“Once More Into the Breach”[i]
Last week, the IRS announced “the start of a sweeping, historic effort to restore fairness in tax compliance by shifting more attention onto high-income earners, partnerships, large corporations and promoters abusing the nation’s tax laws.”[ii]
The IRS added that its efforts “will be driven with the help of improved technology as well as Artificial Intelligence that will help IRS compliance teams better detect tax cheating.”
Defining the Target
In describing the target population of “wealthy” individuals and “high earners,” the IRS explained that it “will intensify work on taxpayers with total positive income above $1 million that have more than $250,000 in recognized tax debt.” The agency stated that it “will have dozens of Revenue Officers focusing on these high-end collection cases in FY 2024” in the hope of “contacting about 1,600 taxpayers in this category that owe hundreds of millions of dollars in taxes.”[iii]
The IRS reminded taxpayers that it will also be increasing its efforts with respect to partnerships, which present “complex structures and tax issues.”[iv] For instance, the IRS has “identified ongoing discrepancies on balance sheets involving partnerships with over $10 million in assets, which is an indicator of potential non-compliance.”[v] The agency stated that it will begin contacting “around 500” such partnerships in early October.
According to IRS Commissioner Danny Werfel, “This new compliance push makes good on the promise of the Inflation Reduction Act to ensure the IRS holds our wealthiest filers accountable to pay the full amount of what they owe.”[vi]
“Render to Caesar”[vii]
Regardless of how much federal income tax any member of the IRS’s target population group actually pays, and regardless of how large a percentage of the total federal tax burden is borne in the aggregate by the members of this group, any such individual who utilizes illegal means to deliberately avoid the payment of their “true” income tax liability should realize there will be a price to pay.[viii] No tax professional would disagree.
Provided the government itself remains within the bounds of the law in its pursuit of such individuals, the latter should have no reason to cry foul as the rest of us – in the role of a Grecian chorus – attest to what will hopefully be their “catharsis by taxation.”[ix]
That said, and acknowledging the IRS has to start somewhere – $1 million of reported income seems as good a place as any – neither the agency not the public should lose sight of the fact that there are plenty of tax evaders whose reported annual income does not exceed this threshold amount. Hopefully these folks will see the error of their ways; if not, the soon-to-be strengthened IRS Whistleblower Office may take an interest in them.
Respect the Law
However, for every tax evader within the IRS’s target population, described above, there are many more members of the group who, through legal means, pursue tax saving strategies. These individuals[x] will consult with knowledgeable and respectable tax advisers who will assist them in identifying tax saving opportunities for which they will develop, and then implement, an appropriate tax strategy.[xi] Some of these taxpayers plan more aggressively than others; for example, their actions may come within the literal language of a particular provision of the Code while also flouting the provision’s legislative purpose.[xii]
Then there are “high-earning” individuals – including many “one percenters” – who do not engage in sophisticated tax planning. These folks simply abide by the letter of the law. Most of them have earned their good fortune and acknowledge their obligation to pay the not insignificant taxes they owe – albeit grudgingly at times – though there are some folks in Washington, D.C.[xiii] who question whether these individuals are paying enough.[xiv]
Limited Partners and Self-Employment Tax
Which brings us to a recent newsworthy development, regarding the potential imposition of self-employment tax on a limited partner, that was reported by several publications last month.[xv]
As you may know, the self-employment tax is comprised of the Social Security and Medicare taxes. It is imposed on the self-employment income of an individual taxpayer. The standard self-employment tax rate is 15.3 percent, but it can easily reach 16.2 percent.[xvi]
“Self-employment income” means the net earnings from self-employment derived by an individual, with certain adjustments.[xvii]
The term “net earnings from self-employment” means (i) the gross income derived by an individual from any trade or business carried on by such individual, less the allowable deductions that are attributable to such trade or business, plus (ii) the individual’s distributive share of income or loss from any trade or business carried on by a partnership of which they are a member.[xviii]
In computing an individual’s gross income and deductions, as well as their distributive share of partnership ordinary income or loss, several items are excluded that may be described as “investment” – or non-business – income and expenses.
Among the more significant of these excluded items is an individual partner’s distributive share of any item of partnership income or loss that is allocated to them in their capacity as a limited partner, without regard to how “active” the limited partner may be or to the size of their partnership interest.[xix]
That said, payments made to such a limited partner for services actually rendered by them to or on behalf of their partnership[xx] are included in the individual’s net earnings from self-employment to the extent those payments are established to be in the nature of remuneration for those services.[xxi] This inclusion derives from the limited partner’s having “actively” participated in the partnership’s business, though the degree and nature of such participation appear to be irrelevant.
Notwithstanding the letter of the law, it appears the IRS has decided – at least under the circumstances of the limited partnership that is the subject of the above-referenced articles – that the self-employment tax should be imposed upon a limited partner’s share of partnership income.
According to the petition filed with the U.S. Tax Court,[xxii] Partnership – which was a state law limited partnership – had two partners during the tax years in question:
- Advisors, which was an S corporation that owned a 0.01 percent general partner interest in Partnership
- Advisors, in turn, was 100 percent owned by the individual taxpayer, and
- Holdings, a limited partnership that owned a 99.99 percent limited partner interest in Partnership.
- Advisors owned a 0.01 percent general partner interest in Holdings, and
- the individual taxpayer owned a 99.99 percent limited partner interest.[xxiii]
Thus, the individual taxpayer owned or was deemed to own, directly and indirectly, (i) 100 percent of the corporation (Advisor) which acted as the 0.01 percent general partner in each of Partnership and Holdings, (ii) all of the limited partner interests in Holdings, and (iii) the 99.99 percent limited partner interest in Partnership.
During the tax years in question, Partnership was engaged in a trade or business; it was not merely investing for its own account. Thus, its income during the years in question was not of the type, generally speaking, that would have been excluded from net earnings from self-employment.
The partnership agreement vested all control over Partnership and its business in Advisors. It also confirmed that Holdings could not participate in the management of Partnership.
Of course, this did not preclude Holdings from providing any non-managerial services to Partnership in connection with the business, though the petition says nothing about Holdings’ having actually done so.
It appears that neither Advisors nor Holdings received any guaranteed payment for services, if any, rendered to Partnership.
Partnership allocated 0.01 percent of its income, gain, expenses, losses, and credits to Advisors, and 99.99 percent to Holdings.
The individual taxpayer must have reported all of Partnership’s taxable income on their personal income tax return.[xxiv]
Holdings, as a limited partner, did not report any of its distributive share from Partnership as net earnings from self-employment.
The taxpayer’s petition disputed the IRS’s assertion[xxv] that Holdings should have reported more than $340 million of its distributive share[xxvi] of Partnership’s taxable income as net earnings from self-employment for the two tax years in question.[xxvii]
Partnership identified Holdings as a limited partner, and Holdings claimed to have acted solely as a limited partner with respect to Partnership.
Without more, and based only on the literal language of the Code,[xxviii] Holdings was correct not to report any of its distributive share of Partnership’s taxable income as net earnings from self-employment.
Why, then, did the IRS assert a deficiency in self-employment tax?
Since 2018, the IRS has had a campaign to promote and ensure partner compliance with the self-employment tax.[xxix]
According to the IRS’s description of this campaign, some individual partners, including service partners in service partnerships organized as state-law limited partnerships, have inappropriately claimed to qualify as “limited partners” not subject to SECA tax.
As stated earlier, unless an individual partner qualifies as a “limited partner” for self-employment tax purposes, the partner’s distributive share of their partnership’s income is subject to self-employment tax.
Thus, if the partner is a general partner[xxx] of a partnership that carries on a trade or business, their net earnings from self-employment include their distributive share of income from that trade or business, without regard to how active in the business the general partner may actually be.[xxxi]
In contrast to a general partner’s return on their “investment” – which is more akin to a return on their services, at least where it can be demonstrated that the general partner did not make a meaningful capital contribution – a limited partner’s return is properly treated as a return on their capital invested in the partnership; thus, the treatment of a limited partner as a passive investor for self-employment tax purposes.
In light of the foregoing, what if a taxpayer: (i) was both a general partner and a limited partner in the partnership, (ii) rendered valuable services to or for the partnership,[xxxii] and (iii) did not receive what may be described as “reasonable compensation” for such services,[xxxiii] whether in the form of either guaranteed payments[xxxiv] or a larger share of partnership income?
Under those circumstances, may it be said that the taxpayer should be paid or allocated more? Perhaps, but that doesn’t explain the IRS’s apparent position in the above-described matter in which the agency sought to recharacterize the nature of the limited partner’s (Holdings) distributive share.
In any case, the S corporation (Advisor) was the general partner; the individual taxpayer was a member of the limited partner. Presumably, the individual was employed by the S corporation, which reasonably compensated them for their services.
Alternatively, does the IRS intend to contest the nature of the limited partner’s involvement in the partnership? After all, the same S corporation managed both Partnership and Holdings, and the individual who owned and managed the S corporation was a limited partner in Holdings.
That said, how can the IRS disregard these separate business entities, or will it claim there is a basis for treating them, in effect, as alter egos of one another?
Seems to me like the IRS may be reaching too far. Its regulations project on the subject has been in limbo for years. Congress has failed to act, and is unlikely to any time soon.
That leaves the Courts. Stay tuned as this case, and others like it, wind their way through the system.
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The opinions expressed herein are solely those of the author(s) and do not necessarily represent the views of the Firm.
[i] Query whether Commissioner Danny Werfel can exhort his agents to action as well as Henry V did his knights and men-at-arms, and especially his archers (who comprised the great majority of the English force), at Agincourt, as Shakespeare tells us. For a great account of the battle, read Bernard Cornwell’s historical novel Agincourt.
[iii] According to the World Economic Forum, less than 0.50% of “U.S. Americans” have an annual income of more than $1 million. However, about 7% have a net worth of more than $1 million. https://www.weforum.org/agenda/2022/04/united-states-actual-perceived-income-gap-economy/.
[iv] The IRS will try to expand upon its 2021 Large Partnership Compliance Program by adding additional large partnerships to examine. “With the help of AI, the selection of these returns is the result of groundbreaking collaboration among experts in data science and tax enforcement, who have been working side-by-side to apply cutting-edge machine learning technology to identify potential compliance risk in the areas of partnership tax.” By the end of September, the IRS stated, “it will open examinations of 75 of the largest partnerships in the U.S. that represent a cross section of industries.”
[v] Taxpayers filing partnership returns are showing discrepancies in the millions of dollars between end-of-year balances compared to the beginning balances the following year. The number of such discrepancies has been increasing over the years. Many of these taxpayers are not attaching required statements explaining the difference. This effort will focus on high-risk large partnerships to quickly address the balance sheet discrepancy.
[vi] You may recall that the Act (Pub. L. 117-169) provided funding to expand and modernize the IRS, with an emphasis on enforcement. It remains to be seen how much funding the IRS will actually receive. Stay tuned as we approach the start of the government’s next fiscal year.
[vii] Mark 12:17, KJB.
[viii] The following quotation is attributed to Thomas Jefferson: “To compel a man to furnish funds for the propagation of ideas he disbelieves and abhors is sinful and tyrannical.” That may be, though others would certainly disagree. What recourse does the recalcitrant taxpayer have? “Vote the bastards out,” as someone once said – but that takes numbers – or “vote with your feet.” Thus, the migration out of New York and California.
[ix] But don’t underestimate the hubris of these individuals.
[x] Some of whom are more arrogant than others.
[xi] How often have you heard how unfair it is that the wealthy have access to, and can afford to retain the services of, sophisticated tax advisers? The fact is, only the wealthy have need of such tax advice. Sometimes, they even pay for it.
[xii] This approach often reminds me of this line from the late, beloved British comedian, Benny Hill: “We heard what she said, we knew what she meant.” OK, it may be a bit of a stretch.
[xiii] And in Albany, Sacramento, Springfield, Boston, etc.
[xiv] Brandon, Bernie, and Liz come to mind.
Think about it, in 2022 the cutoff for the “top 1%” that these elected officials have vilified was approximately $570,000 for a household and approximately $400,000 for a single earner. https://dqydj.com/top-one-percent-united-states/. Taxpayers at that ”entry” level, and even beyond, are working hard for what they bring home – they are not passive investors waiting for the checks/wires to arrive.
[xv] See, e.g., “Steve Cohen Fights a $10 Million Tax Bill to Derail an IRS Plan,” Bloomberg Daily Tax Report, August 18, 2023.
Taxes aside, can we forgive Mr. Cohen for the Mets’ poor showing this year?
Cohen’s case is not the only case before the Tax Court that raises questions about the application of the self-employment tax to limited partners. Soroban Capital Partners filed petitions on July 21, 2022 for Docket Nos. 16217-22 and 16-218-22. Likewise, Denham Capital Management LP filed a petition with the Tax Court on June 22, 2023 for Docket No. 9973-23.
[xvi] IRC Sec. 1401. The rate consists of two parts: 12.4% for social security (old-age, survivors, and disability insurance) and 2.9% for Medicare (hospital insurance).
For 2023, the amount of self-employment income that is subject to the Social Security Tax is capped at $160,200. There is no such cap for the 2.9% Medicare tax, though an individual may be liable for an additional 0.9% Medicare Tax if their self-employment income exceeds a threshold amount ($250,000 for a joint return, in 2023).
[xvii] IRC Sec. 1402(b).
[xviii] IRC Sec. 1402(a).
[xix] IRC Sec. 1402(a)(13).
[xx] So-called “guaranteed payments.” IRC Sec. 707(c).
[xxi] IRC Sec. 1402(a)(13).
[xxii] Point72 Asset Management LP et al. v. Comm’r, Docket Number 12752-23. https://s3.amazonaws.com/pdfs.taxnotes.com/2023/2023-23390_TNTCourts_Point72_Asset_petition.pdf.
[xxiii] For income tax purposes. The petition states there were other limited partners; perhaps grantor trusts of which the taxpayer was the deemed owner for tax purposes.
[xxiv] On Part II of Schedule E of their Form 1040.
The presence of Advisor, a state law corporation that was “regarded” for tax purposes per Reg. Sec. 301-7701-2(b), ensured that Partnership would be treated as a partnership for tax purposes per Reg. Sec. 301.7701-3(b).
[xxv] The basis for the IRS’s claim is unclear from the petition and the attached notices.
[xxvi] Query whether this was its entire share.
[xxvii] The petition states that the IRS did note seek to re-allocate income between the general partner and the limited partner. It also stated that the IRS did not seek to change any partner’s distributive share. Thus, it appears that the IRS’s focus was on changing the tax treatment of the limited partner’s distributive share for purposes of the self-employment tax.
[xxviii] IRC Sec. 1402(a)(13).
[xxix] https://www.irs.gov/businesses/corporations/lbi-active-campaigns. As indicated earlier, there appear to be at least three cases before the Tax Court that probably originated from this campaign.
[xxx] Or its equivalent in the case of a limited liability company.
[xxxi] The general partner is effectively treated as being engaged in the partnership’s trade or business; their distributive share of the partnership’s trade or business income retains its character in the hands of the general partner as if it were realized directly by the partner.
[xxxii] In whatever capacity.
[xxxiii] Consider the IRS’s approach toward S corporations. S corporations must pay reasonable compensation to a shareholder-employee in return for services that the employee provides to the corporation before non-wage distributions may be made to the shareholder-employee. The instructions to the Form 1120-S, U.S. Income Tax Return for an S Corporation, state “Distributions and other payments by an S corporation to a corporate officer must be treated as wages to the extent the amounts are reasonable compensation for services rendered to the corporation.”
The IRS has the authority to reclassify payments made to shareholders from non-wage distributions (which are not subject to employment taxes) to wages (which are subject to employment taxes).
[xxxiv] I’m not aware of a “reasonableness requirement” for guaranteed payments for services.