Definition of Limited Partner for Self-Employment Tax Purposes

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.

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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

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Regulations (26 CFR part 1) under section 1402 of the Code.

Explanation of Provisions

The proposed regulations contained in this document define which

partners of a federal tax partnership are considered limited partners

for section 1402(a)(13) purposes. These proposed regulations apply to

all entities classified as a partnership for federal tax purposes,

regardless of the state law characterization of the entity. Thus, the

same standards apply when determining the status of an individual

owning an interest in a state law limited partnership or the status of

an individual owning an interest in an LLC. In order to achieve this

conformity, the proposed regulations adopt an approach which depends on

the relationship between the partner, the partnership, and the

partnership's business. State law characterizations of an individual as

a ``limited partner'' or otherwise are not determinative.

Generally, an individual will be treated as a limited partner under

the proposed regulations unless the individual (1) has personal

liability (as defined in Sec. 301.7701-3(b)(2)(ii) of the Procedure and

Administration Regulations) for the debts of or claims against the

partnership by reason of being a partner; (2) has authority to contract

on behalf of the partnership under the statute or law pursuant to which

the partnership is organized; or, (3) participates in the partnership's

trade or business for more than 500 hours during the taxable year. If,

however, substantially all of the activities of a partnership involve

the performance of services in the fields of health, law, engineering,

architecture, accounting, actuarial science, or consulting, any

individual who provides services as part of that trade or business will

not be considered a limited partner.

By adopting these functional tests, the proposed regulations ensure

that similarly situated individuals owning interests in entities formed

under different statutes or in different jurisdictions will be treated

similarly. The need for a functional approach results not only from the

proliferation of new business entities such as LLCs, but also from the

evolution of state limited partnership statutes. When Congress enacted

the limited partner exclusion found in section 1402(a)(13), state laws

generally did not allow limited partners to participate in the

partnership's trade or business to the extent that state laws allow

limited partners to participate today. Thus, even in the case of a

state law limited partnership, a functional approach is necessary to

ensure that the self-employment tax consequences to similarly situated

taxpayers do not differ depending upon where the partnership organized.

The proposed regulations allow an individual who is not a limited

partner for section 1402(a)(13) purposes to nonetheless exclude from

net earnings from self-employment a portion of that individual's

distributive share if the individual holds more than one class of

interest in the partnership. Similarly, the proposed regulations permit

an individual that participates in the trade or business of the

partnership to bifurcate his or her distributive share by disregarding

guaranteed payments for services. In each case, however, such

bifurcation of interests is permitted only to the extent the

individual's distributive share is identical to the distributive share

of partners who qualify as limited partners under the proposed

regulation (without regard to the bifurcation rules) and who own a

substantial interest in the partnership. Together, these rules exclude

from an individual's net earnings from self-employment amounts that are

demonstrably returns on capital invested in the partnership.

Proposed Effective Date

These regulations are proposed to be effective beginning with the

individual's first taxable year beginning on or after the date these

regulations are published as final regulations in the Federal Register.

Special Analyses

It has been determined that this notice of proposed rulemaking is

not a significant regulatory action as defined in EO 12866. Therefore,

a regulatory assessment is not required. It also has been determined

that section 553(b) of the Administrative Procedure Act (5 U.S.C.

chapter 5) does not apply to these regulations, and, because the

regulations do not impose a collection of information on small

entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not

apply. Pursuant to section 7805(f) of the Internal Revenue Code, this

notice of proposed rulemaking will be submitted to the Chief Counsel

for Advocacy of the Small Business Administration for comment on its

impact on small business.

Comments and Public Hearing

Before these proposed regulations are adopted as final regulations,

consideration will be given to any written comments (a signed original

and eight (8) copies) that are submitted timely to the IRS. All

comments will be available for public inspection and copying.

A public hearing has been scheduled for Wednesday, May 21, 1997, at

10 a.m. in the Auditorium, Internal Revenue Service building, 1111

Constitution Avenue, NW, Washington, DC. Because of access

restrictions, visitors will not be admitted beyond the Internal Revenue

Service building lobby more than 15 minutes before the hearing starts.

The rules of 26 CFR 601.601(a)(3) apply to the hearing.

Persons that wish to present oral comments at the hearing must

submit written comments by April 14, 1997 and submit an outline of the

topics to be discussed and the time to be devoted to each topic (signed

original and eight (8) copies) by April 30, 1997.

A period of 10 minutes will be allotted to each person for making

comments.

An agenda showing the scheduling of the speakers will be prepared

after the deadline for receiving outlines has passed. Copies of the

agenda will be available free of charge at the hearing.

Drafting Information

The principal author of these regulations is Robert Honigman of the

Office of Assistant Chief Counsel (Passthroughs & Special Industries).

However, other personnel from the IRS and Treasury Department

participated in their development.

List of Subjects in 26 CFR Part 1

Income taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

Accordingly, 26 CFR part 1 is proposed to be amended as follows:

PART 1--INCOME TAXES

Paragraph 1. The authority citation for part 1 continues to read in

part as follows:

Authority: 26 U.S.C. 7805 * * *

Par. 2. Section 1.1402(a)-2 is amended by:

1. Revising the first sentence of paragraph (d).

2. Removing the reference ``section 702(a)(9)'' in the first

sentence of paragraph (e) and adding ``section 702(a)(8)'' in its

place.

3. Revising the last sentence of paragraph (f).

4. Revising paragraphs (g) and (h).

5. Adding new paragraphs (i) and (j).

The revisions and additions read as follows:

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Sec. 1.1402(a)-2 Computation of net earnings from self-employment.

* * * * *

(d) * * * Except as otherwise provided in section 1402(a) and

paragraph (g) of this section, an individual's net earnings from self-

employment include the individual's distributive share (whether or not

distributed) of income or loss described in section 702(a)(8) from any

trade or business carried on by each partnership of which the

individual is a partner. * * *

* * * * *

(f) * * * For rules governing the classification of an organization

as a partnership or otherwise, see Secs. 301.7701-1, 301.7701-2, and

301.7701-3 of this chapter.

(g) Distributive share of limited partner. An individual's net

earnings from self-employment do not include the individual's

distributive share of income or loss as a limited partner described in

paragraph (h) of this section. However, guaranteed payments described

in section 707(c) made to the individual for services actually rendered

to or on behalf of the partnership engaged in a trade or business are

included in the individual's net earnings from self-employment.

(h) Definition of limited partner--(1) In general. Solely for

purposes of section 1402(a)(13) and paragraph (g) of this section, an

individual is considered to be a limited partner to the extent provided

in paragraphs (h)(2), (h)(3), (h)(4), and (h)(5) of this section.

(2) Limited partner. An individual is treated as a limited partner

under this paragraph (h)(2) unless the individual--

(i) Has personal liability (as defined in Sec. 301.7701-3(b)(2)(ii)

of this chapter) for the debts of or claims against the partnership by

reason of being a partner;

(ii) Has authority (under the law of the jurisdiction in which the

partnership is formed) to contract on behalf of the partnership; or

(iii) Participates in the partnership's trade or business for more

than 500 hours during the partnership's taxable year.

(3) Exception for holders of more than one class of interest. An

individual holding more than one class of interest in the partnership

who is not treated as a limited partner under paragraph (h)(2) of this

section is treated as a limited partner under this paragraph (h)(3)

with respect to a specific class of partnership interest held by such

individual if, immediately after the individual acquires that class of

interest--

(i) Limited partners within the meaning of paragraph (h)(2) of this

section own a substantial, continuing interest in that specific class

of partnership interest; and,

(ii) The individual's rights and obligations with respect to that

specific class of interest are identical to the rights and obligations

of that specific class of partnership interest held by the limited

partners described in paragraph (h)(3)(i) of this section.

(4) Exception for holders of only one class of interest. An

individual who is not treated as a limited partner under paragraph

(h)(2) of this section solely because that individual participates in

the partnership's trade or business for more than 500 hours during the

partnership's taxable year is treated as a limited partner under this

paragraph (h)(4) with respect to the individual's partnership interest

if, immediately after the individual acquires that interest--

(i) Limited partners within the meaning of paragraph (h)(2) of this

section own a substantial, continuing interest in that specific class

of partnership interest; and

(ii) The individual's rights and obligations with respect to the

specific class of interest are identical to the rights and obligations

of the specific class of partnership interest held by the limited

partners described in paragraph (h)(4)(i) of this section.

(5) Exception for service partners in service partnerships. An

individual who is a service partner in a service partnership may not be

a limited partner under paragraphs (h)(2), (h)(3), or (h)(4) of this

section.

(6) Additional definitions. Solely for purposes of this paragraph

(h)--

(i) A class of interest is an interest that grants the holder

specific rights and obligations. If a holder's rights and obligations

from an interest are different from another holder's rights and

obligations, each holder's interest belongs to a separate class of

interest. An individual may hold more than one class of interest in the

same partnership provided that each class grants the individual

different rights or obligations. The existence of a guaranteed payment

described in section 707(c) made to an individual for services rendered

to or on behalf of a partnership, however, is not a factor in

determining the rights and obligations of a class of interest.

(ii) A service partner is a partner who provides services to or on

behalf of the service partnership's trade or business. A partner is not

considered to be a service partner if that partner only provides a de

minimis amount of services to or on behalf of the partnership.

(iii) A service partnership is a partnership substantially all the

activities of which involve the performance of services in the fields

of health, law, engineering, architecture, accounting, actuarial

science, or consulting.

(iv) A substantial interest in a class of interest is determined

based on all of the relevant facts and circumstances.

In all cases, however, ownership of 20 percent or more of a

specific class of interest is considered substantial.

(i) Example. The following example illustrates the principles of

paragraphs (g) and (h) of this section:

Example. (i) A, B, and C form LLC, a limited liability company,

under the laws of State to engage in a business that is not a

service partnership described in paragraph (h)(6)(iii) of this

section. LLC, classified as a partnership for federal tax purposes,

allocates all items of income, deduction, and credit of LLC to A, B,

and C in proportion to their ownership of LLC. A and C each

contribute $1x for one LLC unit. B contributes $2x for two LLC

units. Each LLC unit entitles its holder to receive 25 percent of

LLC's tax items, including profits. A does not perform services for

LLC; however, each year B receives a guaranteed payment of $6x for

600 hours of services rendered to LLC and C receives a guaranteed

payment of $10x for 1,000 hours of services rendered to LLC. C also

is elected LLC's manager. Under State's law, C has the authority to

contract on behalf of LLC.

(ii) Application of general rule of paragraph (h)(2) of this

section. A is treated as a limited partner in LLC under paragraph

(h)(2) of this section because A is not liable personally for debts

of or claims against LLC, A does not have authority to contract for

LLC under State's law, and A does not participate in LLC's trade or

business for more than 500 hours during the taxable year. Therefore,

A's distributive share attributable to A's LLC unit is excluded from

A's net earnings from self-employment under section 1402(a)(13).

(iii) Distributive share not included in net earnings from self-

employment under paragraph (h)(4) of this section. B's guaranteed

payment of $6x is included in B's net earnings from self-employment

under section 1402(a)(13). B is not treated as a limited partner

under paragraph (h)(2) of this section because, although B is not

liable for debts of or claims against LLC and B does not have

authority to contract for LLC under State's law, B does participates

in LLC's trade or business for more than 500 hours during the

taxable year. Further, B is not treated as a limited partner under

paragraph (h)(3) of this section because B does not hold more than

one class of interest in LLC. However, B is treated as a limited

partner under paragraph (h)(4) of this section because B is not

treated as a limited partner under paragraph (h)(2) of this section

solely because B

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participated in LLC's business for more than 500 hours and because A

is a limited partner under paragraph (h)(2) of this section who owns

a substantial interest with rights and obligations that are

identical to B's rights and obligations. In this example, B's

distributive share is deemed to be a return on B's investment in LLC

and not remuneration for B's service to LLC. Thus, B's distributive

share attributable to B's two LLC units is not net earnings from

self-employment under section 1402(a)(13).

(iv) Distributive share included in net earnings from self-

employment. C's guaranteed payment of $10x is included in C's net

earnings from self-employment under section 1402(a). In addition,

C's distributive share attributable to C's LLC unit also is net

earnings from self-employment under section 1402(a) because C is not

a limited partner under paragraphs (h)(2), (h)(3), or (h)(4) of this

section. C is not treated as a limited partner under paragraph

(h)(2) of this section because C has the authority under State's law

to enter into a binding contract on behalf of LLC and because C

participates in LLC's trade or business for more than 500 hours

during the taxable year. Further, C is not treated as a limited

partner under paragraph (h)(3) of this section because C does not

hold more than one class of interest in LLC. Finally, C is not

treated as a limited partner under paragraph (h)(4) of this section

because C has the power to bind LLC. Thus, C's guaranteed payment

and distributive share both are included in C's net earnings from

self-employment under section 1402(a).

(j) Effective date. Paragraphs (d), (e), (f), (g), (h), and (i) are

applicable beginning with the individual's first taxable year beginning

on or after the date this section is published as a final regulation in

the Federal Register.

Margaret Milner Richardson,

Commissioner of Internal Revenue.

[FR Doc. 97-701 Filed 1-10-97; 8:45 am]

BILLING CODE 4830-01-U