Potential implication of recent sec. 469 court decisions for self-employment tax rules.

• Author: Ellis, Audrey

In several recent cases, courts have held that a member of a limited liability company (LLC) or a limited liability partnership (LLP) should be treated like a general partner for purposes of testing for material participation under the Sec. 469 passive activity rules. (See Garnett, 132 T.C. 19 (2009); Thompson, 87 Fed. Cl. 728 (2009), acq. in result (3/9/10); and Newell, T.C. Memo. 2010-23.) These cases concluded that a member of an LLC or an LLP who can exercise management authority is not automatically treated as a limited partner for purposes of applying the Sec. 469 material participation tests. The courts have viewed the ability to participate in management as a more significant factor than limited liability in making this determination.

Temp. Regs. Sec. 1.469-5T(a) provides seven tests for establishing a taxpayer's material participation in an activity for purposes of the passive loss rules. However, under Sec. 469(h)(2), no interest in a limited partnership as a limited partner is treated as an interest with respect to which a taxpayer materially participates, except as provided in the regulations. The regulations apply a much more restrictive standard to limited partners, who can materially participate only to the extent that they meet one of three tests (rather than one of the seven tests). The court cases determined that the taxpayers did not hold LLC units as limited partners and therefore should not be treated as presumptively passive under Sec. 469(h)(2).

For purposes of self-employment taxes, many members of LLCs have treated themselves as limited partners and have therefore reported that their distributive share of income was not subject to self-employment tax under Sec. 1402(a)(13). The recent Sec. 469 court cases did not specifically rule with respect to Sec. 1402. However, if the rationale of the cases were to be applied beyond Sec. 469, this self-employment tax position might be more difficult to sustain.

Sec. 1402 Overview

Individuals are subject to self-employment tax on net earnings from self-employment income. Net earnings from self-employment are defined under Sec. 1402(a) as gross income derived by an individual from any trade or business carried on by the individual, less deductions, plus the individual's distributive share of income or loss from any trade or business carried on by a partnership of which he or she is a member.

Self-employment tax is the equivalent of FICA tax in the nonemployee context. The current...