply to "earnings from work."²¹

Much has changed since the original enactment of Section 1402(a)(13). At that time, limited partners generally acted as purely passive investors. State partnership laws and the structure of LP and LLC operating agreements have evolved a great deal. Today, many state partnership laws provide an expansive scope of "permissible" activities for limited partners and LLC members -- and operative documents often allow limited partners and LLC members to provides services to the partnership, vote on matters, guarantee debts of the partnership, and even own general partner or managing member interests.²² We now also have LLPs, entities which are essentially the same as general partnerships but for the fact that a partner's specific personal liability for partnership debts is limited, to some extent, under applicable state law.²³ The use of LLCs and LLPs, as compared to limited partnerships, has increased significantly -- both allow members to combine flow-through taxation with some limited liability shield and active participation in the operations of the enterprise

Despite these developments, there has been no binding guidance since Section 1402(a)(13) was initially enacted in 1976 (over 35 years ago). The issuance of the 1997 Moratorium and the 1997 Proposed Regulations remaining untouched, in proposed form, have left taxpayers with little guidance beyond the text of Section 1402(a)(13) and confusion as to why no guidance has been issued. This lack of guidance became "front-page news" when the Renkemeyer decision was issued earlier this year. In that case, members of a limited liability law firm partnership, a LLP, took the position that the Section 1402(a)(13) exclusion applied to their distributive share of partnership income because the organizational documents characterized their interests as LP interests and because under state law they had limited liability protection. The Tax Court stated:

The discussion that follows is divided into four parts:

Treasury's most thorough attempt to address the above-described issues was reflected in the 1997 Proposed Regulations, which were never finalized.²⁷ The 1997 Proposed Regulations would have compelled a partner to be treated as a "non-limited partner"²⁸ if:

Specifically, we recommend that the term "limited partner" generally be defined in a manner consistent with the principles that govern in the material participation test of Section 469,³³ but with certain specific modifications we recommend below. If our recommendation were to be adopted, the term "limited partner" for SECA purposes would exclude any partner who "materially participates" in the partnership's trade or business. A similar approach was recommended by the Joint Committee of Taxation in 2005 for determining whether partners (and S corporation shareholders) would be subject to SECA taxes.³⁴ Under Temporary Treasury Regulations Section 1.469-5T(a), an individual is considered to materially participate in an activity for the taxable year only if:

Second, Temporary Treasury Regulation Section 1.469-5T(a)(4) refers to the concept of a "significant participation activity." This concept is designed to take into account a situation where a taxpayer participates in multiple trade or business activities (possibly through more than one entity), in each case for 100 hours or more; where the aggregate amount of participation in such activities exceeds 500 hours, the taxpayer is treated as material participating in each. We believe a variation on this test makes sense in the context of defining "material participation" for purposes of Section 1402 -- in fact, we recommend that a broader "aggregation" test be adopted in this context. We recommend a broader aggregation test because we believe it is common in many business contexts for partnership entities that are related to establish "series" entities, brother-sister type entities, or entities under common control, but with some variation in the composition of the outside investors. With this in mind, we recommend that an activity should constitute a "significant participation activity" if the taxpayer participates in the activity for more than a de minimis amount of time, and the taxpayer's total participation in the activities of entities that are under common management or control exceeds 500 hours.

This approach will require some articulation of the measure for ascertaining when entities will be considered to be under "common management or control"; for this purpose, a test could take into account overlapping equity ownership of the voting power or value of the relevant entities' equity interests, or both. For example, an assumption could be made that if a certain percentage of the equity value of two or more entities is held by the same persons, they are under common control. A separate test could apply, independent of the ownership of equity value, that examines "common control" of two or more enterprises by reference to voting power or by reference to board composition. By way of analogy, under Section 280G a change in effective control of an entity is deemed to occur if any one person or persons acting as a group acquire stock possessing 20% or more of the voting power of a corporation.³⁷ A similar approach might be appropriate in this context, examining the effective control of various entities by reference to overlap in ownership of voting power or a certain threshold of overlap in board composition. Such a 20% overlap threshold would seem to be a sufficient amount of overlapping ownership to merit an aggregation of activities for purposes of the "significant participation activity" measure we refer to here.

The modifications we propose above to the existing definition of material participation under Section 469 would tend to expand the universe of taxpayers who are deemed to be "material participants" for purposes of Section 1402. We believe this is appropriate for a few reasons. Under Section 469, meeting the "materially participation" test will tend to reduce the individual's tax liability (by avoiding a provision that prohibits the use of partnership losses to shelter income from other sources). In this context, therefore, taxpayers have every incentive to satisfy the definition of material participation (and therefore would be unlikely to divide their services among different related partnerships in an effort to avoid qualifying as a "material participant"). Under Section 1402, however, a taxpayer who meets the materially participation test will tend to increase her tax liability (by being subject to SECA tax). In this context, therefore, taxpayers will have every incentive to "fail" the definition of material participation. We do not believe that taxpayers should be able to avoid becoming "material participants" simply by forming a series of related entities and dividing their services among them. For these reasons, while we generally recommend an approach that is largely guided by the standards for material participation under Section 469, we believe that the modifications recommended above will discourage form-driven tax planning and produce a result more consistent with what we understand to be the intended application of Section 1402.³⁸

There are other provisions in the Code, notably Section 736, where the statutory language calls for a distinction to be made between "general" and "non-general" partners. Indeed the analysis for Section 736 purposes is somewhat analogous to that required for Section 1402(a)(13), as the question there is whether a payment to a retiring partner represents a form of disguised compensation for services. In relation to Section 736, some commentators have suggested a "materiality" threshold in evaluating the degree and nature of a partner's contributions to the partnership.³⁹ While a similar recommendation could apply for Section 1402(a)(13), we believe a test that draws on the Section 469 material participation rules makes the most sense in the context of the self-employment tax for a number of reasons. First, as discussed in the 2010 NYSBA Report, there will be significant advantages to using the Section 469 material participation test for determining whether a partner's distributive share should be subject to SECA taxes, since the Treasury Department and the Service have already dedicated substantial resources to crafting a test that distinguishes between passive investors and active participants and have experience in applying this test. Second, the test is more objective and precise and therefore easier to administer. Finally, adopting a material participation test that follows the relevant approach under Section 469 would generally require taxpayers to take consistent tax positions with respect to Section 1402, the passive loss rules of Section 469, and the new Section 1411 Tax.⁴⁰

First, we believe the reference to "substantially all" in the definition of "service partnership" as it appeared in the Proposed Regulations unnecessarily confuses matters and is likely to give rise to inappropriate tax planning and disputes. Clearly an entity can be engaged in multiple businesses, and drawing lines between whether substantially all of its activities fall within a specific category of business activity, or less than substantially all, seems unnecessary. The relevant feature is that the partnership is providing services and that therefore a partner providing those services is engaging in work. For SECA purposes it should not matter how the amount of those services compares to the remainder of the partnership's activities. We recommend that any income resulting from, or attributable to, the service-providing activities of a service partnership (i.e., from the service business itself), cannot be treated as being earned by a limited partner for purposes of Section 1402 (where the relevant partner provides more than a de minimis amount of service to the partnership).

There are other provisions in the Code where "substantially all" is referenced in relation to a determination that is tied in some manner to the provision of services, but in these cases the reference test is relevant to a tax or allowance of some kind that applies to the entity as a whole. For example, under Section 448 a "qualified personal service corporation" is allowed to use the cash method of accounting if it meets a function test and an ownership test. The function test is tied to whether "substantially all" of the services of the entity fall into certain specified fields. The applicable Regulations address the meaning of "substantial services," providing that the test is satisfied only where 95% or more of the "time spent" by employees every year (in their capacity as such) is devoted to performing services in the relevant field.⁴² Another example can be found in Section 41 of the Code, which provides for a research tax credit and defines "qualified research" by reference to the nature of certain activities carried on. Section 41(d) refers to whether "substantially all" of the activities constitute a process of experimentation. Applicable regulations provide that the "substantially all" requirement is met only if 80% or more of a taxpayer's activities, measured on a cost or other consistently applied reasonable basis constitute elements of a process of experimentation.⁴³

We believe that the SECA tax calls for a different approach than we see in these other contexts. In these other contexts, where the entity's overall eligibility for a specific rule is being determined, the proportion of services to other activities may be relevant. In the SECA context, the only relevant inquiry is whether the partner is providing services that would, if conducted directly by the partner, constitute "self-employment." Section 1402 references "a" trade or business and Section 1402(a)(13) refers to items of income or loss "of a limited partner." There is nothing in the current framework of Section 1402 that mandates an all-or-nothing test, or an all-or-nothing result (i.e., that all of a service provider's allocable share of income would be treated as NESE). Instead, Section 1402 permits (and in fact calls for) a rule that only the income attributable to the service business to be treated as NESE.⁴⁴ For these reasons, we recommend that the term SP should be defined as "any partnership whose activities include any trade or business involving the performance of services" in the specified fields.

We also believe that some consideration should be given to expanding the list of service fields, so as to include other non-capital intensive service businesses, such as providing investment advice or management, computer programming, design services, or other services that are not capital intensive. Previous proposals have included a definition of service business that listed specific fields, but adding a reference to "any other trade or business with respect to which the Secretary determines that capital is an insignificant income-producing factor."⁴⁵ We do not see any logical basis for leaving other non-capital intensive businesses, or the wide range of personal service businesses that are not within the limited specified fields referred to in the 1997 Proposed Regulations, entirely out of this regime. We recommend that an expanded list be included in the regulations, along with authorization for the Secretary to expand the list to include other non-capital-intensive businesses.

While we support the "material participant" test outlined above for partners in non-SPs, in the case of SPs, we believe that any partner who provides more than a de minimis amount of services to the SP be subject to the SECA tax on that service partner's share of the SP's income from providing services. We do not think the material participation test is appropriate here because we believe that any partner that provides services to a SP should be subject to SECA tax on her share of the SP's services income.⁴⁶ This mirrors the result that would occur if the individual were engaged in the provision of services directly, as a sole proprietor.

If the provisions of the 1997 Proposed Regulations are adopted, it may be possible for taxpayers to structure an interest that is received for services to mirror an interest of an outside, passive, investor in the partnership. Our 2008 NYSBA report on proposals to modify the tax treatment of the Carried Interest⁵¹ reflected the enormous complexity involved in segregating an interest received "for capital" from an interest received "for services." In theory, while we have supported the premise that SECA tax should not apply to the portion of any allocable share of income representing a return on capital invested or a return of "enterprise value," we question whether a "material participant" should be permitted to carve out (or bifurcate) an interest, treating it as a "LP" interest for Section 1402 purposes. Given the range of complex issues such a bifurcation approach presents, we recommend that a partner of a partnership who provides more than a de minimis amount of services should not be allowed to bifurcate the partner's interest in the partnership, regardless of whether she holds different classes of interests in the partnership, some of which are arguably identical to those of a non-service provider (for service partnerships by their nature are not capital intensive). We think consideration should also be given to whether a material participant should be allowed to bifurcate an interest, treating it as a LP interest for SECA tax purposes.

We note that the tracing principles we are recommending would not resolve the SECA tax treatment when one of the entities in the tiered structure is an S corporation. For example, a lower tier partnership might issue an interest to an S corporation, and a shareholder of the S corporation might "materially participate" in the business of the lower tier partnership and receive his distributive share indirectly, as a dividend distribution by the S corporation. Given the current statutory framework, regulatory guidance under Section 1402 may not be sufficient to address tiered ownership structures involving S corporations. The reason is that the SECA statute currently provides that a shareholder of an S corporation is not subject to SECA tax on dividends (and this is the case even if the source of the dividends is the S corporation's distributive share of partnership income). As we noted above, S corporations raise issues that are beyond the scope of this report, although we refer to the proposed S corporation legislation discussed in our 2010 NYSBA Report.⁵²

Most (but not all) investment income excluded from SECA will be subject to the Section 1411 Tax beginning in 2013. The statutory language of Section 1411 reflects Congress' intent to tax income not already taxed by SECA, in particular certain types of passive income from investments, including (i) dividends, interest, and capital gain, (ii) income from any business that is a "passive activity" with respect to the taxpayer, and (iii) income from "trading" in financial instruments or commodities.

While Section 1411 imposes the same rate of tax on investment income as SECA imposes on service income, Section 1411 differs from Section 1402 in certain respects. First, Section 1411 only applies to individual taxpayers whose modified adjusted gross income exceeds a threshold amount of $200,000 ($250,000 in the case of taxpayers who jointly file returns)).⁵³ Second, the 3.8 percent tax (none of which is deductible)⁵⁴ applies only to the "net investment income" of such taxpayers, not all investment income.⁵⁵

"Net investment income" is defined in Section 1411(c)(1)(A) as the sum of:

• Gross income from interest, dividends, rents and royalties, other than such income which is derived in the ordinary course of a trade or business not described in paragraph (c)(2) (Section 1411(c)(1)(A)(i));

• Other gross income derived from a trade or business that is a passive activity with respect to the taxpayer (within the meaning of Section 469), or that involves the trade or business of trading in "financial instruments and commodities" (as defined in Section 475(e)(2)) (Section 1411(c)(1)(A)(ii);

• Net gain (to the extent taken into account in computing taxable income) attributable to the disposition of property other than property held in a trade or business that is not covered in paragraph (c)(2) (Section 1411(c)(1)(A)(iii).

For tax purposes, most investment partnerships fall into one of two categories: those that do not engage in any trade or business and those that engage in a "trading" trade or business. A typical private equity, LBO or venture capital fund ("Private Equity Fund") falls into the first category because it invests in stock of privately-held corporate portfolio companies.⁵⁸ A typical hedge fund ("Hedge Fund") invests in marketable securities, generally buying and selling with a certain degree of frequency, and therefore falls into the second category, provided that its investment activities qualify as "trading" in stocks and securities.⁵⁹

Investment partnerships often grant a "carried interest" to the managing member/general partner (the "Manager") as partial consideration for managing their investments. Because a carried interest qualifies as a partnership interest for tax purposes, any income allocable to the Manager will retain its character at the partnership level and will therefore be subject to tax to the Manager or its individual owners as capital gain or other investment income. As such, the income is exempt from SECA tax under Sections 1402(a)(3) or 1402(a)(2). As additional consideration for managing its investments, most investment partnerships also pay a periodic management fee to the Manager or an affiliate of the Manager, determined by reference to committed and/or invested capital.

As described more fully below, we believe that Section 1411 applies to the carried interest whether the investment partnership is a Private Equity Fund that "invests" in stocks or securities for its own account or a Hedge Fund that "trades" in stocks or securities for its own account. We do not believe that an individual's "material participation" in any trade or business of the Manager or any other affiliate that owns a direct or indirect interest in the carried interest is relevant to this determination.⁶⁰

The rest of the income will generally consist of dividends (or interest) from the same portfolio companies of the fund. Section 1411(c)(1)(A)(i) taxes dividends and interest except to the extent "derived in" a trade or business in which the individual materially participates. It is here that the literal language of the statute is arguably ambiguous as applied to the carried interest. As described more fully below, Section 1411 could be construed to exclude such income on the basis that it is "derived" from the Manager's investment management trade or business, not the underlying fund. Under this interpretation, however, the statute could potentially tax the Manager on its allocable share of the capital gain but exempt the Manager on its allocable share of any intervening dividends. We do not believe that Congress could have intended to discriminate between dividends and capital gain on the same equity investment because there would be no apparent policy rationale for doing so. Accordingly, Congress must have intended to tax these dividends on the basis that they are "derived from" the carried interest in the Private Equity Fund, not from any separate trade or business activities of the Manager (if any).

Section 1411 does not define the term "financial instruments." The same term appears in several other provisions of the Code, including Section 731, Section 954, and Section 6038D. Notably, Section 6038D draws a distinction between stock or security and financial instrument. For purposes of Section 1411, we believe Treasury should issue guidance to clarify that the term "financial instrument" includes stock, securities, derivatives and other similar instruments of the type typically held by a Hedge Fund.⁶²

The individual members in any fund with a Split-UTP Structure will be subject to tax under Section 1411 on their entire allocable share of the investment income of the fund because the UTP owner of the carried interest will not be engaged in any trade or business (passive or otherwise). In a fund with a Single-UTP Structure, the same individuals may assert that they "materially participate" in the investment management trade or business of the UTP Manager. In such a case, they may further contend that the references to "trade or business not described" or "trade or business not covered" in paragraph (c)(2) refer to the trade or business of the UTP and that Section 1411 therefore excludes all or a portion of their investment income attributable to the carried interest.

We do not believe this is a proper reading of the statute. First, funds that adopt Split-UTP Structures usually do so to reduce state and local taxes on the carried interest, not to establish any overriding business objective. For this reason, the separate UTPs usually have substantial overlapping owners. Second, it would make no sense for the statute to favor individuals employed by funds with Single UTP Structures where the grantee of the carried interest actually provides the bargained for services over individuals employed by funds with Split UTP Structures. In fact, we believe the statute was drafted in order to avoid this interpretation, since Section 1411 specifically makes use of the phrases "derived from" and "attributable to" in its text. We believe this usage was purposeful, and that the use of these phrases implies the necessity of a tracing approach.

In the case of a Private Equity Fund, therefore, because the investment partnership is not engaged in a trade or business, any income from the carried interest should not qualify as attributable to any trade or business and should therefore be subject to tax under either Section 1411(c)(1)(A)(i) (e.g., dividends or interest) or (c)(1)A)(iii) (capital gain) -- regardless of whether the Manager merely holds the carried interest as a passive holding company or actually provides the investment management services. The same logic would extend to the Hedge Fund scenario.

Although the Tax Court recently addressed the trade or business determination in the fund context in Dagres v. Commissioner,⁶³ we do not believe that Dagres has any bearing on the application of Section 1411 to the carried interest. In Dagres, the taxpayer was an owner of various general partners of venture capital funds. Each general partner managed the investments of the funds, for which it received a carried interest and a periodic management fee. After a loan by the taxpayer became worthless, the taxpayer claimed an ordinary bad debt loss under Section 166. The Tax Court allowed the ordinary loss, finding that the loan arose in connection with the taxpayer's (and general partner's) trade or business of providing investment management services to the underlying funds.⁶⁴

The reason that Dagres is drawing attention among tax advisors to investment partnerships is that the general partner in Dagres had subcontracted its entire service obligation to an affiliate, which received the entire management fee directly from the relevant funds. As such, the general partner in Dagres operated in a manner similar to the general partner of a fund in a Split-UTP Structure. The finding of the Tax Court, that the general partner was nevertheless engaged in a trade or business, may therefore call into question whether a tax-exempt or foreign member of such an entity is required to treat its allocable share of the capital gain as "unrelated business taxable income" under Section 512 or "effectively-connected income" under Section 882, respectively. Regardless of whether this concern is legitimate, Dagres is not relevant to the question of whether Section 1411 applies to the carried interest because it addresses the trade or business (if any) of the wrong entity.

As described above, the only trade or business of any relevance to Section 1411 in the fund context is the trade or business of the issuer of the carried interest, not its owner, whether such owner is an individual, a UTP or an S corporation. Nevertheless, we believe that it would be helpful, in the interest of aiding the administration of this new statutory provision, if Treasury were to confirm this interpretation by issuing some future guidance

Finally, if specific guidance were to be issued regarding the scope of Section 1411, such guidance could articulate what principles apply in other tiered structures. For example, an ownership interest in a partnership could be dropped into an upper tier entity characterized as an S corporation. The Manager of an investment partnership could hold a carried interest through a vehicle taxed as an S corporation, and that S corporation could earn management fee income in exchange for services. We believe the statutory language of Section 1411 would allow for a tracing approach even with the use of intermediary entities such as S corporations. Specifically, Section 1411(c)(4) looks through to the "inside assets" of certain entities for purposes of one of the prongs of the definition of "net investment income." This reflects, in our view, an extension of the principle that the concept of "net investment income" was designed to look to the source of specific income, as evidenced by the use of the words "derived by" or "derived from" in the statute. Application of these provisions should not be easily evaded through the use of an S corporation, and guidance could provide that where an S corporation shareholder materially participates in the business of an S corporation or a lower tier partnership, any dividends earned by the S corporation and/or its shareholders that are attributable to an investment in a lower tier flow-through entity will similarly be treated as being derived from the relevant underlying asset and subject to tax under Section 1411.

Thirteen years have passed since the 1997 Moratorium expired; the Moratorium provided a 12-month "no final action" period, and it then expired. Since it expired, Congress has not renewed it, nor has Congress amended Section 1402(a)(13). Rather, Congress remained silent until 2010, when Congress enacted new Section 1411. Section 1411 reflects a Congressional view that income that is exempt from the Section 1401 tax because it is not sufficiently linked to a trade or business to be "earned income" (i.e., is passive income), should instead be subject to a mirror tax imposed at the same rate, if earned by certain individuals. This approach implies an understanding that all earned income was already subject to the Section 1401 SECA tax (or the FICA tax).

Section 1402(a)(13) was enacted to prevent individuals from treating "passive income" as if it were "earned income."⁶⁵ The 1997 Proposed Regulations represented Treasury's attempt to carry out Congress's initial goal. The 1997 Proposed Regulations were, however, criticized as contradicting the statute (for example, by (i) departing from an approach based simply on traditional State law classifications and (ii) subjecting to SECA tax income that is in substance a return on invested capital). The criticisms motivated Congress to issue the Moratorium that would slow down the process and give everyone (including Congress) time to consider these issues.⁶⁶

Fourteen years have passed and Congress has not spoken again regarding Section 1402(a)(13). During that decade and a half, LLC and LLPs have proliferated, and state partnership and limited liability company laws have become even more flexible -- all developments that facilitate earned income being derived through partnership interests that are not "general partner" interests. In addition, the newly-enacted Section 1411 intentionally imposes a 3.8% Medicare tax on income that represents a "return on invested capital."

For all of these reasons, we do not believe the Moratorium (or the concerns that prompted the Moratorium) have relevance today in evaluating the scope of the Treasury Department's authority to issue interpretive regulations under Section 1402(a)(13).

Furthermore, and most importantly, the Supreme Court's decision earlier this year in Mayo Foundation for Medical Education v. US⁶⁷ provides clear support for the Treasury Department's authority to issue regulations along the lines discussed above. In Mayo, the Supreme Court held that the two-step standard established in Chevron U.S.A. Inc. v. Natural Resources Defense Council, Inc.⁶⁸ is to be applied when determining the validity of interpretive regulations issued by the Treasury Department.⁶⁹ The issue in Mayo was the validity of the definition of the term "student" as set forth in Treasury regulations pertaining to FICA taxes. The Court began its analysis with the first step of the two-part test established in Chevron, asking if the precise question at issue had been addressed by Congress, concluding that Congress had not addressed the meaning of the term "student." Similarly, in the case of Section 1402(a)(13), Congress has not addressed the meaning of the term "limited partner," despite the fact that this definition is crucial for purposes of applying the provisions of Section 1402 and the tax imposed by Section 1401. The Court in Mayo then applied the second step of the Chevron test: whether the rule is a "reasonable interpretation of the enacted text."⁷⁰ An agency rule may not be invalidated unless it is "arbitrary or capricious in substance, or manifestly contrary to the statute."⁷¹ There, the Court found that the Treasury's definition of "student," which excluded individuals working more than 40 hours per week, easily satisfied the second step because Treasury "reasonably sought a way to distinguish between workers who study and workers who work" and "focusing on the hours an individual works and the hours he spends in studies is a perfectly sensible way of accomplishing that goal."⁷² With respect to the regulatory guidance recommended in this Report, Treasury would be acting to rationalize and clarify the scope of the rules applicable to partners of pass-through entities for self-employment tax purposes -- and to insure that the imposition of the self-employment tax does not turn upon the formalistic categorization of an entity as either a "limited partnership," "limited liability company," or "limited liability partnership," but rather on whether the distributive share of partnership income is attributable to services performed by the partner. Regulations which seek to distinguish between a passive income stream and an income stream earned in exchange for the performance of services are clearly consistent with the underlying purpose of the statutory provisions. We view this as a reasonable and necessary objective.

Thus, we believe that interpretive guidance issued by the Treasury defining the meaning of "limited partner," along the lines of the guidance contained in the 1997 Proposed Regulations, should easily meet the Mayo standard so long as the notice and comment procedures mandated by the Administrative Procedures Act⁷³ are met; under the Mayo standard, such guidance would be neither arbitrary nor capricious. Furthermore, we believe that any modifications to the 1997 Proposed Regulations along the lines we recommend in this Report would easily meet the Chevron standard adopted in Mayo. In each case, the rules adopted would not be manifestly contrary to the statute because the spirit of the rule is already expressed in Section 1402(a)(10). In Section 1402(a)(10), periodic payments made to retired partners are effectively excluded from federal employment taxes if, among other things, the recipient "partner rendered no services with respect to any trade or business carried on by such partnership (or its successors) during the taxable year . . . in which such amounts were received. . . ." A rule that subjects partnership distributions to self-employment tax where the partner provides services with respect to the partnership's business is not manifestly contrary to an existing statute that subjects partnership distributions to self-employment tax where the retired partner provides services with respect to the partnership's trade or business. Based on this application of the Chevron standard, we believe that Treasury has the authority to issue regulations defining the scope of "limited partner," as described below.

Furthermore, the fact that the 1997 Proposed Regulations were not previously finalized, or that there may have been arguable inconsistencies in positions articulated over the years, should not serve as a basis for challenging any regulations ultimately adopted. In this regard, we wish to draw attention to the Court's statement in Mayo that "[u]nder National Muffler . . . a court might view an agency's interpretation of a statute with heightened skepticism when it has not been consistent over time, when it was promulgated years after the relevant statute was enacted, or because of the way in which the regulation evolved. . . . Under Chevron, in contrast, deference to an agency's interpretation of an ambiguous statute does not turn on such considerations. We have repeatedly held that '[a]gency inconsistency is not a basis for declining to analyze the agency's interpretations under the Chevron framework. . . . And, we have found it immaterial to our analysis that a 'regulation was prompted by litigation. . . .'"⁷⁴

² All Section references contained herein are, unless otherwise indicated, to the Internal Revenue Code of 1986, as amended (the "Code").

³ Section 1411 was adopted as part of the Health Care and Education Reconciliation Act of 2010; it imposes a 3.8% Medicare contribution tax on certain individuals, estates and trusts with respect to "net investment income." Section 1411 is discussed in more detail later in this Report. The term "investment partnership" is not used in Section 1411. Rather, "investment partnership" is a term we use herein to refer to a partnership that issues an "investment services partnership interest," as that term is defined in proposed legislation contained in Section 412 of the American Jobs Act of 2011, S. 1549 (2011).

⁴Renkemeyer, Campbell & Weaver LLP v. Commissioner, 136 T.C. No. 7 (Feb. 9, 2011).

⁵ Technically revenue collected under the Section 1411 Tax can be spent on expenses other than Medicare expenses. STAFF OF THE JOINT COMMITTEE ON TAXATION, DESCRIPTION OF THE SOCIAL SECURITY TAX BASE, June 21, 2011, p. 24.

⁶ The terms FICA and SECA are defined in the beginning of the background section below.

⁷See STAFF OF THE JOINT COMMITTEE ON TAXATION, TECHNICAL EXPLANATION OF THE REVENUE PROVISIONS OF THE RECONCILIATION ACT OF 2010, March 21, 2010 ("JCT Paper March 2010") pp. 134-136. See also The White House, "The President's Proposal" (Feb. 22, 2010), http://www.whitehouse.gov/sites/default/files/summary-presidents-proposal.pdf (last visited Aug. 30, 2011).

⁸ The NYSBA Tax Section submitted Report No. 1218 last September, "Report on Legislative Proposal Regarding Employment Taxes and Professional Service Business" (the "2010 NYSBA Report") on the proposal introduced in the House of Representatives regarding the application of employment taxes to professional service businesses conducted through partnership entities and S corporations. That legislative proposal would have addressed a broader universe of business entities, including S corporations. This Report, in contrast, is focused on the question of what regulatory guidance can be issued within the current statutory framework of Section 1402 and Section 1411.

⁹ Prop. Treas. Reg. Section 1.1402(a)(2), REG-209824096 (1/13/1997).

¹⁰ 131 S. Ct. 704 (2011).

¹¹See Section 3101(a) and Section 3111(a).

¹² The 12.4% tax is referred to as the old age, survivors, and disability insurance tax and cap is currently $106,800); the 2.9% tax is referred to as the Medicare hospital insurance tax.

¹³ A detailed description of employment taxes under current law can be found in STAFF OF THE JOINT COMMITTEE ON TAXATION, DESCRIPTION OF THE SOCIAL SECURITY TAX BASE, June 21, 2011.

¹⁴ JCT Paper March 2010 at pp. 134-136.

¹⁵ Rev. Rul. 69-184, 1969-1 C.B. 256.

¹⁶See H.R. REP. NO. 95-702(I), pp. 40-41 (1977) (This report addressed P.L. 95-21, "Social Security Amendments of 1977"). See also William L. Raby & Burgess J.W. Raby, "Self-Employment Income of LLC 'Partners'," 2003 TNT 108-49 (June 5, 2003).

¹⁷ H.R. 2014 Sec. 734 (1997) on Sec. 935 "Moratorium on certain Regulations," Taxpayer Relief Act of 1997, P.L. 105-34.

¹⁸See NYSBA 2010 Report.

¹⁹ 61 T.C. 241 (1973). In Ellsasser, the Court held that the statutory language, pre-Section 1402(a)(13), required an individual who was a limited partner and provided only capital to the partnership to pay self employment tax on his share of the distributive income of the partnership. "As a limited partner, Ellsasser received a share of . . . profits. The amount of such share was determined in part by the ratio of his capital contribution to the total capital contributed by all of the limited partners. . . . The general partners received a larger percentage of the profits than did the limited partners on account of their active participation in the business. Regardless, it was recognized that capital was essential to the operation of [the partnership]." Id. at 243.

²⁰ H.R. REP. NO. 95-702(I), pp. 40-41 (1977) (emphasis added).

²¹ The Tax Court also pointed this out in Renkemeyer at 89.

²²See, e.g., DEL. CODE ANN. tit. 6 § 17-302, 303 (2011); N.Y. P'SHIP LAW § 121-108, 302 (McKinney 2011); 1953 N.Y. Op. Att'y Gen. 193.

²³See generally, Amy S. Elliott, "Tax Court Decision Could Reignite Debate Over Partnerships and Employment Taxes," 2011 TNT 48-3 (Mar. 11, 2011); Martin A. Sullivan, "Economic Analysis: Renkemeyer Annual Cost to Partners Could Exceed $1 Billion," 2011 TNT 55-2 (Mar. 22, 2011); Clarence G. Kehoe et al., "Renkemeyer Article Rankles Attorneys, Accountants," 2011 TNT 74-9 (Apr. 18, 2011); Monte A. Jackel, "Has Politics Trumped Policy?," 2011 TNT 94-8 (May 16, 2011).

²⁴Renkemeyer, supra note 4, at 89.

²⁵See NYSBA Tax Section Report "Report on the Self-Employment Tax as Applied to Owners of Interests in Pass-Through Entities," December 9, 1994 (the "1994 NYSBA Report"), NYSBA Tax Section report "Comments on Self-Employment Regs," March 27, 1997 (the "1997 NYSBA Report"), NYSBA Tax Section Report "Comments on JCT Recommendation Relating to Employment and Self-Employment Taxes of Partners, LLC Members and S Corporation Shareholders" (the "2005 NYSBA Report"), September 23, 2005 and the 2010 NYSBA report.

²⁶Renkemeyer, at 84.

²⁷ As mentioned above, these regulations were not ultimately adopted, and were the subject of the Moratorium. See H.R. 2014, Sec. 734 (1997).

²⁸ It should be noted that neither Section 1402 nor the 1997 Proposed Regulations use the term "general partner." The provisions in Section 1402(a) simply refer to a distributive share of income from a partnership in which one is "a member"; the provisions of (a)(13) refer to limited partner, and the regulations describe cases where one will not be treated as a "limited partner." Thus, in our discussion herein we will often refer to a non-LP class of interests.

²⁹ Prop. Treas. Reg. § 1.1402(a)-2(h)(2)(i).

³⁰ Prop. Treas. Reg. § 1.1402(a)-2(h)(2)(ii); see also the 1997 NYSBA Report at para. 22-24.

³¹ Prop. Treas. Reg. § 1.1402(a)-2(h)(2)(iii). An exception to this rule applies under Prop. Treas. Reg. Section 1.1402(a)-2(h)(4), where a LP interest is identical to that of other non-service providing members of the partnership.

³² We enunciated this same view in our 1997 report on the Proposed Regulations. See 1997 NYSBA Report at paras. 11-12 and 16.

³³ Prop. Treas. Reg. § 1.1402(a)-2(h)(2)(iii).

³⁴ JOINT COMM. ON TAXATION, OPTIONS TO IMPROVE TAX COMPLIANCE AND REFORM TAX EXPENDITURES, 95-104 (January 27, 2005). In our 2005 NYSBA Report we supported this approach, with some questions regarding whether it was appropriate to apply Section 469's look back rules (Prongs (5) and (6) of the material participation test, discussed below) to SECA taxes, which are meant to tax income earned from "actually working."

³⁵ The "significant participation activity" concept could be very meaningful in the Section 1402 context. As we discuss below, we recommend some type of aggregation rule is appropriate in the Section 1402 context so that the relevant application of the SECA tax is not avoided through structures whereby taxpayers set up multiple 'series' of partnership entities. See discussion, infra p. 16.

³⁶ Temp. Treas. Reg. § 1.469-5T(a).

³⁷ Treas. Reg. § 1.280G-1, Q&A 28.

³⁸ The IRS has recently argued that members of a LLC and limited partners of a LLP are "limited partners" for Section 469 purposes. (See Paul D. Garnett, et ux. v. Com'r, 132 TC 368 (2009); Thompson v. U.S., 87 Fed. Cl. 728 (2009). ("[IRS] contends that petitioners obtained a tax benefit by failing to designate their interests as "general partner" interests, in that they thereby avoided self-employment tax pursuant to section 1402(a)(13), which excludes from self-employment earnings certain distributive shares of a "limited partner." Garnett, at 382-83). No such inconsistent treatment would exist if the regulations were to require the general partner test under Section 469 to be applicable for Section 1402 purposes.

³⁹See "L.A. Bar Members Suggest Ways to Classify LLC Owners as Partners," 96 TNT 96-32 (May 3, 1996). See also Frost, "Square Peg, Meet Round Hole II: We Still Don't Know Whether to Classify LLC Members as General Partners or Limited Partners for Federal Tax Purposes," 75 TAXES 676 (Dec. 1995).

⁴⁰ Our recommendations in this Report are limited to the rules that should apply in the context of Section 1402, and a review of the relevant tests for purposes of Section 736 or other Code provisions where distinctions are made between "general partners" and non-general partners is beyond the scope of this Report.

⁴¹ Prop. Treas. Reg. § 1.1402(a)-2(h)(5).

⁴² Treas. Reg. § 1.448-1T(3)(4).

⁴³ Treas. Reg. § 1.41-4(a)(6).

⁴⁴ Indeed, a tracing approach already exists since items of passive income that are allocated to a partner would be excluded from SECA tax by virtue of the provisions of Section 1402(a)(2) or (a)(3), for example.

⁴⁵See Health Security Act, S. 2351, 103d Cong., 2d Sess. Section 716 (1994).

⁴⁶ In the 1997 NYSBA Report, we stated that "[t]o the extent that the Proposed Regulations' requirement of identical interests relates to a concern that non-limited partners who do not put up capital should not be permitted to rely on the bifurcation rules, we would support an explicit rule to that effect. Specifically, we suggest that a partner who materially participates in the partnership's business, and who receives in exchange for services solely a disproportionate profit share, should not be entitled to rely on the bifurcation exceptions."

⁴⁷ Prop. Treas. Reg. § 1.1402(a)-2(h)(3).

⁴⁸ 1997 NYSBA Report, at para. 32.

⁴⁹ 1997 NYSBA Report, at paras. 33-34. The 1997 NYSBA report's analysis of the special bifurcation provisions noted some additional comments on the benchmark test contained in the regulations, namely that (i) the "immediately after requirement" should be modified to require only that the limited partners own their interests (on other than a transitory basis) at some time during the same taxable year; (iii) "continuing" should mean "other than transitory"; and (iv) the "are identical" requirement should be replaced with a comparative "to the extent similar" rule that focuses on the economics of the interests involved. Id. 34-37.

⁵⁰ To illustrate this point, assume X is a material participant in a restaurant business. Due to his material participation, any allocable share of the earnings from the restaurant business would appear not to be captured by Section 1411. If Section 1402 allows X to "bifurcate" some portion of his interest (the portion that is identical to that of outside investors), X would not be subject to tax under Section 1401 for that portion (while the outside investors, assuming they meet the relevant income threshold under Section 1411, would be taxed on their income allocations at a 3.8% rate under Section 1411). This example may indicate that there should be no bifurcation allowed under Section 1402 for anyone who is a "material participant" in the partnership, in order to rationalize the results for both passive and active members or partners.

⁵¹See NYSBA Report No. 1166 "Report on Proposed Carried Interest and Fee Deferral Legislation," pp. 19-30, Sept. 24, 2008.

⁵² We expressed strong support in the past for legislation that would rationalize the tax treatment of all flow-through entities, including S corporations. See the 2010 NYSBA Report.

⁵³ Section 1411(a)(1).

⁵⁴ Unlike Section 1402, which provides for a limited deduction for SECA taxes, taxpayers will not be able to claim a deduction for taxes imposed by Section 1411.

⁵⁵ For example, capital gain realized by a partnership on assets held in its trade or business (i.e., a building held in a restaurant business) and allocable to an individual partner who materially participates in the trade or business of the partnership is exempt from tax under Section 1411.

⁵⁶ Section 1411(c)(2).

⁵⁷ American Jobs Act of 2011, S. 1549, Sec. 412 (2011).

⁵⁸ Investing in stock or securities on a long term basis, in order to realize capital gains, dividend or interest income is not generally considered to constitute a trade or business. See Higgins v. Commissioner, 312 U.S. 212 (1941); Purvis v. Commissioner, 530 F. 2d 1332 (9th Cir. 1976); Chiang Hsiao Lang, 23 T.C. 1040 (1955).

⁵⁹ If a particular Hedge Fund does not buy and sell marketable securities will sufficient frequency to qualify as a "trader," it will fall into the first category of funds.

⁶⁰ These comments on Section 1411 supplement the comments reflected in our Letter dated September 29, 2010, addressing certain ambiguities that we thought should be addressed under Section 1411. This Report comments more specifically on the interaction of Section 1411 and Section 1402.

⁶¹ Section 1411(c)(1)(A)(ii).

⁶² Some hedge funds "originate" loans. Whether the interest on the loans may be exempt from tax under Section 1411 as attributable to "loan origination activities" is not entirely clear. It would be helpful if future guidance addressed whether Section 1411 applies to interest on originated loans.

⁶³ 136 T.C. 12 (2011).

⁶⁴ Section 166 allows an individual to take an ordinary income deduction for a loan (held by the individual) that is not a security and that becomes worthless within the taxable year, provided that the loan is created in connection with a trade or business of the individual. The Tax Court stated that "Mr. Dagres's dominant motivation for lending [the money] to the obligor was to gain preferential access to companies and deals to which [the obligor] might refer [Mr. Dagres], so that Mr. Dagres could use that information in the venture capital activities," id. at 163, which, arguably, would indirectly increase the income to Mr. Dagres from management fee payments from the venture capital funds to its general partners.

⁶⁵See H.R. REP. NO. 95-702(I), pp. 40-41 (1977) (addressing P.L. 95-21, Social Security Amendments of 1977). See also William L. Raby & Burgess J.W. Raby, "Self-Employment Income of LLC 'Partners'," 2003 TNT 108-49 (June 5, 2003).

⁶⁶ It has been suggested that Congress passed the moratorium in 1997 in part because of a failure to provide notice and follow certain other procedures required by the Regulatory Flexibility Act (5 U.S.C. 601-12), which had been expanded in 1996 to include Treasury regulations, Sec. 241, Small Business Regulatory Enforcement Fairness Act of 1996, P.L. 104-121. See Stuart Levine & Marshall Paul, IRS Shifts Focus With Controversial New SE Tax Proposed Regulations, 86 J. TAX'N 325, 330 (1997). (The Regulatory Flexibility Act requires administrative agencies to evaluate the impact of rulemaking on small entities. When a proposed rule imposes a significant economic impact on a substantial number of small entities, the administrative agency must analyze alternatives that would achieve the purpose of the rule without unnecessarily burdening small entities. Pursuant to the statute, the administrative agency makes its initial analysis available for public comment, after which it publishes the final analysis in the Federal Register with the final rule.) Such failure in 1997 would not be relevant to regulations proposed now, providing the proper notice and comment procedures are followed.

⁶⁷ 131 S.Ct. 704 (2011). In addition to Mayo Foundation for Medical Education v. United States, infra, other courts have upheld interpretive tax regulations in litigation challenging their validity in recent years. For example, in McNamee v. Dept. of the Treasury, 488 F.3d 100 (2nd Cir. 2007), the Second Circuit in 2007 upheld the validity of the check the box regulations, where the taxpayer challenged their application to a single member LLC (thereby imposing liability on him for unpaid payroll taxes of the accounting firm). The Sixth Circuit, in Litriello v. United States, 484 F.3d 372 (6th Cir. 2007), reached a similar conclusion, stating "It is unnecessary, in our judgment, to engage in an exegesis of Chevron here. The perimeters of that opinion and its directive to courts to give deference to an agency's interpretation of statutes that the agency is entrusted to administer and to the rules that govern implementation, as long as they are reasonable, is clear, and are clearly applicable in this case." Litriello, at 377. Indeed, the Court in Litriello went on to also address the question of state law classification, which the taxpayer raised as an obstacle to the government's regulations, but the Court did not accept this argument: "The federal government has historically disregarded state classifications on businesses for some federal tax purposes." Litriello, at 379.

⁶⁸ 104 S. Ct. 2778 (1984).

⁶⁹ The Court decided whether to apply the less deferential standard from National Muffler Dealers Assn., Inc. v. United States, 99 S. Ct. 1304 (1979) or to apply the more deferential standard of Chevron. Specifically, the Court stated, "Aside from our past citation of National Muffler, Mayo has not advanced any justification for applying a less deferential standard of review to Treasury Department regulations than we apply to the rules of any other agency. In the absence of such justification, we are not inclined to carve out an approach to administrative review good for tax law only. . . . The principles underlying our decision in Chevron apply with full force in the tax context." Mayo, at 713.

⁷⁰Mayo, at 714.

⁷¹Mayo, at 711, citing Household Credit Services, Inc. v. Pfennig, 541 U.S. 232, 242 (2004).

⁷²Mayo, at 715.

⁷³ P.L. 79-404.

⁷⁴Mayo, at 712.