Chapter 13 - § 13.8 • WHAT SHOULD BE DONE?

• Jurisdiction: Colorado

§ 13.8 • WHAT SHOULD BE DONE?

§ 13.8.1—Current Law

Current law still provides clear answers for partnerships and state-law limited partnerships.⁴¹ However, individual members of LLCs still must determine how they will treat their distributive share of ordinary income from their LLC. As a result of the now-expired moratorium following the issuance of the 1997 Proposed Regulations and subsequent inaction, there is no formal authority with respect to the appropriate treatment of a member's distributive share. This means that members and their advisors will have to determine how to account for self-employment income based on the sparse authority available.

The only guidance in this area is in the form of private letter rulings holding that a member is a partner and "the members' distributive shares of income are not excepted from net earnings from self-employment (NESE) by § 1402(a)(13)."⁴² This would suggest that all members, regardless of the level of their activities or their authority or participation in management, will be subject to self-employment tax. If this is the correct approach, individuals wishing to limit their exposure to self-employment tax should use S corporations — either corporations that make an election to be treated under subchapter S of the I.R.C., or LLCs that elect to be treated as an association taxable as a corporation and also elect to be an S corporation. See § 13.1.2, "Employee Shareholders of S Corporations" and "The S Election" in § 12.2.8.

§ 13.8.2—A Possible but Likely Erroneous Assumption

A second approach would be to assume that all members are "limited partners" and, except to the extent the payments represent guaranteed payments for services, the entire distributive share of ordinary income is excluded from net earnings from self-employment. There is no authority for this approach and several private letter rulings have suggested that, to the contrary, a member is presumed to be a general partner unless expressly made a limited partner by regulations.⁴³

§ 13.8.3—Assume that the 1997 Proposed Regulations Are Close to What the Final Regulations Will Look Like

A third alternative is to assume that the 1997 Proposed Regulations are close to what the final regulations for LLCs will look like, and to draft and report based on a reading of those regulations. The dissension over the 1997 Proposed Regulations is not that they make too many individuals limited partners, but that they take the benefits of being a limited partner away from some state-law limited partners.⁴⁴ That being the case, it seems reasonable to assume that regardless of the 1997-1998 disagreement between Congress and the IRS, the final regulations (if ever adopted) will resemble or be more generous than the 1997 Proposed Regulations. As noted above, there is no authority for this position (or for the proposition that in the absence of regulations, a taxpayer may take "any reasonable position"). An advisor considering applying the 1997 Proposed Regulations should carefully consider the uncertainties raised by the cases and other authority discussed in § 13.8.5, "Conclusion — And Perhaps an Answer — But Maybe Not the Answer Wanted."

In considering whether to give effect to proposed regulations, it is important to note that, under Treasury Regulations § 1.6662-4(d)(3)(iii), proposed regulations are "substantial authority" for purposes of avoiding the accuracy-related penalty with respect to understatement of income tax.⁴⁵ Although the taxes imposed on NESE by I.R.C. § 1401 are colloquially referred to as "employment taxes," § 1401(a) states: "In addition to other taxes, there shall be imposed . . . on the self-employment income of every individual . . . ." I.R.C. § 6662(b) provides that the accuracy-related penalty applies to any "underpayment" that is attributable to any of the specified reasons, including disregard of rules and regulations, and I.R.C. § 6664(a) defines "underpayment" to mean any shortfall in payment of "any tax imposed by this title" (which includes I.R.C. § 1401).

Indeed, Lucy Clark, a national issue specialist in the IRS Examination Specialization Program, said in a monthly IRS news broadcast, "If the taxpayer conforms to the latest set of proposed rules, we generally will not challenge what they do or don't do with regard to self-employment taxes."⁴⁶ Following the decision in Renkemeyer, Campbell & Weaver, LLP v. Commissioner,⁴⁷ discussed in § 13.8.5, "Conclusion — And Perhaps an Answer — But Maybe Not the Answer Wanted," which arguably called into question whether the 1997 Proposed Regulations are valid, IRS special counsel Dianna Mosi, speaking at the May 2011 American Bar Association Section of Taxation meeting, stated that taxpayers "can rely" on the 1997 Proposed Regulations.⁴⁸ In any case, as in all areas in which there is uncertainty, the ultimate decision should be made by an informed client.

If an LLC's members decide to report on the basis of the 1997 Proposed Regulations, advisors should note important distinctions between manager-managed LLCs and member-managed LLCs. Under the LLC Act, if an LLC is member-managed, each member is an agent of the LLC for purposes of carrying on its business in the ordinary course.⁴⁹ Accordingly, under the authority test, each member of a member-managed Colorado LLC will be classified as not being a limited partner and therefore subject to self-employment tax on the self-employment income of the LLC allocated to such member. If a Colorado LLC is manager-managed, each manager will be an agent of the LLC⁵⁰ and therefore classified as not being a limited partner and subject to self-employment tax on the self-employment income of the LLC allocated to the manager (assuming the manager is a member). If a Colorado...