Partnership bifurcation.

• Author: Koppel, Michael D.
• Position: Limited-partner equivalence test

In 1994, the IRS released proposed regulations intended to clarify when a member of a limited liability company (LLC) would be treated as a limited partner not subject to self-employment (SE) tax. Under the regulations, an individual owning an LLC interest was treated as a limited partner if (1) the member lacked the authority to make management decisions (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 state law (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 under the various state laws.

The limited-partner equivalence test referenced the state of organization rather than the state of operation and was partially designed to exclude professional service LLCs from the benefits of limited partner status. The language may lead to disparate treatment, depending on the state of jurisdiction. In one state, nonmanaging members of an LLC might not be able to exclude their distributive share of income from SE tax, while in others, even managing members could. Therefore, prior to organizing, the member could choose the state that afforded the most flexibility as to the degree of participation in control they may exercise without jeopardizing their limited partner status, and minimize their exposure to SE tax.

The proposed regulations contradicted the normal approach of permitting a person who was both a general and limited partner to bifurcate his distributive share of LLC income and exclude the limited partner interest portion from SE tax. Commentators on the 1994 proposed regulations focused on whether the Service would respect the ownership of more than one class of partnership interest for SE tax purposes. The proposed regulations treated an LLC member as a limited partner for his entire interest, or not at all. Commentators, however, pointed to the legislative history of Sec. 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 with both a general partner interest and a limited partner interest is subject to SE tax only on the distributive share attributable to the partner's general partner interest. This intent also may be...