The IRS hopes to issue guidance clarifying the definition of limited partner for purposes of the exemption from self-employment tax, along with guidance analyzing the complicated structures used by partners to claim the exemption.
At the American Bar Association Section of Taxation’s Philadelphia Tax Conference November 14, Anthony Sacco of the IRS Office of Associate Chief Counsel (Passthroughs and Special Industries) gave some details on a project — simply titled “Guidance under section 1402(a)(13)” — included in the government’s initial 2023-2024 priority guidance plan.
The new project was viewed favorably by tax professionals, who for many years have urged the government to provide clarity on section 1402(a)(13). The provision, enacted in 1977, generally excludes a limited partner’s distributive share of partnership income or loss from Self-Employment Contributions Act (SECA) tax. The exclusion doesn’t apply to guaranteed payments that a limited partner receives for services rendered to the partnership.
But because there is no statutory or administrative tax definition of limited partner, determining who qualifies for the section 1402(a)(13) exception became more difficult — and created legal uncertainty for taxpayers and the IRS — after states introduced new types of passthrough entities and amended their laws to allow limited partners to engage in some partnership business activities without losing their limited liability status.
Sacco noted that Treasury and the IRS sought to define limited partner via 1997 proposed regulations (REG-209824-96) that would have ignored state law classifications by adopting a functional analysis (based on liability, management, and participation) for determining limited partner status under section 1402(a)(13). But the government shelved the project after Congress expressed concerns over the proposed regs’ approach and imposed a one-year moratorium on their finalization.
“We are many years away from that now, and there’s still a need for clarity on what limited partner means — is it a state law label or does it mean something else?” Sacco said. He noted that in the interim, the IRS has relied on the Tax Court’s decision in Renkemeyer, Campbell & Weaver LLP v. Commissioner, 136 T.C. 137 (2011), which held that attorney partners who actively participated in a Kansas limited liability partnership weren’t limited partners for purposes of section 1402(a)(13).
Based on its conclusion that the section 1402(a)(13) SECA exclusion is intended to apply only to partners who are merely investors and who don’t perform services for the partnership, the Tax Court adopted a functional test — called the silent investor test by some — that looks at whether a partner’s interest is akin to that of a passive investor.
“Pretty much in all of these cases, we’re looking at service partnerships,” Sacco said. “Not necessarily capital-intensive partnerships, but ones where the income from the partnership is because of services the partners have provided — such as legal services, consulting, investment management, any of those types of things.”
Determining whether a partner is acting more as a passive investor or as a self-employed person is a fact-intensive inquiry, Sacco said. “What we’ve been able to work with is the test that Renkemeyer laid out for us, but we’re also hoping to come out with guidance on a number of fronts — maybe some pieces of guidance to help clarify what is a limited partner, and then also addressing some of the more complicated structures that people are using.”
Litigation or Regulation?
Eric B. Sloan of Gibson, Dunn & Crutcher LLP said that while he thought Renkemeyer provided a good overview of the legislative history to section 1402(a)(13), the ruling is “almost all dicta” because the case didn’t involve a limited partnership.
Sloan added that he’s sympathetic to the IRS’s reluctance to revisit the section 1402(a)(13) guidance project, given Congress’s hostile reaction in 1997. He noted that after the net investment income tax was enacted in 2011, the New York State Bar Association wrote a report urging Treasury and the IRS to address the limited partnership definition question because some passthrough owners were taking the position that they wouldn’t be subject to SECA or to the NII tax.
“I know it’s not your decision, but to try to attack this through litigation just strikes me as the wrong way to go,” Sloan said. “Do it by regulation — there is almost certainly authority.”
Clifford Warren, also with the IRS Office of Associate Chief Counsel (Passthroughs and Special Industries), responded that “in an ideal world, you’re right. But we don’t work in an ideal world, so we do what we can.”
Because Congress didn’t take steps to ensure there were no gaps between SECA and NII tax, it is up to the IRS to address what it views as taxpayers’ abusive attempts to avoid those taxes, Warren said.