Are You “Active” in Your Partnership or LLC To Save Taxes?

The Patient Protection and Affordable Care Act (PPACA) and the American Taxpayer Relief Act of 2012 (ATRA) increased the Medicare tax on earned income and introduced a new tax on the net investment income (NII) of hi-income individuals. The 3.8% tax applies to the extent an individual’s compensation or self-employment income exceeds the specified threshold amounts ($250,000 for married individuals filing jointly and $200,000 for single individuals).

Last month, I discussed the choices between C corporations versus S corporations and material participation by shareholders to avoid the 3.8% tax. This month, I will discuss the NII as it applies to partnerships and limited liability companies. Portions of this article are from Edward G. Ptaszek, Jr.’s and Dana Rountree Andrassy’s recent discussion on this subject.

Trade or business income is included in NII if the business activity is a passive activity with respect to the taxpayer under IRC 469 or involves trading in financial instruments or commodities. For the first time since 2003, corporate and individual rates have flip-flopped, and the maximum income tax rate applicable to individuals is now significantly higher than the rate applicable to corporations. The top individual income tax rate for 2013 is 39.6% for ordinary income and 20% for long-term capital gains and qualified dividends. The top corporate income tax rate for 2013 remains at 35% however, for both ordinary income and capital gains.

The treatment of an owner of a partnership interest, including interests in an LLC taxed as a partnership, depends on whether the business is passive with respect to the owner for purposes of the NII tax rules, and whether the owner is treated as a “limited partner” for purposes of the self-employment tax rules.

An individual partner’s NII includes the partner’s share of flow-through income from a partnership only to the extent the income is derived from a partnership activity that is a passive activity with respect to the partner (or from trading in financial instruments or commodities), or represents a share of the partnership’s investment income. The material participation test under IRC applies to determine whether an activity is passive with respect to a partner. Under the test, a partner materially participates in an activity if the partner’s involvement in the operation of the activity is regular, continuous, and substantial. Thus, in the case of a passive partner, the new NII tax applies to the partner’s entire distributive share of partnership income. On the other hand, if a partner materially participates in the partnership’s business, the NII tax does not apply to the partner’s income from the partnership except to the extent the partner receives a guaranteed payment for services.

The gain or loss included in NII with respect to the sale of a partnership interest is limited to the gain or loss that would be recognized in a hypothetical sale of the partnership’s assets. Any gain recognized on the distribution of money in excess of a partner’s adjusted basis in the partnership interest is also treated as gain from the sale or exchange of the partnership interest, for purposes of the NII tax.

Unfortunately, even a partner whose level of participation avoids the NII tax will likely be subject to self-employment tax on the partner’s entire distributive share of the partnership’s income, as well as any gain on sale of a partnership interest.

As a general rule, self-employment income includes a partner’s entire distributive share of flow-through income from a partnership. An exception applies to the distributive share of a “limited partner,” which is subject to self-employment tax only to the extent of any guaranteed payment to the partner for services actually rendered to or on behalf of the partnership. The term “limited partner” is not defined in the Code, and no definitive guidance has been issued on how the exception should be applied in the case of an LLC or other state law entity taxed as a partnership. Proposed regulations were issued in 1997, but never finalized, that include a relatively narrow definition of “limited partner,” particularly in the case of service partnerships. The definition of “limited partner” under the proposed regulations does not include an individual who either:

  1.   Has personal liability for the partnership’s debts.
  2.   Has authority to contract for the partnership.
  3. Participates in the partnership’s business more than 500 hours in a year.

A partner who participates in the business more than 500 hours per year, but otherwise qualifies as a limited partner and who owns only one class of partnership interest may be treated as a limited partner under the proposed regulations so long as at least 20% of the remaining partnership interests are held by limited partners who have identical rights but who provide no services to the partnership. However, in the case of service partnerships in specified professional fields, any partner who performs more than a de minimis amount of services cannot be treated as a limited partner under the proposed regulations.

The additional Catch-22 for an actively involved limited partner or LLC member is that the level of participation required to qualify a partnership activity as active, with respect to the partner under the NII tax rules, is likely to disqualify the limited partner or LLC member as a “limited partner” under the self-employment tax rules. These rules simply were not drafted and have not been updated to adequately address limited liability company members (or limited partners in LLPs or other newer versions of tax partnerships under state law).

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