compensation & other techniques for getting … · compensation & other techniques for...
TRANSCRIPT
COMPENSATION & OTHER TECHNIQUES FOR GETTING MONEY OUT OF A
CLOSELY HELD BUSINESS
First Run Broadcast: February 14, 2012
1:00 p.m. E.T./12:00 p.m. C.T./11:00 a.m. M.T./10:00 a.m. P.T. (60 minutes)
Careful planning of compensation in closely held businesses – incentive compensation, deferred
comp, retirement plans – is essential to ensure the company’s owners can maximize withdrawals
of money but as tax efficiently as possible. Compensation planning can be complex, involving
income and employment tax rules, special deferred compensation restrictions and penalties, and
the retirement plan maze. Furthermore, application of the rules vary widely across business
entities – C Corps v. S Corps v. LLCs. This program will provide you with a practical guide to
planning compensation at every stage of the process – incentive compensation, deferred
compensation tied to profit participation, retirement contributions – to maximize liquidity and
minimize income and employment taxes across entities for the companies’ owners.
Understanding which compensation-based techniques are most tax-efficient for
withdrawing money from a closely held business
Incentive compensation planning across types of entities
Employment tax planning opportunities for C Corps, S Corps, and LLCs
Deferred compensation planning – and traps
Retirement plans alternatives to maximize tax savings
Speakers:
Rick Wagner is a director of Denver Compensation & Benefits, LLC, a national employee
benefits consulting firm based in Denver, Colorado. He has more than 20 years’ of experience in
employee benefits consulting, providing tax, audit and business advisory services on employee
stock ownership plans, equity-based plan design and compliance, deferred compensation
structuring, and executive compensation. He has also served on the AICPA Oversight Board for
employee benefits and is a frequent speaker on employee benefit plans. Mr. Wagner received his
B.S. from the University of Southern California and his J.D. from the University of California at
Davis.
Brian J. O'Connor is a partner in the Baltimore office of Venable, LLP, where he is co-chair of
the firm’s tax and wealth planning group. He provides sophisticated tax and business advice to
closely-held and publicly-traded businesses and their owners. Before joining Venable, Mr.
O’Connor was an attorney-advisor in the Office of the Chief Counsel of the IRS, where he
worked on high profile legislative projects, regulations and other published guidance relating to
pass through entities. Mr. O’Connor received his J.D., magna cum laude, from Washington and
Lee University School of Law and his LL.M. in tax law, with distinction, from Georgetown
University Law Center.
Alson R. Martin is a partner in the Overland Park, Kansas office of Lathrop and Gage, LLP,
where he has a national practice focusing on business law, taxation, health care, and retirement
plans. He is a Fellow of the American College of Tax Counsel and the American College of
Employee Benefits Counsel. Mr. Martin is the author of "Limited Liability Companies and
Partnerships" and the co-author of "Kansas Corporation Law & Practice (Including Tax
Aspects)." He is the president and a director of the Small Business Council of America. Mr.
Martin received his B.A., with highest distinction, from the University of Kansas, and his J.D.
and LL.M. from New York University School of Law.
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Compensation & Other Techniques for
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Out of a Closely Held Business Location: Teleseminar Credits: 1.0 General Luncheon addresses, business meetings, receptions are not to be included in the computation of credit. This form denotes full attendance. If you arrive late or leave prior to the program ending time, it is your responsibility to adjust CLE hours accordingly.
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© 2008 Venable LLP
SALARY-BASED TECHNIQUESFOR WITHDRAWING MONEY FROM A
CLOSELY-HELD BUSINESS
Brian J. O’Connor, Venable LLP
Baltimore, MD/Washington, DC
February 14, 2012
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© 2010 Venable LLP
COMMONLY USED COMPENSATIONTECHNIQUES FOR CLOSELY-HELDBUSINESSES
Corporate employers
– C corporations
– S corporations
Partnership employers
– GPs
– LPs
– LLCs
– LLPs
– LLLPs
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© 2010 Venable LLP
CORPORATE EMPLOYERS
Salary/Bonus
Unrestricted Stock
Restricted Stock
Options
Stock Appreciation Rights (SARs)
Phantom Stock
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© 2012 Venable LLP
CORPORATE EMPLOYERS
Salary/Bonus
– Cash is king
– Immediately subject to income and
employment taxes
– Generally not subject to forfeiture
– Immediately deductible by employer
Unrestricted Stock
– Immediate equity
– Immediately subject to income and
employment taxes
– Generally not subject to forfeiture
– Immediately deductible by employer
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© 2010 Venable LLP
CORPORATE EMPLOYERS
Restricted Stock
– Forfeitable equity – subject to vesting
– Taxation as vesting takes place (absent an
election under Code Section 83(b))
– Taxed on excess of value of stock (at time of
vesting or Code Section 83(b) election) over
the amount paid by employee
– Withholding issues
– Deductible to employer as taxable to
employee
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© 2010 Venable LLP
CORPORATE EMPLOYERS
Options – Nonqualified
– Employee locks in the right (but not the
obligation) to buy stock in the future at a fixed
price
– “Deferred equity”
– Employee generally taxed on “spread”
between value of stock received upon exercise
and the exercise price
– Withholding issues
– Deductible to employer as taxable to employee
– Exercise price must be at FMV at the time of
issuance to avoid Code Section 409A issues
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© 2010 Venable LLP
CORPORATE EMPLOYERS
Options – Qualified
– Same as above except (i) employee not taxed
upon exercise (although the “spread” is a tax
preference for AMT purposes and many
restrictions apply); and (ii) not deductible to
employer
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© 2010 Venable LLP
CORPORATE EMPLOYERS
SARs
– Employee receives right to excess of the value
of a number of shares of stock over a
specified base value
– Payout made either in cash or shares
– Employee taxed on amounts when received
as ordinary income subject to employment
taxes
– Amounts subject to withholding on Form W-2
– Employer deduction matches employee
inclusion
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CORPORATE EMPLOYERS
Phantom Stock
– Employee receives right to full value of a
number of shares of stock
– Payout made either in cash or shares
– Employee subject to income tax on amounts
received as ordinary income.
– FICA taxes, however, apply when phantom
shares vest
– Employer deduction matches employee
inclusion
© 2010 Venable LLP
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PARTNERSHIP EMPLOYERS
Salary/Bonus
– Similar to corporate employer situations
except that partners are generally unable to
qualify as employees for tax purposes
Options
– Same as above except that only corporations
can issue qualified options
SARs/Phantom Stock
– Similar to amounts issued by corporate
employers except that partners are generally
unable to qualify as employees for tax
purposes
© 2010 Venable LLP
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PARTNERSHIP EMPLOYERS
Unrestricted/Restricted Interests
– Capital Interests
– Profits Interests
Capital Interests
– Represent share of liquidation proceeds at
time of issuance
– Taxed comparably to issuances of stock by
corporate employers
– Employer partnership receives tax deduction
equal to employee’s inclusion amount
© 2010 Venable LLP
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PARTNERSHIP EMPLOYERS
Profits Interests
– Interests participate in future profit and cash
flow but do not receive any share of existing
capital or liquidation proceeds
– Immediate equity
– Under current law, profits interests are not
taxable upon receipt or vesting as long as (i)
the partnership is not publicly traded; (ii) the
future income stream is not too certain and
predictable; and (iii) the interest is not
disposed of within 2 years.
– Issuing partnership receives no deduction
© 2010 Venable LLP
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PARTNERSHIP EMPLOYERS
Profits Interests
– Only form of actual equity receivable by
service providers on a tax-free basis
– In many cases, disposition event can qualify
for capital gain treatment
– Possibility of legislative change
– Also referred to as “carried interests”
© 2010 Venable LLP
14 BA0/302430v2 © 2010 Venable LLP
Presenter Contact Information
Brian J. O’Connor
Venable LLP
(410) 244-7863
PROFESSIONAL EDUCATION BROADCAST NETWORK
Employment Tax Planning Across Business Entities
Alson R. MartinLATHROP & GAGE LLP10851 Mastin, Suite 1000
Overland Park, Kansas 66210(o) (913) 451-5170
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TABLE OF CONTENTS
I. EMPLOYMENT TAX RULES APPLY DIFFERENTLY TO DIFFERENTENTITIES; C CORPORATIONS, S CORPS, LLCS, AND PARTNERSHIPS. .............. 1
A. Concepts Important To Noncorporate Entities & Their SECA Obligations.......... 1
1. Trade Or Business...................................................................................... 1
2. Rates........................................................................................................... 3
3. Guaranteed Payments................................................................................. 3
B. Partnerships............................................................................................................ 4
1. General Partners......................................................................................... 4
2. Limited Partners Of Limited Partnerships. ................................................ 4
C. LLCs & LLPs Taxed As Partnerships. .................................................................. 4
1. IRS Ruling Position. .................................................................................. 5
2. Court Position On LLPs & LLCs. ............................................................. 6
3. 1997 Proposed Regulations & LLCs and LLPs......................................... 8
a. 3 Tests For Functional Limited Partner. ........................................ 8
b. Application To LLCs. .................................................................... 9
c. Application To LLPs.................................................................... 10
d. Second/Multiple Class Exception. ............................................... 10
D. LLLPs. ................................................................................................................. 14
E. Lifetime Retirement Payments To Retired General Partner Or LLCManaging/Manager Member. .............................................................................. 15
1. General Rule. ........................................................................................... 15
2. LLP General Partner Qualifies................................................................. 16
3. LLC Member Qualifies............................................................................ 17
F. Retirement Payments To Limited Partners. ......................................................... 17
G. Corporations......................................................................................................... 18
1. S Corporations. ........................................................................................ 18
2. C Corporations. ........................................................................................ 18
a. Taxation As Separate & Not A Pass-Through Entity. ................. 18
b. Social Security and Medicare Taxes and Income TaxWithholding. ................................................................................ 19
c. Dividends. .................................................................................... 19
TABLE OF CONTENTS(continued)
Page
-ii-
II. SPECIALPARTNERSHIP ISSUES; DUAL STATUS WORKERS & SPOUSES;FARMING; RETIREMENT PLAN COMPENSATION............................................... 19
A. Partnerships.......................................................................................................... 19
1. Individuals Working In Different Capacities........................................... 20
2. Spouses. ................................................................................................... 20
a. Non-Community Property States; 761(f) ElectionEliminates Need To File Form 1065 For Joint Ventures............ 20
b. No 761(f) Election For LLCs, LLPs Or Other State LawEntities. ........................................................................................ 22
c. Spousal Business In Community Property States. ....................... 22
3. Farming – Eligibility For CRP Versus Trade Or Business...................... 23
4. Calculating Earned Income For Retirement Plan Purposes. .................... 24
III. S CORP DISTRIBUTIONS V. EMPLOYEE-OWNER SALARIES; THE RISKOF “UNREASONABLY LOW” COMPENSATION.................................................... 25
A. No Compensation & All Distributions. ............................................................... 25
1. Distributions Recharacterized As Wages Due To No(Unreasonably Low) Compensation. ...................................................... 25
2. Applicability Of § 162. ............................................................................ 26
B. Some Compensation & Large Distributions. ....................................................... 27
IV. SITUATIONS WHERE SECA (SELF-EMPLOYMENT TAX) DOES NOTAPPLY TO LLC INCOME; PLANNING OPPORTUNITIES....................................... 29
A. One Class Of Interest. .......................................................................................... 29
B. Manager Managed LLC; Material Participation Exception................................. 29
C. Two Classes Of Owners – Non-Service LLC; Family Members May Play........ 30
D. Separate Equipment & Real Estate Leasing Entities. .......................................... 30
E. Third Party Manager. ........................................................................................... 31
F. Conclusion. .......................................................................................................... 31
V. REAL WORLD LIMITS OF PLANNING OPPORTUNITIES...................................... 31
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I. EMPLOYMENT TAX RULES APPLY DIFFERENTLY TO DIFFERENTENTITIES; C CORPORATIONS, S CORPS, LLCS, AND PARTNERSHIPS.
Employment tax considerations are but one of a host of considerations in choice of entityplanning. This outline will focus solely on the difference an entity type makes regardingemployment taxes.
A. Concepts Important To Noncorporate Entities & Their SECA Obligations.
1. Trade Or Business.
General partners of general partnerships and sole proprietors engaged in a "trade or business"(same meaning as under IRC § 162) are subject to self-employment tax (SECA tax). A trade orbusiness activity is regular, frequent, and undertaken for the primary purpose of profit. Anactivity undertaken merely for investment does not constitute a trade or business. IRC § 1401(a).
The net earnings from self-employment (NESE) of a general partner in a partnership is thepartner's distributive share from any trade or business of the partnership, adjusted for certainitems of partnership income that are passive in nature (i.e., rentals of real estate, dividends, andinterest are excluded from NESE unless such amounts are received by the partnership in thecourse of a trade or business as a dealer in the related property). If a general partner's distributiveshare is a net loss, it is deducted from NESE.Net income from self-employment generally includes active income from self-employment. Inthe case of a partner in a partnership, the term includes a partner's share (whether or notdistributed) of income and loss from a partnership engaged in a trade or business. IRC § 1402(a).Therefore, passive income such as rents, capital gains, interest, and dividends (including trueSubchapter S dividends) are excluded from the definition. IRC §§ 1402(a)(1), 1402(a)(2).Income of limited partners is also generally excluded from SE income unless a limited partnerreceives a guaranteed payment. IRC § 1402(a)(13). Income that is excluded from the definitionof “self-employment income” is not subject to the self-employment tax and cannot be countedfor purposes of calculating allowable contributions to qualified plans. IRC § 401(c)(2). Apartner may deduct one-half of self-employment taxes paid. See IRC § 164(f).
For purposes of this outline, LLCs and LLPs will be assumed to be taxed as partnerships (orproprietorships in the case of those owned by one individual). For LLCs taxed as corporations,their employment tax treatment will be the same as for a regular C or Subchapter S corporation,as the case may be.
The multi-member partnership, LLC, LLP, and LLLP report their income and tax attributes onan information return (Form 1065) and provide each owner with a Schedule K-1 showing thatowner’s allocation of the entity’s tax attributes. Section 1401 of the Internal Revenue Code(Code) imposes a tax on the self-employment income of every individual (SECA tax). The term“self-employment income” is defined in § 1402(b) as the net earnings from self-employmentderived by an individual.
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Section 1402(a) defines an individual’s “net earnings from self-employment” as the grossincome derived by an individual from any trade or business carried on by such individual, alsowith certain limitations. Section 1402(a)(1) generally excludes from the computation of "netearnings from self-employment" rentals from real estate and from personal property leased withthe real estate (including such rentals paid in crop shares) together with the deductionsattributable thereto, unless such rentals are received in the course of a trade or business as a realestate dealer, with an exception. Under this exception, any income derived by the owner ortenant of land must be included in the computation of "net earnings from self-employment" if-
(A) such income is derived under an arrangement, between the owner or tenantand another individual, which provides that such other individual shall produceagricultural or horticultural commodities (including livestock, bees, poultry, andfur-bearing animals and wildlife) on such land, and that there shall be materialparticipation by the owner or tenant (as determined without regard to anyactivities of an agent of such owner or tenant) in the production or themanagement of the production of such agricultural or horticultural commodities,and
(B) there is material participation by the owner or tenant (as determined withoutregard to any activities of an agent of such owner or tenant) with respect to anysuch agricultural or horticultural commodity. Section 1402(c) provides that theterm “trade or business”, when used with reference to self-employment income ornet earnings from self-employment, shall have the same meaning as when used in§ 162 (relating to trade or business expenses), less allowable deductions.
Reg. § 1.1402(c)-1 provides that in order for an individual to have net earnings from self-employment, he must carry on a trade or business, either as an individual or as a member of apartnership. Whether or not he is engaged in carrying on a trade or business will depend upon allof the facts and circumstances in the particular case.
The United States Supreme Court ruled that “to be engaged in a trade or business, the taxpayermust be involved in the activity with continuity and regularity, and the taxpayer’s primarypurpose for engaging in the activity must be for income or profit. A sporadic activity…does notqualify.” Commissioner v. Groetzinger, 480 U.S. 23, 35 (1987). The question of whether ataxpayer is engaged in a trade or business requires an examination of the relevant facts ineach case. Id. at 36.
For partners in a general partnership (the typical pass-through entity when § 1402(a) was enactedin 1954), each general partner in a partnership involved in a trade or business simply takes his orher allocable share of partnership income and reports the full amount (except for interest anddividend income and other specified items) on Form 1040, Schedule SE, for purposes ofcomputing SECA tax. Similarly, each general partner uses the same amount for purposes ofcomputing his or her qualified compensation base for purposes of making contributions toqualified retirement plans. For a proprietor or partner, the burden for paying employment taxesand prepaying estimated income taxes rests with the individual, not the business. Estimated taxes
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must be paid throughout the year in quarterly installments to avoid underpayment penalties.Limited partners' distributions are not subject to SE tax. IRC § 1402(A)(13).
2. Rates.
The self-employment tax is imposed on net earnings from self-employment (“NEFSE”).Payments to service providers who are not classified as common law employees for federalpayroll tax purposes are not subject to any payroll tax withholding or payment liability on thepart of the payor. Subject to certain exemption rules, self-employment earnings include incomederived by an individual from any trade or business carried on by such individual plus his or herdistributive share of partnership income or loss from any trade or business carried on by apartnership in which he or she is a partner. Section 1401 imposes SECA tax on “self-employment” income at the rate of 15.3%, a combination of a 12.4% old-age, survivors, anddisability insurance (OASDI) tax and a 2.9% Medicare tax. The OASDI tax is only imposed onthe first $106,800 of “net earnings” (which allows for offsets to gross earnings for deductibleexpenses associated with the creation of the income) for 2011.
50% of the SECA tax payments are deductible.
In 2013 and thereafter, as a result of PPACA, the new 3.8% unearned income Medicare taxunder Code § 1411 is in addition to the new .9% hospital insurance tax under § 1401(b) thatwill apply for post-2012 years on self-employment income and wages in excess of the samethresholds, namely $250,000 for married individuals filing jointly ($125k if filing separately) and$200,000 for single individuals. I.R.C. § 3101(b)(2). An employer is required to withhold thisadditional .9% Medicare Tax on all wages of an employee from that employer in excess of$200,000, regardless of the presence or absence of self-employment income or loss of theemployee or his or her spouse, wages earned by his or her spouse (even from the sameemployer), or wages of that employee from other employers. See I.R.C. § 3102(f)(1).
There is a corresponding .9% increase in the self-employment tax, except that the$250,000/$125,000/$200,000 thresholds are reduced (but not below zero) by the taxpayer’swages. As indicated above, these thresholds are not subject to inflation adjustment. Thisadditional .9% tax on wages and self-employment income above the applicable thresholds is notdeductible for income tax purposes.
For example, a single taxpayer in 2013 with modified AGI of $375,000, self-employmentincome of $300,000 from an active proprietorship, and net investment income from a passiveinterest in an LLC would pay an unearned income Medicare tax of $3,800 (3.8% times the lowernet investment income) and would also pay an additional regular Medicare tax of $900 (.9%times the $100,000 excess of his or her self-employment income over $200,000). Thus, ataxpayer who has both high self-employment income and high investment income may besubject to both taxes. None of the 3.8% Medicare tax on investment income is deductible.
3. Guaranteed Payments.
Wages and guaranteed payments paid to a partner are not subject to FICA if the member issubject to self-employment tax. Rev. Rul. 69-184. However, certain LLC members may not be
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subject to self-employment tax on their distributive share if they would be considered limitedpartners under state law and if the LLC were a limited partnership instead of an LLC. Prop.Treas. Reg. §1.1402(a)-18. Otherwise, those members who are involved in the management ofthe business will be treated as general partners for purposes of the self-employment tax. Prop.Treas. Reg. §1.1402(a)-18.
B. Partnerships.
A partnership is defined in § 6(1) of the Uniform Partnership Act as “an association of two ormore persons to carry on as co-owners a business for profit.” The partnership concept, therefore,involves both the operation of an investment or a business and the sharing of profits.
The federal income tax law does not specifically define the term “partnership.” An entity labeledby the parties as a syndicate, group, pool, joint venture or even a trust may be taxed as apartnership. See I.R.C. § 761(a); Rev. Rul. 64-220, 1964-2 C.B. 335. A partnership is thus acatch-all for taxation of those entities are not taxed as an “association” (as the federal tax lawconsiders a corporation). Treas. Reg. § 301.7701-2.The federal income tax law does notspecifically define the term “partnership.” An entity labeled by the parties as a syndicate, group,pool, joint venture or even a trust may be taxed as a partnership. See I.R.C. § 761(a); Rev. Rul.64-220. A partnership is thus a catch-all for taxation of those entities are not taxed as an“association” (as the federal tax law considers a corporation). Treas. Reg. § 301.7701-2.
1. General Partners.
A general partner in a general or limited partnership conducting a trade or business pays self-employment tax on the guaranteed payments he receives from the partnership as well as hisdistributive share of the partnership’s income and loss, regardless of whether some of the incomeis a return on capital contributed. IRC § 1402(a). Pursuant to IRC § 707(c), guaranteedpayments are payments made by the partnership to partners for services rendered to thepartnership or for the use of capital, without regard to the partnership's income. Guaranteedpayments are considered to be made to a recipient who may or may not be a member of thepartnership.
2. Limited Partners Of Limited Partnerships.
Section 1402(a)(13) of the Internal Revenue Code excludes from net earnings from self-employment (NEFSE) “the distributive share of any item of income or loss of a limited partner,as such, other than guaranteed payments described in § 707(c) to that partner for servicesactually rendered to or on behalf of the partnership to the extent that those payments areestablished to be in the nature of remuneration for those services.” Unfortunately, Congressfailed to provide a definition for limited partner in the statute.
C. LLCs & LLPs Taxed As Partnerships.
The Service has issued two sets of proposed regulations dealing with self-employment tax as itapplies to LLCs. See Prop. Treas. Regs. § 1.1401(a)-18 (issued December 29, 1994), replaced by
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Prop. Treas. Regs. § 1.1402(a)-2 (issued January 13, 1997). In 2003, an IRS official stated that iftaxpayers conform to the 1997 Proposed Regulations, then the IRS generally will not challengethe treatment of members of a multiple-member LLC as limited partners for purposes of SECA.Thus, by following the 1997 regulations, taxpayers should not be subject to any penalties eventhough the regulations have never been finalized.
The 1997 proposed regulations apply to all business organizations taxed aspartnerships. The Taxpayer Relief Act of 1997 placed a 12-month moratorium onthe issuance of final regulations dealing with self-employment income tax untilafter June 30, 1998. Pub. L. No. 105-34, § 935, 111 Stat. 788. None have everbeen issued.
Under the 1997 proposed regulations, which replaced the first, if a member-manager of an LLC (but not LLP) has two distinct interests in the LLC, themember could have two types of income. 1997 Prop. Treas. Regs. § 1. 1402(a)-2(h)(3).
The use of a limited partnership or S corporation provides more certainty when itis desired to avoid self-employment income tax. Confronted with the lack ofauthority on this issue, some tax practitioners have taken the position that allpartners in a tax partnership, who are limited partners or partners/members in anLLP or LLC are per se eligible for the § 1402(a)(13) limited partner exemption,although court decisions have disagreed. Others, although not required by law,have followed the guidance under the proposed regulations.
The determination of whether the partner's distributive share of income or loss is defined as netincome from self-employment largely depends on whether the partner is a general partner or alimited partner. This raises questions about the appropriate treatment for owners of LLCs andLLPs. Should an owner of an LLC or LLP be treated as a general partner with the consequencethat the owner's entire distributive share of LLC income or loss will be treated as self-employment income? Alternatively, should an owner, due to state law limited liability, be treatedas a limited partner with the consequence that the owner's entire distributive share of LLC orLLP income or loss will be treated as excluded from self-employment income unless itconstitutes a guaranteed payment?
In contrast to general and limited partnerships where at least one partner will have personalliability, all LLC and LLP owners have limited liability, except for their own torts. Accordingly,the test for determining whether an owner's share of entity income should be treated as netearnings from self-employment for SECA tax purposes should be based on an examination of therole of each individual owner.
1. IRS Ruling Position.
PLRs 9432018 and 9525028 both involved law firms converting from general partnership toLLC status, with all members of each entity actively performing services and managing thebusiness both before and after the conversion. PLR 9525058 ruled that nonvoting members of aprofessional LLC law firm actively engaged in the practice of law who receive compensationguaranteed payments in exchange for services are subject to self-employment tax on that income.
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In PLR 9452024, a group of physicians changed their general partnership to an LLC with all ofthe doctors continuing to provide substantial services and to participate in the daily activities ofthe business.
The Service ruled in all three cases that the LLC members did not qualify for the Section1402(a)(13) exemption from self-employment tax. Although the Service did not provide anyreasoning for its conclusions in PLRs 9432018 and 9525028, PLR 9452024 was based on: (1) thefact that LLCs are not limited partnerships and LLC members are not limited partners, and (2)the nature of the income received by the doctors as self-employment income due their significantservices for the LLC and participation in its daily business activities. The service reasoned thatReg. § 1.1402(a)-2(f) provides that in determining net earnings from self-employment, apartnership is one which is recognized as such for income tax purposes. Therefore, theclassification of the LLC as a partnership under section 7701 means that the members will bepartners for SECA tax purposes. In addition, the members' are not limited partners and theirdistributive share of income is not excepted from net earnings from self- employment by §1402(a)(13). Therefore, the income allocated to each member is includible in computing eachmember's net earnings from self-employment. The Service also noted that § 1402(b) providesthat “self-employment income” means the net earnings from self-employment of an individualduring any taxable year. Section 1402(a) provides that the term “net earnings from self-employment” means the gross income derived by an individual from any trade or businesscarried on by such individual, less the deductions allowed by this subtitle which are attributableto such trade or business, plus his or her distributive share (whether or not distributed) of incomeor loss described in section 702(a)(8) from any trade or business carried on by a partnership ofwhich he or she is a member. Section 1402(a)(13) provides that there shall be excluded from netearnings from self-employment the distributive share of any item of income or loss of a limitedpartner, as such, other than guaranteed payments under § 707(c) to that partner for servicesrendered to or on behalf of the partnership where those payments are remuneration for thoseservices.
Similarly, PLR 9630012 ruled that an active member in an accounting firm LLP who carriesmanagement rights and actively participates in the accounting business of the firm will haveNEFSE on his entire distributive share of income from the firm, and that none of his income willbe excluded under § 1402(a)(13) as payments to a limited partner. This indicates that an activemember of an LLP (which is treated as a general partnership for state law purposes) is neither alimited partner nor treated as a limited partner for purposes of § 1402. See Shop Talk, "AreRetirement Payments to Limited Partners and LLC Members Subject to Self-Employment Tax?,"86 JTAX 62 (January 1997).
2. Court Position On LLPs & LLCs.
In Renkemeyer, Campbell & Weaver, LLP v. CIR, 136 T.C. No. 7 (2011), the court found thatCongress did not intend for active service partners, such as the LLP partners, to be exempt fromself-employment taxes. Specifically, the court referred to the partners' minimal LLP capitalcontributions in exchange for their interests in LLP as indicating that the partners' distributiveshare of income arose from the legal services performed on behalf of LLP and "not . . . as areturn on the partners' investments and . . . not [as] 'earnings which are basically of an investmentnature.'" (citing the Section 1402(a)(13) legislative history). Additionally, Renkemeyer indicated
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that the same rationale could be applied to prevent members of an LLC from qualifying asSection 1402(a)(13) limited partners.
The same considerations will apply to an LLP as to an LLC. The partners of a service providerestablished as a limited liability partnership (LLP) under state law are subject to Self-Employment Contributions Act (SECA) tax on their distributive share of LLP income receivedin respect of their services. Renkemeyer, Campbell & Weaver, LLP v. CIR, 136 T.C. No. 7, 2011WL 490873 (2011). The LLP partners could not avail themselves of the exemption from SECAfor nonguaranteed service payments to “limited partners.” State law entity and limited liabilityclassifications did not shield owners from SECA tax. The three partners produced the bulk ofthe law firm's revenues in their capacities as law firm partners. They each contributed a nominalamount ($110) for their respective partnership units. Thus, it was clear that the partners'distributive shares of the law firm's income did not arise as a return on the partners' investmentand were not "earnings which are basically of an investment nature." Instead, the attorneypartners' distributive shares arose from legal services they performed on behalf of the law firm.
The definition of “limited partner” was at issue Renkemeyer. The Tax Court addressed (1) thespecial allocation of the LLP’s (a law firm treated as a partnership for federal income taxpurposes) distributive share of income to its partners and (2) the treatment of the LLPdistributive share allocations of business income to its service partners (law partners) as beingexempt from SECA tax. After ruling in favor of the IRS on the allocation issue because thepetitioner could not produce a partnership agreement supporting the challenged specialpartnership allocations, the court turned to the SECA tax issue.
The LLP partners argued that the limited partner exemption should apply because (1) the LLPorganizational documents designated their interests as limited partnership interests and (2) theyenjoyed limited liability under state law. The Tax Court disagreed, reaching the result that wouldhave been required under the 1997 temporary regulations. Noting that Congress passed thelimited partner exemption prior to the state law advent of LLPs and LLCs, the court reviewed theexemption’s legislative history and determined that the impetus for the exemption was not alimited partner’s individual protection from the partnership’s liabilities, but instead its status as anon-service investment partner in a traditional limited partnership.
The court ruled that the partners’ distributive shares were subject to the self-employment taxbecause the law firm’s fees were part of the partners’ § 702(a)(8) distributive share and thepartners did not constitute limited partners. Therefore, the exception to self-employment tax forlimited partners did not apply. In determining that the partners did not constitute limited partners,the court looked to statutory construction principles and considered the plain meaning of thephrase, the history of the regulatory interpretation of the exception, and the legislative history ofthe exception.
The court stated that the legislative history provides that limited partners of a limited partnershipare akin to passive investors in that they lack management powers and their distributive sharesarise as a return on invested capital and constitute investment-type earnings. In contrast, the threelaw partners of the LLP enjoyed limited liability protection, had management powers andperformed services that generated the LLP’s income. Accordingly, the court concluded that theinvestment partners of the LLP were not the same as limited partners.
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Renkemeyer demonstrates that service providers to tax partnerships (including LLCs and LLPstaxed as partnerships) in which they are equity partners have self-employment income subject toSECA tax from both their service-related income and partnership equity allocations.Renkemeyer can be interpreted to hold that only passive investors may qualify as limited partnersand that members of entities treated as partnerships for federal income tax purposes (pass-through entities) are subject to an "all-or-nothing" approach. Under this approach, theperformance of services for an entity will subject the service-providing partner’s entiredistributive share to the self-employment tax, regardless of whether such partner has investedcapital in the entity or not.
3. 1997 Proposed Regulations & LLCs and LLPs.
State law distinctions between limited partners, general partners, and members of limited liabilitycompanies do not have any effect on the manner in which a partner would be taxed for purposesof SECA under the 1997 proposed regulations. Where substantially all of the activities of apartnership involved the performance of services in the fields of health, law, engineering,architecture, accounting, actuarial science, or consulting, the1997 proposed regulations providethat any individual providing more than a de minimis amount of services to or on behalf of thepartnership would not be treated as a limited partner.
The 1997 proposed regulations contain three functional tests that apply to all unincorporatednon-service organizations taxed as partnerships, namely, general partnerships, limitedpartnerships (LPs), LLLPs, LLPs, and LLCs and permit interests owned by an individual to bethose of a general partner, a limited partner, or both (a bifurcation of interests).
a. 3 Tests For Functional Limited Partner.
The functional tests consider an owner a limited partner unless the owner fails any one of thefollowing three tests: (1) the “liability test” (whether the owner has personal liability under statelaw for the obligations of the business); (2) the “management test” (whether the owner hasauthority to make contracts on behalf of the business); or (3) the “participation test” (whether theowner participates in the business for more than 500 hours in a year). However, notwithstandingsatisfaction of these tests, a separate superimposed rule provides that a service partner (subject toa de minimis exclusion) in a service partnership may never be considered a limited partner. See1997 Prop. Reg. § 1.1402(a)-2(h)(5).
The three functional tests clarify when the distributive share of an entity's non-managingmembers of non-service entities will not be subject to the self-employment tax. The distributiveshare of an LLP's partner will likely always be subject to self-employment tax regardless of thedegree of participation in management because of the apparent authority to act for the LLP.
The three functional tests constitute an exclusive federal law determination of when an ownerwill be considered a limited partner for purposes of the SECA tax. Under the functional tests, anyowner may be considered a limited partner regardless of that partner's status under state law.Similarly, even a person considered a limited partner under state law will not necessarily beconsidered a limited partner for purposes of the SECA tax. Finally, in some entities, there maynot be any limited partner not subject to the SECA tax. For example, since all partners in general
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partnerships and LLPs have either actual or apparent authority to make contracts for thepartnership, no partner of an LLP will be considered a limited partner under the functional test ofthe 1997 Regulations.
In order meet the “liability” test and be liable for the SECA tax, an owner must be personallyliable for partnership obligations and the personal liability must be created by state law imposingliability solely due to being an owner. 1997 Prop. Reg. § 1.1402(a)-2(h)(2)(i). Owner liability foran entity's obligations created by contractual guarantees or personal conduct does not count.
The management test relies on the “authority” of an individual to make contracts on behalf of thepartnership as determined by the law where formed. 1997 Prop. Reg. § 1.1402(a)-2(h)(2)(ii)states: “Has authority (under the law of the jurisdiction in which the partnership is formed) tocontract on behalf of the partnership.” This is not by its terms limited to statutory authority.
The more than 500-hour “participation test” is based on the Section 469 “material participation”standards. Prop. Reg. § 1.1402(a)-2(h)(2)(iii).
Persons desiring to qualify as functional limited partners under the three functional tests shouldbe careful to document that they devoted no more than 500 hours to the business activities of thepartnership. Additionally, they should avoid dealing with third parties on behalf of the entity orits activities to avoid the possibility that they will have apparent authority to represent thebusiness.
b. Application To LLCs.
SMLLC. Under the 1997 proposed regulations, single-member LLC, even if manager-managed,has only one member, and there are no other members to own a substantial portion of thepotential second class of functional limited partner interests. Therefore, unlike a single memberS corporations, the sole member of a single member LLC cannot under these proposedregulations avoid the SECA tax on any of the company's income, regardless of whether thecompany is member- or manager-managed, unless the LLC elects to be taxed as an S
Member Managed. No member of a member-managed LLC can be considered a functionallimited partner because of the retention of the statutory power to bind the LLC. Since this powercannot be divested by the private operating agreement among the members, such members cannever qualify as functional limited partners—even if they otherwise satisfy the liability andparticipation tests. In addition, as discussed below, the dreaded retention of statutory apparentauthority to represent the LLC also means that the second class exception will never apply to amember-managed LLC because, no matter that different rights are created in different classes ofinterests, each class will always possess such statutory apparent authority under the 1997Regulations.
Manager Managed. Members who are also not managers can be functional limited partners ifthey do not participate in the business for over 500 hours per year and the company is not aservice LLC. Any “guaranteed payment” for services received by the non-managing memberwill, however, be subject to the SECA tax. A guaranteed payment is one determined withoutregard to the net income of the partnership. Rev. Rul. 81-300.1 No one need guaranty the
1 The term guaranteed payment encompasses more than just salary payments made to partners. It includescertain payments made to a partner for the use of capital and these payments are similar to interest. A guaranteedpayment is deducted in the computation of partnership income if it is ordinary and reasonable under IRC section162. A guaranteed payment is an amount paid to a partner that is determined without regard to the partnership
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payment. A payment for services is a guaranteed payment because it is paid regardless ofwhether the entity has net income.
Manager Managed. Managers of a manager-managed LLC cannot be functional limited partnersbecause of their statutory authority to bind the company. Thus, their distributive shares and allguaranteed payments to them are subject to the SECA tax.
Bifurcated Interests; Manager Limited Partner Interests. If (1) the manager also owns a non-managing interest in the same company and (2) other members who are functional limitedpartners own at least 80 percent of that class of interest, then the manager can avoid SECA taxon the income from the second class of interest if the company is not a service LLC.
c. Application To LLPs.
Just as members in a member managed LLC, no partner in an LLP may avoid the SECA tax onany partnership income from its trade or business. Regardless of the number of classes ofinterests held by such a member (and the authority rights that attend those interests), there can beno other members without statutory apparent authority who may qualify as functional limitedpartners and who own a substantial portion of a potentially qualifying second class interest.
d. Second/Multiple Class Exception.
Even when an individual is not a functional limited partner under the liability, management, orparticipation tests, the 1997 proposed regulations contain a second or multiple class exceptionthat provides a method whereby an owner not considered a functional limited partner maynevertheless attempt to avoid SECA tax on a portion of that owner's distributive share of incomefor non-service entities. The owner may do so only with regard to that portion of distributableincome properly allocable to a “second class” of ownership interest meeting several tests. SeeProp. Reg. § 1.1402(a)-2(h)(6)(i): “An individual may hold more than one class of interest in thesame partnership provided that each class grants the individual different rights or obligations.”
An individual who is a service partner in a service partnership may not be a limited partner underthis separate class exception. See Prop. Reg. § 1.1402(a)-2(h)(6). The four second/multiple classexception requirements are as follows:
The separate ownership interest must be considered a “second class” [Prop. Reg. §§1.1402(a)-2(h)(3) (first sentence), 1.1402(a)-2(h)(6)(i)];
That second class must be owned at least in part by others who are considered functionallimited partners (i.e., those satisfying the three functional liability, management, andparticipation tests) [Prop. Reg. § 1.1402(a)-2(h)(3)(i)];
Functional limited partners must own at least a substantial and continuing interest in thesecond class, which is determined based on all of the relevant facts and circumstances. Inall cases, however, ownership of 20 percent or more of a specific class of interest isconsidered substantial. [Prop. Reg. §§ 1.1402(a)-2(h)(3)(i),1.1402(a)-2(h)(6)(iv)]; and
income. Generally, if the partner performs a service for the partnership that he/she also performs for others (such asan attorney, architect, stockbroker, etc.), payments will be deducted or capitalized by the partnership under IRC §707(a). However, if he or she works exclusively or primarily for the partnership, payments are guaranteed paymentsper IRC § 707(c) (if not based on partnership income). See IRS publication Partnerships Audit Technique Guide(ATG) (Sept. 2002).
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The multiple class owner's rights and obligations with respect to the second class must beidentical to the rights and obligations of the other functional limited partners in thesecond class (excluding the mere receipt of a guaranteed payment). See Prop. Reg. §1.1402(a)-2(h)(3)(ii).
Under the proposed regulations, a “second class” of ownership exists when all the owners' rightsand obligations are not identical. Any difference, no matter how small, in ownership rights andobligations creates a second class. See Prop. Reg. § 1.1402(a)-2(h)(6)(i). For example, eventhough all LLC and LLP owners share a common owner liability shield, two classes ofownership interest will exist where state law vests contractual authority in some but not allowners. In manager-managed LLCs, two classes of interests are created by a statutorymanagement designation of managers and members. The different management rights create twoseparate interests. In member-managed LLCs and LLPs, different rights must arise by contractrather than statute through the operating or partnership agreement other than management rightsbecause all owners will have apparent authority. Thus, that class must have attributes other thanmanagement rights in order to satisfy the “second/multiple class exception.”
The second/multiple class also must be owned in part by persons considered functional limitedpartners. Prop. Reg. § 1.1402(a)-2(h)(3)(i). At least one owner (excluding multiple owners nottreated as functional limited partners) of the second class must be a functional limited partner.Those functional limited partners (excluding multiple owners not treated as functional limitedpartners) must own a “substantial and continuing” interest in the second class. Prop. Reg. §1.1402(a)-2(h)(3)(i). “Continuing” is not defined term but “substantial” includes a safe harbortest of 20 percent or more of the second class. Prop. Reg. § 1.1402(a)-2(h)(6)(iv). Thus, in orderto satisfy the safe harbor standard, functional limited partners (excluding second/multiple classowners) must own at least 20 percent of the second class. Stated another way, second/multipleclass owners not considered functional limited partners may not own more than 80 percent of thesecond class. Additionally, a second/multiple class owner's (not considered a functional limitedpartner) ownership rights in the second class must be identical to those owned by the functionallimited partners in the same class. Prop. Reg. § 1.1402(a)-2(h)(3)(ii).
(i) Second/Multiple Class Exception Application to LLCs.
A SMLLC can never satisfy this exception because there will be no function limited partners.
The second/multiple class exception also cannot apply for a member-managed company bycreating different management rights in an operating agreement because they will have apparentauthority and thus will not have any functional limited partners and that second class cannotsatisfy the other requirements for the class. Thus, regardless of the number of classes of interests,all the income of a member-managed company will be subject to the SECA tax.
Non-manager members of a manager-managed LLC will be functional limited partners unlessthey participate in the business for more than 500 hours per year. The income attributable to theirnon-manager interest is not subject to the SECA tax although any guaranteed payment remainssubject to the tax.
Material participation exception. Manager-members of a manager-managed LLC can never befunctional limited partners because of their statutory management authority. Consequently, allincome attributable to that interest, as well as any guaranteed payments, is subject to the SECA
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tax. However, if (1) a manager also owns a second class of non-manager member interest and (2)there are other member owners of that class who (i) are not managers and are functional limitedpartners, and (ii) own at least 20 percent of the aggregate class of non-manager interests, amanager's income attributable to that qualifying second class of interest may avoid the SECAtax.
Generally, an owner who participates in an entity's business for more than 500 hours in a taxableyear cannot be considered a functional limited partner because of the failure of the participationtest. However, a “participating partner” may nevertheless qualify as a limited partner if thefollowing four tests are satisfied: (1) the partner is not considered a functional limited partneronly because of failing the participation test; (2) there are other functional limited partnerssatisfying the three functional tests (including the participation test); (3) the functional limitedpartners (excluding the participating partner) own a substantial (20 percent or more) andcontinuing interest in the same class of partnership interest; and (4) the participating partner'srights and obligations with respect to the class are identical to the rights and obligations of theother functional limited partners in the same class (excluding the mere receipt of a guaranteedpayment).
Thus, a non-manager member in a manager-managed LLC receiving a guaranteed payment formore than 500 hours of service (i.e., a “participating” member) is subject to the SECA tax on allof the guaranteed payments and also the trade or business income attributable to the member'sownership interest. However, where the company also has functional limited partners (non-manager members not providing in excess of 500 hours of service) that own at least 20 percentof those interests, the “participating” member may nevertheless avoid the SECA tax on thecompany income attributable to the ownership interest. This flexibility permits some of non-manager members to become more active in the business.
A manager of a manager-managed LLC may not use this rule since the manager fails both theauthority to bind the LLC and participation tests. Nevertheless, this does not prevent the managerfrom qualifying a second class under the second/multiple class exception discussed above for thebenefit of another “participating” member.
Generally, this requires that the allocation be consistent with the underlying economicarrangements of the members, and that the nontax economic effect of the allocation besubstantial. An allocation will be considered to have an economic effect if the LLC maintains itsbook capital accounts in accordance with IRC § 704(b), makes distributions in accordance withpositive capital accounts, and requires LLC members to restore deficits in their capital accountsupon liquidation of their interest. The economic effect of the allocation will be consideredsubstantial if a reasonable possibility exists that the allocation will significantly change theincome to be received by the members from the LLC, independent of the tax consequences.
(ii) Second/Multiple Class Exception Nott Useful To LLPs.
Just as with member-managed LLCs, the second/multiple class exception does not benefitpartners in an LLP because there are no functional limited partners because there are no partnerswho lack apparent authority. Consequently, all LLPs will be treated exactly like generalpartnerships even though no partner is personally liable for any partnership obligation and somepartners may not actively participate in management. Unlike LLCs, however, the traditionalinvolvement of an LLP in the provision of services would likely prevent these partnerships from
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qualifying anyway, at least with regard to all partners providing more than a de minimis amountof services. As a result, the draconian residual results of applying the functional limited partnertest to LLPs is perhaps less damaging in this context.
(iii) Guaranteed Payments.
The receipt of or right to receive a guaranteed payment by one but not all owners will not createa second class of ownership interest. Prop. Reg. § 1.1402(a)-2(h)(6)(i) (last sentence).Accordingly, an owner receiving a guaranteed payment for less than 500 hours of service to theentity (to satisfy the participation test and who satisfies the remaining liability and authoritytests) may be considered a functional limited partner.
Thus, the receipt of a guaranteed payment for less than 500 hours of service will not prevent anon-manager-member of a manager-managed LLC from avoiding the SECA tax on the incomeattributable to the ownership interest. The guaranteed payment will be subject to the SECA tax.Secondly, as a functional limited partner, such member may assist manager-members inqualifying any second member’s interests as a second class, provided the functional limitedpartner owns, along with other functional limited partners, at least 20 percent of the class. Thesecond/multiple class owner will not violate the identical rights clause of the second classrequirement because of the presence of a guaranteed payment. Additionally, the manager’sreceipt of a guaranteed payment does not disqualify the manager from owning a second class ofinterest.
(iv) Service Partnerships.
A service partner in a service partnership is prohibited from becoming a functional limitedpartner under the functional tests or any one of the discussed exceptions. Prop. Reg. § 1.1402(a)-2(h)(5). A service partnership is one in which substantially all the activities involve theperformance of services in the fields of health, law, engineering, architecture, accounting,actuarial science, or consulting. Prop. Reg. § 1.1402(a)-2(h)(6)(iii). However, a person is not aservice partner if the person provides only a de minimis amount of services. Prop. Reg. §1.1402(a)-2(h)(6)(ii). It is not clear whether the de minimis rule applies on an annual basis. In theunlikely event that it does, the provision of more than a de minimis amount of services in oneyear would permanently make the partner a service partner.
Nevertheless, persons performing more than a mere de minimis amount of services can takeadvantage of the SECA tax exclusions by using two or more entities. For example, a secondentity could own and lease equipment or real estate. All “separate” entity activities should besupported by a separate business purpose and contain arm's-length economic arrangements toavoid a substance over form application of the de minimis exception.
Because LLP partners and member-managed LLC members can never avoid the SECA tax onany trade or business income, the benefit from application of this service rule will be to thosemanager-managed LLCs involved in the provision of services. However, non-manager membersproviding more than a de minimis amount of services will not be able to avoid the SECA tax onincome attributable to their ownership interest. Under the functional limited partner rulesdiscussed above, they could provide up to 500 hours of service (expanded under the participationexception) and still avoid the SECA tax. However, where the LLC is a service LLC, thesemembers will be subject to the SECA tax on their entire share of company income. The only way
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such a member in a service company may avoid the SECA tax is to provide no more than a deminimis amount of services.
(v) Family Members.
The proposed regulations contain no family-attribution rules. Thus the requirement for a 20%passive ownership interest could be satisfied by splitting ownership in the LLC between familymembers, provided that the overall allocation of income has a “substantial economic effect” andsatisfies the requirements of IRC § 704(b). This strategy has the advantage of providing non SEincome to one spouse and also spreading income across tax rates when children or other familymembers are in lower tax brackets. Any allocation of income to the members of the LLC musthave a “substantial economic effect” and satisfy the requirements of IRC § 704(b) for it to berespected by the IRS.
D. LLLPs.
A limited liability limited partnership (LLLP) is a limited partnership which registers with thesecretary of state as an LLLP. The effect of registration is to limit the vicarious liability of thegeneral partners in the same fashion that registration as an LLP limits the liability of the generalpartners of a general partnership.
Income from an investment LLLP, an entity permitted in many but not all states, would not besubject to SE tax except for any payments for services.
The ethical rules2 now permit operating businesses, including professional practices, to use theLLLP form where permitted by state law.3
2 Over forty years ago, in the ABA's Committee on Ethics and Professional Responsibility informallyopined that law practice could not be conducted in limited partnership format. However, ABA Formal Opinion 96-401 (8/2/96) issued by the ABA's Ethics Committee reversed its 1965 position, and concluded that the Model Rulesof Professional Conduct permit lawyers to practice in an LLP or LLLP if the applicable law provides that the lawyerrendering legal services remains personally liable to the client, the requirements of the law of the relevantjurisdiction are met, and the form of business organization is accurately described by the lawyers in theircommunications. The ABA Formal Opinion makes no reference to the Committee's prior informal opinions to thecontrary prohibiting practice in limited partnership form.
1 Opinion 96-401 assumes there is compliance with applicable state statutes and other controlling law, anddoes not purport to indicate appropriate choice of law rules involving multi-jurisdictional law firms. The ABAOpinion states that a requirement of any ethically permissible business form for lawyers is that the lawyer renderingthe legal services to the client must be personally responsible to the client. The Opinion states the understanding thatall of the LLP and LLLP laws (then enacted) of the various states meet this requirement. The ABA Opinionconcludes that lawyers can avail themselves of the LLP (or LLLP) business form without that constituting anagreement with a client prospectively limiting the lawyer's liability to a client for malpractice within the scope ofModel Rule 1.8, because LLPs and LLLPs do not insulate a lawyer from liability for his own negligence. Rather, thelimitation on vicarious liability created by LLPs and LLLPs derives solely from state law, not from an agreementbetween a lawyer and his client.
Notwithstanding the green light given by the ABA Opinion, law firm and other professional LLLPs andlimited partnerships are rare. There are, however, LLLP service providers in Arizona, Arkansas, Colorado,Delaware, Florida, Georgia, Hawaii, Kentucky, Maryland, Massachusetts, Minnesota, Montana, Nevada, and Texas,based on an internet Google search in late 2011.
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The tax consequences of operation of a professional services firm in LLLP form remain unclear.While "partnership" and "partner" are defined for tax purposes, "general partner" and "limitedpartner" are not. "Partnerships" and "partners" are included in Section 761 and Reg. 1.761-1 byreference to the Regulations under Section 7701. Section 7701(a) defines "partner" to include amember in a syndicate, group, pool, joint venture or other unincorporated organization.
Self Employment Income. Payments to general partners in an LLLP operating a trade orbusiness will be subject to SE tax under the rules applicable to general partners, discussed above.Will the income of the limited partners in the LLLP constitute net earnings from self-employment (NEFSE)? Section 1402(a)(13) provides that the distributive share of any item ofincome or loss of a limited partner is excluded from the computation of NEFSE, other thanguaranteed payments for services to the limited partner. If so, the professionals who are limitedpartners in an LLLP would not pay SE taxes on their distributive share of partnership income andthose amounts would not be eligible for retirement plan contributions, eliminating social securityand Medicare tax until the law changes in 2013 under the 2010 health reform legislation.However, this is not a likely result.
Will The LLLP's Trade Or Business Be Imputed To Its Limited Partners? The question ofwhether a limited partnership's trade or business is imputed to "active" limited partners is notsettled. Butler v. CIR, 36 TC 1097 (1961), acq., held that a lawyer who was an "active" limitedpartner in a business limited partnership could deduct his unpaid loan to the LP as a business baddebt. Imputation to "active" limited partners in a professional service LLLP would seem to besimilarly appropriate.
However, TAM 9728002 held that the partnership's trade or business should not be imputed tolimited partners, but only to general partners, in connection with the attempted deduction of legalfees incurred by a limited partner in a lawsuit against the general partner, thereby resulting in aSection 212 itemized deduction rather than a Section 162 above-the-line deduction. The Servicelimited Butler to its facts because Butler was more than a passive investor—he was a keymember of the firm "and more like a general partner even though labeled a limited partner."Many if not all service LLLP general partners arguably will be as active as general partners in aservice LLP, and thus imputation of trade or business status may be appropriate, even underTAM 9728002. The approach of the proposed 1997 regulations is likely to prevail – more than ade minimis amounts of services will result in self-employment income and the payments arelikely to be classified as guaranteed payments as payments for services.
E. Lifetime Retirement Payments To Retired General Partner Or LLCManaging/Manager Member.
1. General Rule.
3 Where permitted, existing pass-through entities except S corporations could convert without tax liability.Rev. Rul. 95-37 ruled that a conversion of a general partnership into an LLC was governed by Section 721(providing neutral consequences to the partners and the unincorporated entities), and determined that the particularform used to convert the general partnership into an LLC did not affect the tax consequences (effectively, permittingthe substance of the conversion to control over the form). Similarly, Rev. Rul. 95-55 ruled that the registration of ageneral partnership as an LLP pursuant to that state's law was a Section 721 transaction based on Rev. Rul. 84-52and Rev. Rul. 95-37. There appears to be no reason why the IRS would not apply a similar favorable Section 721analysis to conversions into LLLPs.
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This 1402(a)(10) exclusion from SECA is not available to severance payments to shareholder-employees of corporations or limited partners. Under IRC § 1402(a)(10) and Reg. 1.1402(a)-17(c)(1), exclusion of payments to “general partners” from self employment tax is an all-or-nothing proposition as to whether payments on account of retirement received by a retiredpartner during the tax year of the partnership are excluded. A “general partner” can exclude fromNEFSE (income subject to self-employment tax) amounts received if the requirements of IRC §1402(a)(10) and Reg. 1.1402(a)-17 are met, namely:
The payments must be received by the partner pursuant to a written plan of thepartnership.
The payments must be made on account of retirement, on a periodic basis, topartners generally or to a class or classes of partners, with the paymentscontinuing at least until the partner's death. These payments can be front loaded.See PLR 200403056, where most of the payments were made in the first 5 yearsafter retirement and $100 a year thereafter.
The partner must render no services with respect to any trade or business carriedon by the partnership during the tax year of the partnership in which the amountswere received.
No obligation may exist as of the close of the partnership's tax year from the otherpartners to the retired partner except with respect to retirement payments underthe plan.
The partner's share, if any, of the capital of the partnership must have been repaidin full before the close of the partnership's tax year in which such amounts werereceived.
The retired partner must have no financial interest in the partnership except forthe right to retirement payments.
If payments are not made to the retired partner on a periodic basis that continue at least until thepartner's death but rather terminate after a fixed number of years, the former general partner willinclude the retirement payments in NEFSE. If the partner has a right to a fixed percentage of anyamounts collected by the partnership after the date of retirement that are attributable to servicesrendered prior to her retirement to clients of the partnership, the payments received by her forthat tax year are not excluded from NEFSE since, as of the close of the partnership's tax year, anobligation (other than an obligation with respect to retirement payments) exists from the otherpartners to the retired partner. See Reg. 1.1402(a)-17(c)(2), Example (3).
2. LLP General Partner Qualifies.
PLR 9630012 holds that payments made on account of a retired partner of an LLP that meet therequirements of § 1402(a)(10) will be excluded from NEFSE.
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3. LLC Member Qualifies.
PLR 200142004 ruled that § 1402(a)(10) relief is available for payments to an attorney who wasa retired member of an LLC classified as a partnership for federal income tax purposes. The LLCmaintained a retirement benefit program for its members (treated as partners for tax purposes)that provided for payments directly from the law firm to the retiree. On retirement, the retiredpartner relinquishes her interest in the LLC, in exchange for the balance of her capital account inthe firm, the retirement benefits under the nonqualified retirement program, and other benefitspayable under the firm's benefit plans. The retired partner is entitled to a retirement paymentequal to the sum of the average of the partner's three highest distributions for any previouscalendar year. The amount is paid out, without interest, in a series of monthly payments for aperiod of not less than 60 and not more than 120 months. Thereafter, the retired partner isentitled to payments of no less than $100 per month for the rest of the partner's life.
After describing the requirements of § 1402(a)(10) and Reg. 1.1402(a)-17, PLR 200142004concludes that the LLC's retirement program is a bona fide retirement plan within the meaning of§ 1402(a)(10), and meets the other requirements of the statute and the Regulation. In connectionwith the requirement that the payments by a partnership must continue at least until the partner'sdeath, the ruling observes that although the payments by the LLC are likely to be reduced afterthe initial 60–120 month period, the monthly payments thereafter will never fall below $100 permonth and will continue until the retired partner's death. The letter ruling is consistent with theService's position (in earlier letter rulings) involving redemptions of general partners in a generalpartnership agreement in not requiring level, equal amounts of retirement benefit paymentsthroughout the retired partner's lifetime. A step-down in the amount is permissible as long as thepayments are retirement payments for at least the duration of the retired partner's life.
F. Retirement Payments To Limited Partners.
Limited partners enjoy an exemption from NEFSE during the period they are limited partners.Code § 1402(a)(13) provides that NEFSE does not include the distributive share of any item ofincome or loss of a limited partner, as such, other than guaranteed payments described in §707(c) to that partner for services actually rendered to or on behalf of the partnership to theextent that those payments are established to be in the nature of remuneration for those services.
Thus, a limited partner who actively renders services (permitted in many states without seriousrisk of unlimited personal liability for partnership obligations, pursuant to the Revised UniformLimited Partnership Act) and receives § 707(c) guaranteed payments for services determinedwithout regard to partnership income has NEFSE. Any remaining share of income as a limitedpartner will not be NEFSE. See Code § 1402(a)(13); Reg. 1402(a)-1(b). Moreover, if thelimited partner does not receive a § 707(c) payment, i.e., does not receive compensationdetermined "without regard to partnership income," but rather merely receives her distributiveshare of income (e.g., a percentage of net profits) for services, no portion of those paymentsconstitutes NEFSE.
Prop. Reg. 1.1402(a)-2 does not permit a service partner in a service partnership to be a "limitedpartner" for purposes of § 1402(a)(13). See 1997 Prop. Reg. 1.1402(a)-2(h)(5). If this proposed
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rule were followed, the pre-retirement payments to such a limited partner would be NEFSE. Nocases, rulings, or regulations under § 1402(a)(13) deal with payments to retired limited partners.
G. Corporations.
1. S Corporations.
S corporation shareholders are not subject to self-employment tax on dividend distributions fromthe S corporation or retirement plan contributions. IRC § 1402(a)(2). Wages paid by the Scorporation to a shareholder/employee are subject to the customary payroll taxes, and the Scorporation must pay the employer's share of those taxes. The S corporation determines its taxattributes at the entity level and then allocates them among its shareholders. The S corporationhas less flexibility in allocating than the multi-member LLC because the S corporation mustallocate tax attributes equally to each share. The S corporation reports its income, expenses, andtax attributes on information return Form 1120-S and provides each owner with a Schedule K-1showing that owner’s allocation of the entity’s tax attributes. The owner of an S corporationreceives a W-2 for wages and a K-1 for other income and deductions.
The S corporation shareholder who works for the corporation is an employee whose reasonablecompensation is subject to Social Security and Medicare taxes in the same way as C corporationemployees are taxed. The corporation's portion is deductible and the employee's portion iswithhold and paid over to the IRS by the corporation. The shareholder-employee of an Scorporation is not subject to SE tax on payments from the S corporation.
Thus, the distinction between an S corporation and LLC in this regard may be significant. Forexample, S corporation employees/shareholders can avoid the impact of Social Security andMedicare taxes by receiving both compensation and dividend income from the S corporation.Unless recharacterized as compensation, dividend income is not wages or self-employmentincome subject to FICA or self-employment tax. IRC §1402(a)(2).
The same withholding rules for FICA and Medicare taxes apply as for C corporations, so thatshareholder-employees of S corporations do not pay SE tax but rather are subject to thewithholding requirements for income and payroll taxes. The benefit of the S corporation is:
The ability for high income shareholder employees, active in business, to receivedividends not subject to Medicare tax from distributions from business as opposed toinvestment income. Such distributions are exempt from the new Medicare tax after 2012on business income paid as a distribution (dividend) but not on investment income paidas a distribution.
There is no Medicare tax for owners on employer’s retirement plan contributions (appliesfor shareholder-employees of C corporations also).
2. C Corporations.
a. Taxation As Separate & Not A Pass-Through Entity.
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Regular "C" corporations are taxed separately from their shareholders under subchapter C of theInternal Revenue Code. Any reasonable salary and bonus is deductible as a business expense tothe C-Corporation. Also, if the C corporation distributes dividends to the shareholders, thedividends are taxed at a special "qualified dividends" tax rate of 15% to the shareholder and arenot deductible to the corporation. Thus, dividends from a C corporation are taxed twice, once atthe corporate level and again at the shareholder level. Since the corporation has already paid taxon its earnings, this distribution qualifies as a "qualified dividend" to a shareholder and is taxedat the lower 15% tax rate.
C corporations are the only business type that can split profits between retained earnings anddividends. S corporations and partnerships must report all profits as a distribution, even if thebusiness has retained some of the cash for next year's operating expenses. The ability to choosewhen and how much you are taxed by controlling when and how much money is distributed is acrucial tax advantage for C corporations. This means that there is more flexibility with a Ccorporation to pick your tax rate than there is with the other options.
b. Social Security and Medicare Taxes and Income Tax Withholding.
Shareholders who work for the business are generally employees for purposes of income tax andsocial security (FICA) withholding. Income tax withholding means that the principal receiveslower take-home pay and makes monthly instead of quarterly payments on income and socialsecurity taxes. The only loss from income tax withholding is the short term interest on the firsttwo months tax deposits. FICA applies to wages up to the social security taxable wage base,which is indexed for inflation, the employer and employee rate is 7.65% each for a total of15.3%. The 1.45% Medicare tax on pay in excess of the taxable wage base is also paid by theemployer and employee. The employer’s portion is income tax deductible. For those taxed assole proprietors and partners, the self-employment tax is 15.3% up to the taxable wage base and2.9% above the wage base, half of which is deductible, so it is comparable to the corporate FICAand Medicare taxes. Again, for 2011, the employee's share of these taxes is reduced by 2%,resulting in a total tax of 13.3%.
The Medicare tax increases to 3.8% in 2013 for married taxpayers with adjusted taxable incomeover $250,000 and single taxpayers with income over $200,000.
c. Dividends.
Profits retained by the C corporation may be paid as dividend distribution income toshareholders, thereby creating portfolio income as well as savings on social security andMedicare taxes. A C corporation need not pay dividends, except as necessary to avoid theaccumulated earnings tax of I.R.C. §§ 531-537 or the personal holding company tax of I.R.C §§541-547.
II. SPECIALPARTNERSHIP ISSUES; DUAL STATUS WORKERS & SPOUSES;FARMING; RETIREMENT PLAN COMPENSATION.
A. Partnerships.
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1. Individuals Working In Different Capacities.
For federal tax purposes, one cannot be both a partner and a common law employee of the sameentity at the same time. The IRS has stated this position in Revenue Ruling 69-184 and solidifiedthat position in other rulings. See, e.g., IRS Legal Memorandum 200117003. Thus, income froma partnership paid to a general partner (or member of an LLC taxed as a general partner) engagedin trade or business is all self-employment income, except to the extent that this incomeconsists of dividends, interest, capital gains, real estate rentals, or shares of limited partnershipincome. Norwood v. CIR., T.C. Memo. 2000-84 held where a general partnership interest thatwas subject to self-employment tax, it was irrelevant how much time petitioner devoted to theactivity. Likewise, Treasury Regulations Section 1.707-1(c) specifically provides thatguaranteed payments cannot be wages, and Reg. § 1.402(a)(13) provides that guaranteedpayments to a partner are subject to self-employment tax, even when such payments are made toa limited partner.
One technique used by pass-through organizations is to separate their capital and their servicesinto two or more separate entities. In appropriate situations, this can also help accomplish otherincome tax and estate planning goals. Thus, the equipment and premises used in the activity canbe owned by an investment entity and leased to the operating entity. See Edwin D. Davis v. CIR,64 T.C. 1034 (1975).] This type of structure should allow the profit of the separate entities toescape self-employment tax.
Treasury Regulations Section 1.707-1(c) specifically provides that guaranteed payments are notwages, and Treasury Regulations Section 1.402(a)(13) provides that guaranteed payments to apartner are subject to self-employment tax, even when such payments are made to a limitedpartner. Other income paid to a limited partner is not self-employment income. IRC1402(A)(13).
An individual working for a corporation or partnership who is not a partner or self-employed canbe classified as an employee with respect to one type of service and compensation and as anindependent contractor with respect to another type of service and compensation. The IRS Officeof the Chief Counsel has advised that because the determination as to whether a worker is anemployee or an independent contractor depends on the facts and circumstances of the particularcase, it is not possible to provide an across-the-board answer as to which is the proper form onwhich all of a worker's compensation should be reported. See CCM 200224008.
2. Spouses.
a. Non-Community Property States; 761(f) Election Eliminates NeedTo File Form 1065 For Joint Ventures
Each spouse's share of income or loss from a qualified joint venture is taken into account indetermining the spouse's net earnings from self-employment. IRC § 1402(a)(17). A joint ventureis an undertaking of a business activity by two or more persons where the parties involved agreeto share in the profits and loss of the activity. The Internal Revenue Code defines a partnership ina negative manner by describing what is not a partnership. I.R.C. §§761(a) and 7701(a)(2).
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A business jointly owned and operated by a married couple, in which both spouses materiallyparticipate, is treated as a partnership for federal tax purposes, and the spouses must comply withfiling and recordkeeping requirements imposed on partnerships and their partners. See theinstructions to IRS Form 1065, where IRS states: “Generally, if you and your spouse jointly ownand operate an unincorporated business and share in the profits and losses, you are partners in apartnership and you must file a Form 1065.
However, married co-owners can elect to reporting on a Schedule C, C-EZ or F as well as aseparate Schedule SE in the name of each spouse and avoid filing a partnership return. Thiselection permits certain married co-owners to avoid filing partnership returns if each spouseseparately reports a share of all of the businesses' items of income, gain, loss, deduction, andcredit. Under the election, both spouses will receive credit for social security and Medicarecoverage purposes. See IRC 761(f). Section 1402(a)(16) providing that if a taxpayer makes anelection to be treated as a qualified joint venture, each spouse's share of the income or loss is tobe taken into account in computing self-employment tax. The instructions, but not section 761(f),state that once an election is made, it cannot be revoked without IRS consent. However, theelection could probably be revoked by (1) admitting another member to the joint venture, (2)transferring the entire interest of one spouse to the other or (3) by transferring the interests to anS or C corporation.
The IRS has stated, informally, that no final Form 1065 need be filed where the QJV election ismade despite the fact that the spouses had previously filed Form 1065. That may create issueswith computer-generated notices looking for the Form 1065.
In general, spouses do not need an Employer Identification Number (EIN) for the qualified jointventure where they make the 761(f) election. An EIN is not needed because an EIN is notrequired for a sole proprietorship unless the sole proprietorship is required to file excise,employment, alcohol, tobacco, or firearms returns. If an EIN is required, the filing spouse shouldcomplete a Form SS-4 and request an EIN as a sole proprietor. If the spouses already have anEIN for the partnership, one spouse cannot continue to use that EIN for the qualified jointventure. The EIN must remain with the partnership (and be used by the partnership for any yearin which the requirements of a qualified joint venture are not met). If the business hasemployees, either of the sole proprietor spouses may report and pay the employment taxes dueon wages paid to the employees, using the EIN of that spouse's sole proprietorship. If thebusiness already filed Forms 941 or deposited or paid taxes for part of the year under thepartnership's EIN, the spouse may be considered the “successor employer” of the employee forpurposes of determining whether the wages have reached the social security and federalunemployment wage base limits.
Initially there was a concern that, by making a 761(f) election, rental real estate business income,which is normally excluded from net earnings subject to self-employment tax, would now besubject to self-employment tax because it would be included on Schedule C. The IRS resolvedthis issue by stating that the election does not convert income derived from a rental real estatebusiness normally excluded under IRC section 1402(a) into net earnings subject to self-employment tax. See Chief Counsel Advice 200816030.
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IRC section 761(f)(1)(B) does not indicate how a spouse's ownership interest in a qualified jointventure is to be determined, most likely, in accordance with applicable state law. See Aquilino v.United States, 363 U.S. 509 (1960); Morgan v. CIR, 309 U.S. 78 (1940). The House reportmerely states the following: "All items of income, gain, loss, deduction, and credit are dividedbetween the spouses in accordance with their respective interests in the venture." As the qualifiedjoint venture is applied, one may discover taxpayers in separate property states attempting tomanipulate their respective ownership interests of the joint venture by creating a greaterownership interest in one spouse, to reduce the amount of income subject to tax because of thelimit on wages subject to Social Security taxation (2002 report). The Joint Committee onTaxation addressed the issue of manipulation of net earnings and handling as follows: "The newprovision is not intended to prevent allocations or reallocations, to the extent permitted underpresent law, by courts or by the Social Security Administration of net earnings from self-employment for the purposes of determining Social Security benefits of an individual" [JointCommittee on Taxation, Technical Explanation of the "Small Business and Work OpportunityTax Act of 2007" (JCX-29-07)].
b. No 761(f) Election For LLCs, LLPs Or Other State Law Entities.
The IRS interprets the 761(f) election not to apply to spouses who operate in the name of a statelaw entity, including a general or limited partnership or limited liability company. According toinformation on IRS's website, the election can be made only for a business operated by spousesas co-owners that is, or should otherwise be, taxed informally as a partnership. Seehttp://www.irs.gov/businesses/small/article/0,,id=177376,00.html.
The legislative history of the act, however, makes no mention of a requirement that a qualifiedjoint venture be unorganized and thereby not an organized entity such as a limited liabilitycompany (LLC).
By disallowing spousal LLCs the opportunity to elect out of default partnership classification,the IRS has severely limited the useful application of the IRC section 761(f) election, as manyhusband-and-wife businesses are conducted out of LLCs to reduce liability exposure. Withcreative planning, the section 761(f) election may arguably be achieved through a longer routeby forming two single-member LLCs, one for each spouse, that are thereby disregarded businessentities for federal tax purposes under Treasury Regulations section 301.7701-2(a).
c. Spousal Business In Community Property States.
Spouses in a community property state can elect whether or not to file Form 1065, thepartnership return, at their option where they are the sole owners of the partnership or LLC taxedas a partnership. The IRS allows qualified entities composed of community property to bedisregarded, which has the same effect as the 761(f) election. See Rev. Proc. 2002-69 limiting inits application to wholly owned spousal community property entities to avoid the possibility ofincome shifting among spouses in separate property states that do not file a joint return. Reg.§1.66-l(a). IRC section 761(f)(1), however, alleviates the concern over income shifting byrequiring that both spouses file a joint return in order to qualify for the election. This prevents aspousal business in a separate property state from filing separate returns and dividing theirrespective ownership interests in the joint venture in such a way that the taxpayer within the
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higher marginal tax bracket owns the smaller percentage of the entity and the taxpayer with thelower marginal tax bracket owns the greater percentage.
3. Farming – Eligibility For CRP Versus Trade Or Business.
Can both spouses qualify for separate “person” status for federal farm program purposes, buthave only one of them be materially participating in the farming operation for self-employmenttax purposes? While the active engagement rules for federal farm program purposes are similarto the rules for determining whether income is subject to self-employment tax, their satisfactiondoes not control the self-employment tax issue.
In Vianello v. CIR, T.C. Memo. 2010-17, the taxpayer was a CPA in Kansas City. In 2001, heacquired 200 acres of cropland and pasture approximately 150 miles from his office. At the timeof the acquisition, a tenant (pursuant to a lease with the prior owner) had planted the croplandwith soybeans. The tenant provided the equipment and labor and deducted the cost of chemicalsand fertilizer from total sale proceeds of the bean and pay the landlord one-third of the netamount. The petitioner never personally met the tenant but the parties did agree via telephone tocontinue the existing lease arrangement for 2002.The tenant made all the decisions with respectto raising and marketing the crop. As for the pasture, the tenant mowed it and maintained thefences. The lease terminated in early 2003, and the petitioner had another party plow under thefall-planted wheat in the spring of 2004 prior to the planting of Bermuda grass. The petitionerbought two tractors in 2002 and a third tractor and hay equipment in 2003.
The petitioner did not report any Schedule F income for 2002 or 2003 but did claim a Schedule Floss for each year as a result of depreciation claimed on farm assets and other farming expenses.The petitioner concluded that he materially participated in the trade or business of farming forthe years at issue. The petitioner claimed involvement in major management decisions,provided and maintained fences, discussed row crop alternatives, weed maintenance andBermuda grass planting with the tenant. The petitioner's revocable trust was an eligible “person”under the farm program payment limitation rules because it satisfied the active engagement test.The petitioner also claimed he bore risk of loss under the lease because an unsuccessful harvestwould mean that he would have to repay the tenant for the tenant’s share of the costs.
The Tax Court ruled that the petitioner was not engaged in the trade or business of farming for2002 or 2003. The tenant paid all the expenses with respect to the 2002 soybeancrop, and made all of the cropping decisions. In addition, the court noted that the facts wereunclear as to whether the petitioner was responsible under the lease for reimbursing the tenantfor input costs in the event of an unprofitable harvest.
Importantly, the court noted that the USDA’s determination that the petitioner’s revocable trustsatisfied the active engagement test and was a co-producer with the tenant for farm programeligibility purposes “has no bearing on whether petitioner was engaged in such a trade orbusiness for purposes of section 162(a) … ," citing A.B.C.D. Lands, Inc. v. Comr.,41 T.C. 840 (1964) and Hasbrouck v. Comr., T.C. Memo. 1998-249, aff’d. without publishedopinion, 189 F.3d 473 (9th Cir. 1999). The court held that the Regulations under I.R.C. §1402“make it clear that petitioner’s efforts do not constitute production or the management of theproduction as required to meet the material participation standard.” Thus, the petitioner was not
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engaged in the trade or business of farming either for either deduction or self-employment taxpurposes.
The IRS says that, the mere execution of a CRP contract by a taxpayer means that the taxpayer isengaged in the trade or business of farming. IRS Notice 2006-108; CCA 200325002. Wuebker v.Commissioner, 205 F.3d 897 (6th Cir. 2000) held that Conservation Reserve Program (CRP)payments received by a farmer actively engaged in the business of farming were includible inself-employment income. The court concluded that their "agreement . . . required them toperform several ongoing tasks with respect to the land enrolled in the CRP, the very land theyalready owned and had previously farmed." The Sixth Circuit noted that the taxpayers wererequired under the CRP contract to perform tasks intrinsic to the farming trade or business (e.g.,tilling, seeding, fertilizing, and weed control) that required the use of their farming equipment.Id. at 903. In addition, under the court’s view, the CRP payments were not payments of rent forthe use or occupancy of property and therefore were not rentals from real estate excluded fromSECA by § 1402(a)(1). The Court observed that the essence of the CRP program is to preventparticipants from farming enrolled property and to require the participants to perform variousactivities in connection with the land continuously throughout the life of the contract with thegovernment's access limited to inspections. Id. at 904. Furthermore, the Sixth Circuit looked tothe "substance, rather than the form, of the transaction" in determining that the income derivedfrom the CRP contract is includible in self-employment income earned in lieu of farm income,for which SECA tax was due. Under § 126(a), gross income does not include the excludableportion of payments received under certain conservation programs. Revenue Ruling 2003-59holds that all or a portion of cost sharing payments received under the CRP are eligible for theexclusion from gross income permitted by § 126. The ruling also holds that rental payments andincentive payments received under the CRP are not cost sharing payments and therefore are notexcludable from gross income.
Vianello also indicates that spouses may be able to qualify for separate person status for USDApayments while one spouse is not materially participating for self-employment tax purposes.
Passive farm rental income is subject to self-employment tax if there is an “arrangement” (orcontract) requiring material participation on the landlord’s part. Mizell v. Com’r, T.C. Memo.1995- 571; Tech. Ach. Memo. 9637004 (May 1, 1996); but see McNamara v. Com’r, 236 F.3d410 (8th Cir. 2000)(self-employment tax not due if fair market rentals charged), nonacquiescenceAOD CC-2003-003 (Oct. 20,2003).
4. Calculating Earned Income For Retirement Plan Purposes.
A partner or LLC member's net earnings from self-employment, in determining how much anLLC can contribute to a qualified plan on a member's behalf, are reduced by: (1) the actualamount of the contribution made on behalf of the self-employed individual; and (2) the member'stax deduction for one half of the self-employment tax paid by the individual member. IRC §§415(c)(3)(B), 401(c)(2)(A). Thus, the effective maximum contribution rate on behalf of amember is 20 percent of compensation, not 25 percent. If the LLC only has a profit sharing plan,the maximum effective contribution rate is approximately 12 to 13 percent, as opposed to 15percent in the case of corporate employees (see Panel Publishers, The Pension Answer Book).
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In addition, contributions by a corporation to a pension plan on behalf of a shareholder-employeeare not subject to FICA or Medicare tax, whereas all of an LLC's member's distributive share ofthe LLC is subject to self-employment tax FICA (subject to the annual cap) and unlimitedMedicare tax. See GCM 39807.
III. S CORP DISTRIBUTIONS V. EMPLOYEE-OWNER SALARIES; THE RISK OF“UNREASONABLY LOW” COMPENSATION.
A. No Compensation & All Distributions.
1. Distributions Recharacterized As Wages Due To No (Unreasonably Low)Compensation.
Unreasonable compensation issues can also arise when the employer is an S-corporation. Thereis an incentive to avoid paying payroll taxes (FICA and FUTA) that are imposed on wages bypaying a low level of compensation to a shareholder-employee. The same factors used indetermining reasonable compensation paid by a C-corporation under § 162 will also apply indetermining a minimum reasonable salary paid by an S-corporation. See Krahenbuhl, 27 T.C.M.(CCH) 155 (1968). In rare occasions, normally involving family members, the IRS may seek totreat salary as excessive if it wishes to reallocate it to another employee (whose compensationmay be under the FICA wage
The Service will attempt to recharacterize S-corporation dividend distributions as“compensation” subject to social security taxes where the wages paid to the taxpayer areunreasonably low. If successful, the IRS collections additional FICA and Medicare taxes, plusinterest and perhaps penalties.
An S Corporation must pay reasonable compensation (subject to employment taxes) toshareholder-employee(s) in return for the services that the employee provides to the corporationbefore non-wage distributions may be made to that shareholder-employee. Rev. Rul. 74-44,1974-1 C. B. 287 involves two shareholders of an S-corporation who were paid no salary for theexpress purpose of avoiding the FICA and FUTA taxes. Although the Ruling did not address thedefinition of what constitutes reasonable compensation, it did hold that the payment of nocompensation is per se unreasonable where shareholder-employees provide substantial servicesto the corporation. See Stephen R. Looney & Richard B. Comiter, Reasonable Compensation,Dividends vs. Wages – A Reverse in Positions, 7 J. Partnership Tax’n 364, 375 (1991).
However, the case of Paula Construction Co. v. Commissioner, 58 T.C. 1055 (1972), aff’d 474F.2d 1345 (5th Cir. 1983) shows that the entire amount distributed to a shareholder by a C-corporation (which had inadvertently lost its “S” status) can be treated as a dividend distributionto shareholders rather than “compensation” where corporate records fail to indicate any “intent”to treat the amounts distributed as compensation for services. However, it is unlikely the failureto document distribution as “compensation” would be a good defense to an IRS claim that an S-corporation’s salaries were unreasonably low. Rather, Paula Construction is a case where thetaxpayer was bound by its own characterization.
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The issue in S-corporations is the flip side of the situation that occurs when a C-corporationattempts to disguise profit distributions as salaries. There have been several “unreasonablecompensation” cases where the court has recharacterized part or all of a shareholder-employee’sdividend distribution from an S-corporation as “compensation” subject to employment taxes.See Joseph Radtke, S.C. v. U.S. 712 F. Supp. 143 (E. D. Wis. 1989), aff’d 895 F.2d 1196 (7th Cir.1990). see also Spicer Accounting, Inc. v. U.S., 918 F.2d 90 (9th Cir. 1990); Fred R. Esser, P.C.v. U.S., 750 F. Supp. 421 (D. Ariz. 1990); Estate of Wallace v. Commissioner, 95 T.C. 525(1990); Western Management, Inc. v. Commissioner, No. 04-70795 (9th Cir. April 12, 2006)..
In Radtke, Joseph Radtke, an attorney, was the sole shareholder and sole member of the board ofdirectors of the Taxpayer, Joseph Radtke, S.C., which provided legal services. Under anemployment contract with his corporation, Mr. Radtke had received an annual base salary for1982, determined by the corporation’s board of directors, of $0 per year; however, Mr. Radtkereceived $18,225 in dividends that year, on which he paid income taxes. The Service claimedthe dividend distribution should be recharacterized as “compensation” subject to FICA or FUTAtaxes.
The District Court held in favor of the IRS on its motion for summary judgment, stating that Mr.Radtke was clearly an employee of the company (in fact, the only full-time employee for theyear in question) and he provided substantial services. The Court further stated that the“dividends” received by Mr. Radtke “…functioned as remuneration for employment.” 712 F.Supp. at 145. The Court concluded that an employee cannot be permitted to evade FICA andFUTA taxes by characterizing all of his or her remuneration as something other than wages. Id.at 146.
2. Applicability Of § 162.
The two-part test under § 162(a)(1) requires: (1) the amount of the payment must be reasonablein relation to services performed, and (2) the payment is in fact intended as compensation forservices rendered. The argument made by the Service in the S-corporation cases where salariesare unreasonably low is that payments distributed ostensibly as dividends are in fact intended tobe compensation for services rendered.
A few cases have applied § 162(a)(1) to hold that wages paid to a shareholder-employee of an S-corporation were not unreasonably low. Each of these cases involved factual situations in whichthe shareholder-employees performed few services on behalf of the corporation and devotedlittle time to the corporation’s activities. See Trucks, Inc. v. U.S., 588 F. Supp. 638, 642-43(D.C. Neb. 1984); and Davis v. Commissioner, 64 T.C. 1034 (1975).
On the other hand, many cases have upheld the IRS’s conversion of dividend distributions tocompensation. Doctor Kenneth K. Sadanaga, DVM, worked full-time for Bristol- MeyersSquibb Co. in the years 1994, 1995, and 1996. Sadanaga, a veterinarian, also offered consultingand surgical services to other veterinarians through his S corporation, Veterinary SurgicalConsultants P.C. (VSC). VSC did not pay him a salary. Instead, Sadanaga drew money from theVSC bank account "at his discretion." These amounts were treated as "distributions other thandividend distributions paid from accumulated earnings and profits," while Sadanaga reported onSchedule E of his Form 1040 the VSC net income of $83,995.50, $173,030.39, and $161,483.35
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for, respectively, 1994, 1995, and 1996. In Veterinary Surgical Consultants, P.C., v.Commissioner, 117 T.C. No. 14 (2001), aff’d (3d Cir. 2002), VSC argued that Sadanagareceived distributions of corporate net income, and not wages. This was, said Judge Jacobs, "asubterfuge for reality." Sadanaga performed substantial services for VSC. "Regardless of how anemployer chooses to characterize payments made to its employees," he said, "the true analysis iswhether the payments represent remuneration for services rendered."
VSC argued that Sadanaga paid the maximum FICA tax required by law each year as anemployee of Bristol-Myers Squibb. "This argument is simply a 'red herring,'" said Judge Jacobs."For Federal employment tax purposes, the taxable wage base applies separately to eachemployer." VSC was held liable for the employer FICA tax (both the 6.2 percent old age taxand the 1.45 percent health insurance tax on Sadanaga's drawings up to the FICA maximum ineach year, and the 1.45 percent health insurance tax on the excess). Sadanaga was likewise liablefor the 1.45 percent health insurance tax on the total amount after offsetting his liability for theold age portion of the FICA with the credit for excess FICA as the result of having twoemployers. VSC was the first case involving the Tax Court's authority under § 7436, asamended in December 2000, to deal with employment tax classification issues.
Yeagle Drywall Company, Inc. v. Commissioner, T.C. Memo. 2001-284, aff’d (3d Cir. 2002) isanother case involving the same issue. Like VSC, Yeagle, an S corporation, treated its soleshareholder as a non-employee. Unlike Sadanaga, John Yeagle had no source of income otherthan his S corporation, and, like Sadanaga, he withdrew amounts from the corporation at hisdiscretion. Yeagle Drywall made the same arguments as VSC as to why its treatment of JohnYeagle's payments was proper, also relying on the § 530 argument and the same authorities toestablish reasonableness. Judge Jacobs's conclusion was the same in favor of the IRS.
In Nu-Look Design, TC Memo. 2003-52, the President and sole shareholder paid all corporateearnings as dividends. The court held he performed services and the distributions were reallywages paid to an employee. Nu-Look Design, Inc. is one of six Tax Court memorandumopinions on the question of avoidance of the requirement to pay F.I.C.A. and F.U.T.A. where thetaxpayers lost in attempting to classify income as S corporation dividends rather than wages.
The cases of Nu-Look Design, Inc., Water-Pure Systems, Inc., Specialty Transport & DeliveryServices, Inc., Superior Proside, Inc., Mike J. Graham Trucking, Inc., and Veterinary SurgicalConsultants, P.C. (II), all reported at T.C. Memo. 2003-52 (Feb. 26, 2003), have severalcommon factors, including the same accountant and attorney. The taxpayers, who lost,attempted to describe all or virtually all of their income as being S corporation dividends.
B. Some Compensation & Large Distributions.
David E. Watson, PC v. United States, No. 4:08-cv-004422010, 107 AFTR 2d ¶2011-305 (S.D.Iowa 12/23/10) ruled that the taxpayer must recharacterize a portion of his S corporationdividends as salary and pay additional employment taxes because his compensation wasunreasonably low. This is the second S corporation case to hold compensation is unreasonablylow where some compensation was paid. The other is JD & Associates, Ltd., discussed below.Neither is published and both were decided by district courts in the Eighth Circuit. In 2013, thisissue will likely become even more important. The health care reform legislation enacted in
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March 2010 will increase employment taxes beginning in 2013 by 0.9% on wages above$250,000 for joint filers and $200,000 for single filers.
Watson was a CPA and the sole owner and shareholder in an S corporation, which was a partnerin an accounting firm partnership. At issue were Watson's 2002 and 2003 income tax returns.Watson had reported salary of $24,000 each year and dividends of $203,651 in 2002 and$221,657 in 2003. Watson argued that the intent of the corporation determines the classificationof salary and dividends and that the intent of the corporation is controlling. The IRS argued thatthe cases cited by Watson should not apply because his salary was purposely set low so that hecould avoid paying employment taxes.
Watson's living expenses exceeded his salary. In addition, the median salary for new accountinggraduates in 2002 and 2003 was slightly below $40,000 for each of those years. Watson was ahighly qualified CPA with an advanced degree and 20 years of experience. An IRScompensation expert, Igor Ostrovsky, an IRS general engineer, who offered testimony at trialregarding the fair market value of Watson's accounting services in 2002 and 2003. testified thatthe fair value of Watson's services was $91,044 for each year. The Court concluded that Watsonowed employment taxes on the salary of $91,044 for each of 2002 and 2003.
The Court rejected Watson’s argument that the intent of the corporation controls the breakoutbetween salary and dividends. The Court pointed out that in those cases the corporation(taxpayer) wanted to recharacterize dividends as salary so that it could claim an income taxdeduction for the salary. Watson indicated that he intends to appeal the District Court's decision,so the question will be addressed by a higher court. The decision may offer guidance on whatcourts may consider a fair ratio of salary to total distributions in an S corporation. Watson arguedthat 10.5 percent to 12 percent of the total distribution from the S corporation could be classifiedas salary. The IRS viewed 40 percent to 46 percent as an appropriate proportion. It also imposedadditional payroll taxes, penalties, and interest.
The analysis in these cases is whether the dividend distribution payments are really remunerationfor services rendered. This is a facts and circumstances test. The court provided an illustrativelist of other relevant considerations including: (1) the employee's qualifications; (2) the nature,extent, and scope of the employee's work; (3) the size and complexities of the business; (4) acomparison of salaries paid with the gross income and the net income; (5) the prevailingeconomic conditions; (6) comparison of salaries with distributions to stockholders; (7) theprevailing rates of compensation for comparable positions in comparable concerns; (8) the salarypolicy of the taxpayer to all employees; and (9) in the case of small corporations with a limitednumber of officers, the amount of compensation paid to the employee in prior years.
The court cited many of the cases holding compensation unreasonably low when it was zero. Italso cited JD & Associates, Ltd. v. United States, No. 3:04-cv-59 (D.N.D. May 19, 2006), whereJeffrey Dahl, the sole shareholder, officer, and director of an S corporation, received an annualsalary of $19,000.00 in 1997 and $30,000.00 for each of 1998 and 1999. Dahl received dividendsof $47,000 for 1997, $50,000 for 1998 and 1999. The IRS determined that Dahl's salary wasunreasonably low, and assessed employment taxes, interest, and penalties against the corporationafter recharacterizing portions of the dividend payments as wages to Dahl. Applying an Eighth
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Circuit test from Charles Schneider & Co., Inc. v. CIR, 500 F.2d 148, 182 (8th Cir. 1974) todetermine whether Dahl's compensation was reasonable, the district court concluded it was notand upheld the tax assessments against the corporation.
While the IRS is able to reclassify distributions as wages, it is unclear as to whether they maysuccessfully assert that compensation (and payroll taxes) should have been paid where thecorporation did not make distributions to the shareholder for the year. If so, it would seem anyaffected shareholders would have a wherewithal-to-pay issue and could raise this as a possibledefense.
IV. SITUATIONS WHERE SECA (SELF-EMPLOYMENT TAX) DOES NOT APPLYTO LLC INCOME; PLANNING OPPORTUNITIES.
A. One Class Of Interest.
Under the 1997 Proposed Regulations, Prop. Reg. § 1.1402(a)-2,which the IRS has indicated itwill respect, an individual LLC member is by default treated as a limited partner in a non-serviceorganization unless the individual:
has personal liability for the debts of, or claims against, the partnership by reason ofbeing a partner;
has authority to contract on behalf of the partnership under the state entity statutepursuant to which the partnership is organized (such as the Utah Revised LimitedLiability Company Act); or
participates in the partnership's trade or business for more than 500 hours during thetaxable year.
Even if none of the above tests are met, self-employment income exists if an individualLLC owner performs services as part of the LLC's trade or business if substantially all ofthe activities of a partnership (or LLC) involve the performance of services in the fieldsof health, law, engineering, architecture, accounting, actuarial science, or consulting.
Accordingly, if an LLC member is not personally liable for debts, does not have the power tobind the LLC to a contract and does not provide more than 500 hours of service per year to theLLC, the member will be taxed as limited partner and will not have self-employment taxobligations on his or her LLC income allocations unless the individual performs services as partof a service LLC or receives guaranteed payments for services without regard to the entity's netincome.
B. Manager Managed LLC; Material Participation Exception.
A (25 percent), B (50 percent), and C (25 percent) form an LLC that is classified as a partnershipbut is not a service partnership. C is the sole manager. There is one class of ownership interests.A has no contractual authority to bind the LLC, no liability for LLC obligations, and provides noservices. A is a functional limited partner and A’s distributive share of income or loss is exemptfrom SECA tax under § 1402(a)(13). B and C receive guaranteed payments for personal servicesin excess of 500 hours for the year.
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B's guaranteed payment is subject to the SECA tax, but the mere presence of the guaranteedpayment does not mean that B's distributive share is also subject to the tax. B's guaranteedpayment is SE income but B’s distributable share is not be subject to the SECA tax because A isa functional limited partner and A owns 20 percent or more of those interests (25 percent), and Bis not a functional limited partner solely because of failing the material participation test (e.g., Bis not a manager with authority). Prop. Reg. § 1.1402(a)-2(i) (Ex. (iii).
C also receives a guaranteed payment subject to the SECA tax. C is not a functional limitedpartner because C fails the material participation test as well as the management authority test.Unlike the material participation test, there is no exception to the management test. Accordingly,C's distributive share is also subject to the SECA tax. Prop. Reg. § 1.1402(a)-2(i) (Ex. (iv)).
C. Two Classes Of Owners – Non-Service LLC; Family Members May Play.
1997 Prop. Reg. 1.1402(a)-2 presents small business owners with opportunities to reduce theirSE tax for non-service businesses. 1997 Prop. Reg. 1.1402(a)-2 contains no family-attributionrules applicable to spouses, children, or other relatives. This suggests that the Service will notuse a related-party concept to disregard a Prop. Reg. 1.1402(a)-(2)(h)(2) partner because of therule regarding substantial (20% or more) passive partners. Thus, in order to avoid SE tax, there isno requirement that non-family members own some LLC equity interest.
If a married person operates an LLC that is not engaged in one of the seven service fields with anoperating agreement that provides for the two required classes of interest, he or she could easilylimit the SE tax to the amount of income the members reasonably want to report as self-employment income. This tax would be assessed on only the portion allocated to those memberswith manager interests, plus any guaranteed payments to the member.
A husband and wife operate, and are the sole owners of, an LLC that has net income of $120,000after deducting a $30,000 guaranteed payment to the managing member. If the manager's generalpartner interest were only 1%, SE tax would apply to only $31,200 ((1% x $120,000) + $30,000).This is only 21% ($31,200/$150,000) of the total net income when the guaranteed payment isincluded. Further, if the income were stable, this could equate to a substantial annual taxreduction because of the lower SE tax.
The guaranteed payment should be high enough to be construed as reasonable for the servicesrendered by the members. A standard for reasonable compensation for a similarly employed Scorporation shareholder has been established in S corporation cases, but there is no comparablecriteria to determine the sufficiency of an LLC guaranteed payment for similar services.
Furthermore, the Service does not have substantial support from other authority to recharacterizeany portion of investment class earnings as self-employment earnings. Does this mean that self-employment income that members should report appears is discretionary? Likely not. Taxpractitioners should not be overly aggressive in attempting to minimize the amount of LLCincome subject to SE tax.
The income tax on the LLC income could also be reduced by allocating a portion to familymembers who are in a lower tax bracket than the other members so long as the familypartnership rules are met.
D. Separate Equipment & Real Estate Leasing Entities.
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Tax on SE income can be minimized by having a second entity own and lease equipment andreal estate to an entity taxed as a partnership or sole proprietorship..
E. Third Party Manager.
Use of a third party manager that is compensated by the LLC for any services rendered mayallow this second class of ownership to avoid SE tax. Whether an affiliate of a member can beused as manager is not clear. When it is not feasible to have the managing member hold dualinterests in the LLC and meet the material participation exception, the managing member’s SEtax exposure can still be minimized by naming a manager who is not a member. When thisstrategy is adopted, none of the LLC members would be subject to SE tax on their distributiveshare of LLC income except for guaranteed payments or service entity income. The manager,however, must be compensated by the LLC for any services rendered and, as such, would besubject to SE tax on this compensation (unless it were an entity not subject to SE tax, such as acorporate affiliate of an LLC member). In this situation, however, the IRS could treat the use of arelated-entity manager as a sham transaction unless the management services were provided atarm’s length and with a reasonable business purpose.
F. Conclusion.
These proposed strategies are not without risk, although all are defensible. 1997 Prop. Reg. §1.1402(a)-2 has never been adopted and is not entitled to judicial deference. The IRS, however,has privately stated that until it issues further guidance in this area, it will not challenge LLCmembers on SE tax if the members and the LLC conform to the proposed regulations. Thatshould eliminate penalties from being imposed. Nevertheless, the IRS could, and probablywould, challenge any bifurcation of a managing member’s income if it lacked a “substantialeconomic effect” or was made without regard to the reasonableness of the member’s guaranteedpayment. See Robucci v. CIR, T.C. Memo. 2011-19 (January 24, 2011), discussed below.
V. REAL WORLD LIMITS OF PLANNING OPPORTUNITIES.
As noted above, payments to limited partners and perhaps to members of LLCs other than formanagement services may be exempt from self employment tax except to the extent that they arepayments for services. However, there should be economic substance to any arrangement for itto work.
Robucci P.C. was wholly owned by Dr. Robucci, and this PC was a co-member, along with Dr.Robucci personally, in Tony L. Robucci, M.D., LLC (Robucci LLC). Dr Robucci personallyowned 95% of the LLC and his PC owned 5%. Dr. Robucci 's 95-percent interest in the LLC wasdivided between a 10-percent general partner interest and an 85-percent limited partner interestattributable to Dr. Robucci 's personal goodwill. Westsphere was a management corporationwholly owned by Dr. Robucci. The PC and Westsphere are referred to as the corporations.
The IRS argued and Tax Court Judge Halpern held that the corporations should be disregarded,leaving the Robucci LLC as a SMLLC owned solely owned by Dr. Robucci. Robucci v. CIR,T.C. Memo. 2011-19 (January 24, 2011) holds that (1) the new structure of a sole proprietorpsychiatrist’s practice should be largely disregarded as without substance, (2) the taxpayer
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continues to be taxable as a sole proprietor, and (3) the 6662 substantial understatement penaltyapplies. This case follows a much different path than numerous earlier cases upholdingconversions of sole proprietorships and partnerships into professional corporations. The entitiesinvolved were not implemented properly. The court notes that if they had been, the result mighthave been different. This reminds us of the early PC days, where the IRS was on the attack andsuccessful taxpayers were careful to dot every “I” and cross every “T.”
The court did not need to deal with the two IRS alternative 482 and 269A arguments, bothtypically unsuccessful in prior litigated cases. See footnote 2.
The Taxpayer’s Goal – Tax Reduction.
During his first meeting with Mr. Carson, an attorney and CPA, sole proprietor Dr. Robuccistated that he wanted to do what was best from the standpoint of his own personal tax planningand wanted to minimize the amount of taxes he was paying. Mr. Carson recommended theorganizational structure described above. That discussion covered structuring Dr. Robucci'spractice so as to reduce self-employment tax while also minimizing other tax liabilities. Dr.Robucci did not seek a second opinion from any other C.P.A. or attorney, nor did Mr. Carsonprovide him with a written explanation of the need to form three separate entities. Carsonexplained orally to Dr. Robucci that the LLC would conduct the practice, that for reasons notmade clear to Dr. Robucci, it needed to have two members (Dr. Robucci personally and RobucciP.C.), and that Westsphere would be a business management corporation and not involved inproviding patient care.
Failure To Implement Mr. Carson's Recommended Organizational Structure
Dr. Robucci was the sole shareholder of both corporations. During that same period, RobucciLLC was 95-percent owned by Dr. Robucci and 5-percent owned by Robucci P.C. The courtsays that Robucci P.C.'s interest was as a limited partner. This seems to be incorrect, as footnote4 of the decision notes that Reg. § 301.7701-3(b)(1)(i) states that a multimember LLC that doesnot elect association status (which describes Robucci LLC) is treated, for Federal tax purposes,as a partnership. Thus, Robucci LLC's members would most likely both constitute generalpartners for Federal tax purposes if it were respected as a two-member entity. Several courtdecisions hold that LLC members cannot be limited partners, even if they are merely members ina manager managed LLC. The court’s reasoning makes this issue moot.
Dr. Robucci's 95-percent ownership interest was reflected on Robucci LLC's partnership returnsas an 85-percent interest as a limited partner and a 10-percent interest as a general partner. Whilenot noted by the court, many cases hold that LLC interests of members in a manager managedLLC are not limited partner interests but rather general partner interests. Carson based hisdetermination of an 85-percent limited partner ownership interest for Dr. Robucci on the value ofDr. Robucci's goodwill and what would be a reasonable rate of return on that goodwill at thetime he formed Robucci LLC. Mr. Carson never discussed with Dr. Robucci the basis for the 85-percent-10 percent allocation between his limited and general partner interests in Robucci LLC.Dr. Robucci understood that his 10-percent general partnership interest represented his interest as
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a provider of medical services and his 85-percent limited partnership interest represented hisinterest attributable to his capital contribution of intangibles.
Carson did not prepare a written valuation report to support his conclusions. Critically, Dr.Robucci did not make any written assignment of the tangible or intangible assets of his practiceto Robucci LLC.
Westsphere executed a loan agreement, whereby Dr. R as an "employee" was authorized toborrow money from Westsphere "from time to time" under specified terms and conditions.
Dr. Robucci executed an Employee Business Expense Reimbursement Plan, wherebyWestsphere agreed to reimburse its employees for all employment related expenses uponsubmission of the proof of expenditure documentation specified in the plan. Westsphere alsoadopted a Medical Reimbursement Plan and a Diagnostic Medical Reimbursement Plan. TheOperating Agreement of Robucci LLC designated Robucci P.C. as manager but it was not clearwhether it was signed. Dr. Robucci had a limited understanding of the need for the entitiesformed and the agreements and other documents drafted by Mr. Carson.
Robucci LLC and Westsphere had bank accounts, while Robucci P.C. did not. Dr. Robucci didnot have an employment agreement with any of those three entities, nor did any of them haveemployees during the years in issue. Neither Robucci P.C. nor Westsphere paid a salary to Dr.Robucci or to anyone else during those years. Dr. Robucci did not keep records of any time hemight have spent working for Westsphere. Although Robucci LLC deducted "management fees"for each of the years in issue ($31,475, $25,500, and $38,385 for 2002, 2003, and 2004,respectively), its returns and bank records do not specify to whom they were paid or for whatservices. Dr. Robucci was aware that Westsphere charged management fees to Robucci LLC buthe did not know the nature of those charges except that they related to non-patient care services.
Robucci LLC and the corporations used the same business address but there was no written leaseagreement between Robucci LLC and either of the corporations.
The corporations did not (1) have separate Web sites or telephone listings, (2) pay rent to Dr.Robucci or Robucci LLC, (3) have customers other than Robucci LLC or contracts with anyother third parties, or (4) advertise. Westsphere did not have separate dedicated space in Dr.Robucci's office. Dr. Robucci continued to bill Medicare and Medicaid (a relatively smallportion of his practice) as an individual practitioner and not through Robucci LLC.
During the years in issue, Robucci LLC was a calendar year taxpayer and the corporationsreported on the basis of fiscal years ending November 30.
Dr. Robucci's Self-Employment (SECA) Taxes
Dr. Robucci's 2002, 2003, and 2004 Forms 1040, U.S. Individual Income Tax Return, show thefollowing distributions to him of "passive" and "nonpassive" income from Robucci LLC:
Year Passive Income Nonpassive Income______________________________________________________________________
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2002 $48,153 $5,6652003 57,446 6,8512004 95,1431 11,193
_____________________________________________________________________
Dr. Robucci's 2004 return reported this $95,143 amount as nonpassive incomeon Schedule E, although the 2004 Schedule K-1 from Robucci LLC in connectionwith his 85percent partnership interest lists $95,143 as the distributionattributable to that (passive) interest, and Dr. Robucci's 2004 Schedule SE,Self-Employment Tax, included only $11,193 as net earnings from self-employment.
Dr. Robucci's Schedule SE filed for each of those years lists the 10% “general partner:nonpassive income as gross earnings from self-employment.
The Tax Court noted that the Supreme Court in Gregory v. Helvering, 293 U.S. 465, 469 (1935)stated: "The legal right of a taxpayer to decrease the amount of what otherwise would be histaxes, or altogether avoid them, by means which the law permits, cannot be doubted." Directlyafter that statement, however, the Court added the admonition: "But the question fordetermination is whether what was done, apart from tax motive, was the thing which the statuteintended." Id.
In Chisholm v. Commissioner, 79 F.2d 14, 15 (2d Cir. 1935), Judge Learned Hand elaboratedupon the Supreme Court's admonition in Gregory, stating: "The question always is whether thetransaction under scrutiny is in fact what it appears to be in form".
The issue in these cases is whether the corporations, Robucci P.C. and Westsphere, are entitledto respect as viable business corporations or whether, as in Judge Hand's description of the factsin Gregory, the incorporator's "intent, or purpose, was merely to draught the papers, in fact not tocreate corporations as the court * * * [understands] that word." Id. In other words, were RobucciP.C. and Westsphere corporations in fact as well as in form; i.e., were they "the thing which thestatute intended" when referring to corporations?
A corporation will be recognized as a separate taxable entity if (1) the purpose for its formationis the equivalent of business activity or (2) the incorporation is followed by the carrying on of abusiness by the corporation. Moline Props., Inc. v. Commissioner, 319 U.S. 436, 438-439(1943); Achiro v. Commissioner, 77 T.C. 881, 901 (1981).6 If neither of those requirements issatisfied, the corporation will be disregarded for Federal tax purposes, and all of its income willbe attributed to the true earner. Shaw Constr. Co. v. Commissioner, 35 T.C. 1102, 1114-1117(1961), affd. 323 F.2d 316 (9th Cir. 1963); Aldon Homes, Inc. v. Commissioner, 33 T.C. 582,597-607 (1959).
The Tax Court held that it need not decide the burden of proof issue under § 7491(a) because apreponderance of the evidence supports the resolution of that issue. Therefore, resolution of thatissue does not depend on which party bears the burden of proof. See, e.g., Estate of Bongard v.Commissioner, 124 T.C. 95, 111 (2005).
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Business Purpose Of The Structure.
The taxpayers argue that as "managing member" of Robucci LLC, Robucci P.C. "performedoversight and management" services and that Westsphere was established to (1) "provideoversight, and to manage certain overheads and indirect expenses, including employee benefitssuch as health insurance", (2) "track business expenses and overheads", and (3) create a "group"for group sickness and accident insurance coverage under Colorado law. Taxpayers also arguethat the formation of a multimember LLC, including a corporate member, afforded Dr. Robuccisuperior protection, under Colorado law, against personal liability for acts of Robucci LLC, andthat Robucci P.C.'s interest in Robucci LLC was necessary to accomplish that goal.
The IRS argues that (1) the corporations "were created solely for the purpose of reducing . . .[Dr. Robucci's] tax liability" and to help him "avoid income and self-employment taxes"; (2)taxpayers "did not offer any credible explanation of the business purpose for forming thecorporations"; and (3) taxpayers "did not demonstrate that either corporation engaged in anybusiness activity after it was formed." The court agreed with the IRS.
Taxpayers state two reasons for the formation of Robucci P.C.: (1) Its role as the "managingmember" of Robucci LLC, a role not reflected in Robucci P.C.'s articles of incorporation, whichstate that its "sole purpose" is to practice medicine "through persons licensed to practicemedicine" and (2) the superior protection against personal liability that would be afforded to Dr.Robucci by the formation of a multimember LLC.
Assuming that Robucci P.C. was properly organized under Colorado law, that fact does not meanthat it performed any function that would warrant its recognition as an entity for Federal taxpurposes. E.g., Noonan v. Commissioner, 52 T.C. 907, 909 (1969), affd. 451 F.2d 992 (9th Cir.1971). Although Robucci P.C. may have been a party to an "operating agreement" with RobucciLLC, whereby it was appointed Robucci LLC's "manager," there is no evidence that RobucciP.C. performed any management or other services for Robucci LLC. Robucci P.C. had no assets(other than its interest in Robucci LLC) or employees, it had no service contract with RobucciLLC, and it paid no salary to Dr. Robucci or anyone else during the years in issue. In fact,Robucci P.C. was not intended to perform management services or other business activities. Mr.Carson's handwritten note states: "We need P.C. to be a partner in LLC only; Westsphere is themgmt. corp. P.C. does nada [nothing]."
In support of the second reason of limiting Dr. Robucci’s liability, taxpayers cite In re Albright,291 Bankr. 538 (Bankr. D. Colo. 2003), in which the court permitted the trustee in bankruptcy toliquidate all of the property of a single-member LLC on behalf of creditors. The Tax Court heldthat Taxpayers' reliance upon Albright is misplaced. That case does not involve a creditor's rightto hold the sole member of a single-member LLC personally liable for the LLC's debts. Rather, itholds that all of the LLC's assets are available to satisfy the claims of the sole member's creditors(and not that the sole member's assets are available to the LLC's creditors). The trustee inAlbright did not attempt to pierce the "corporate" veil to reach the member's personal assets tosatisfy the LLC's debts
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The court concluded that Robucci P.C. was not formed for a purpose that "is the equivalent of abusiness activity" within the meaning of Moline Props., Inc. v. Commissioner, 319 U.S. at 439.
Westsphere Management Corporation
Taxpayers list three purposes for the organization of Westsphere: management, the tracking ofoverhead and indirect expenses, and to form a group for insurance purposes. However, theevidence refutes the notion that those alleged purposes constituted bona fide nontax purposes.Although, Westsphere had a checking account, like Robucci P.C., it had no employmentagreement with Dr. Robucci and no employees. Nor did it perform any management or otherservices for Robucci LLC in the person of Dr. Robucci.
Rather, Dr. Robucci continued to conduct his practice as he always had, including the retentionof Ms. Williams as his billing assistant. Both before and after the formation of Robucci LLC,Ms. Williams was the billing assistant for Dr. Robucci's practice. Although she receivedinstructions from Dr. Robucci in letters with a letterhead "Tony L. Robucci, M.D., AProfessional L.L.C.," she considered herself to be the employee of Dr. Robucci.
The only activity allegedly attributable to Westsphere during the audit years was itsreimbursement of various expenses incurred by Dr. Robucci and Robucci LLC pursuant to thevarious plans. Dr. Robucci testified that that activity consisted of electronic transfers of fundsbetween bank accounts. Thus, Dr. Robucci continued, as in prior years, to pay the expenses ofhis practice, but allegedly out of Robucci LLC's bank account. Westsphere's only alleged"service" was to reimburse those expenses by electronic transfers of funds from its account toRobucci LLC's account. The bank account statements in the record provide scant evidence thatthere were, in fact, regular interaccount transfers from Westsphere to Robucci LLC. Forexample, Westsphere's bank statement dated January 23, 2003, shows debits of $5,097.60 and$1,114.84 for a 2002 Medical Expenses Reimbursement and a Health Insurance PremiumReimbursement, but the absence of corresponding credits to Robucci LLC's account on the samedate or thereafter indicates that the transfer of funds was to Dr. Robucci's personal account. Infact, the bank statements contained no correlation between debits to Westsphere's bank accountand credits to Robucci LLC's bank account. Any interaccount transfers, to the extent theyoccurred, were the equivalent of taking money from one pocket and putting it into anotherbecause Dr. Robucci controlled both entities. Such a procedure hardly qualifies as a "businessactivity" under Moline Props., Inc. v. Commissioner, supra at 439.
The taxpayers also argued that the organization of Westsphere was essential in order to create a"group" eligible for group sickness and accident insurance. Whatever the merits of taxpayers'concerns in that regard, it is not clear how the formation of Westsphere alleviated thoseconcerns. The "groups" to be afforded coverage are "groups of persons," generally, underpolicies issued to an employer for the benefit of the employees, which include officers,managers, and other employees of the employer. See Colo. Rev. Stat. sec. 10-16214(1)(a). It isdifficult to see how the organization of Westsphere, which neither is an employee of RobucciLLC nor has employees of its own, could serve to qualify for small group or small employerhealth insurance. More importantly, there is no evidence that Robucci LLC made any effort toobtain group health insurance for its sole operative, Dr. Robucci. Dr. Robucci or Robucci LLC
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continued to pay premiums for health insurance but it is not clear that the policy differed fromthe one Dr. Robucci had as a sole proprietor.
The court concluded that Westsphere was not organized for a purpose that "is the equivalent of abusiness activity" under Moline Props., Inc. v. Commissioner, supra at 439. Rather, Robucci P.C.and Westsphere were "hollow corporate shells." The court ruled that neither carried on abusiness after incorporation, the second alternative prong for corporate viability under MolineProperties. Because Robucci P.C. and Westsphere served no significant purpose or functionother than tax avoidance, they should be disregarded. What we said in Aldon Homes, Inc. v.Commissioner, 33 T.C. at 598, in disregarding 16 so-called alphabet corporations is equallyapplicable to this case:
The alleged business purposes impressed us simply as a lawyer's marshaling of possible businessreasons that might conceivably have motivated the adoption of the forms here employed butwhich in fact played no part whatever in the utilization of the [structure employed]
Thus, Robucci LLC was a single-member LLC. The result is that Dr. Robucci is a sole proprietorfor Federal tax purposes, which was his status before the formation of Robucci LLC and thecorporations. It follows, and we hold, that the net income arising from his psychiatric practiceduring the years in issue, including any amounts paid to Robucci P.C. and Westsphere, was self-employment income of Dr. Robucci subject to self-employment tax under § 1401.
Imposition Of The 6662 Accuracy-Related Penalty
The IRS has established that Dr. Robucci's understatements of income tax for the years in issueare substantial as they exceed both 10 percent of the correct tax and $5,000. Therefore, there wasno need to determine whether Dr. Robucci was negligent under § 6662(b)(1).
Section 6664(c)(1) provides that the penalty shall not be imposed with respect to any portion ofan underpayment if a taxpayer shows that there was reasonable cause for, and that the taxpayeracted in good faith with respect to, that portion. The determination of whether a taxpayer actedwith reasonable cause and in good faith is made on a case-by-case basis, taking into account allpertinent facts and circumstances. Circumstances that may indicate reasonable cause and goodfaith include an honest misunderstanding of law that is reasonable in light of all of the facts andcircumstances, including the experience, knowledge, and education of the taxpayer. Reliance onthe advice of a professional tax advisor does not necessarily demonstrate reasonable cause andgood faith. Reg. § 1.6664-4(b)(1).
Under § 7491(c), the IRS bears the burden of production, but not the overall burden of proof,with respect to Dr. Robucci's liability for the § 6662(a) penalty. By demonstrating that Dr.Robucci's understatements of income tax exceed the thresholds for a finding of "substantialunderstatement of income tax" under § 6662, the IRS has satisfied his burden of production.
CPA/Attorney As Promoter; Second Opinion Required For Reasonable Cause. The IRS arguedthat there was no reasonable cause for the positions taken by Dr. Robucci and that he did not act
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in good faith. In the IRS's view, "[p]etitioner should have requested a second opinion aftergetting advice that was clearly too good to be true". The IRS viewed Mr. Carson as "thepromoter of the arrangement, who earned substantial fees for incorporating the various shamentities and preparing the tax returns at issue.” Taxpayers denied that Mr. Carson was a promoterand argues that, in the light of Mr. Carson's status as an independent, experienced C.P.A., Dr.Robucci was under no obligation to obtain a second opinion before he could reasonably rely onMr. Carson's advice.
Under those circumstances, Dr. Robucci, even though he was not a tax professional, should havequestioned the efficacy of the arrangement that purported to minimize his taxes while effectingvirtually no change in the conduct of his medical practice. He should have sought a secondopinion. By not doing so, Dr. Robucci failed to exercise the ordinary business care and prudencerequired of him under the circumstances. See United States v. Boyle, 469 U.S. at 251; HaywoodLumber & Mining Co. v. Commissioner, 178 F.2d 769, 770771 (2d Cir. 1950), modifying 12T.C. 735 (1949), which involve circumstances exemplifying the exercise of ordinary businesscare and prudence.
Too Good To Be True. The court held that even if we were to agree with petitioner that Mr.Carson was not a promoter, we agree with the IRS that the tax result afforded by implementingMr. Carson's suggestions, i.e., the dramatic reduction in Dr. Robucci's self-employment taxes,was "too good to be true.” See, e.g., Neonatology Associate, P.A. v. Commissioner, 299 F.3d at234 ("When * * * a taxpayer is presented with what would appear to be a fabulous opportunity toavoid tax obligations, he should recognize that he proceeds at his own peril."); McCrary v.Commissioner, 92 T.C. 827, 850 (1989) (stating that no reasonable person should have trustedthe tax scheme in question to work).
Carson’s Structure Might Have Worked If Implemented Properly.
Somewhat contrary to its statement that the structure led to a tax result that was too good to betrue, the court stated that Mr. Carson's goal of directing some of Dr. Robucci's income to a third-party corporate management service provider and bifurcating Dr. Robucci's interest in RobucciLLC so that he would be separately compensated for the use of his intangibles was notunreasonable. On the contrary, had it been more carefully implemented, it well might have beenrealized, at least in part. In footnote 11, the court noted that although it is the IRS's position thatprofit distributions to service-providing members of a multimember, professional service LLCare never excepted from net earnings from self-employment by § 1402(a)(13), which exceptsdistributions to a limited partner other than sec. 707(c) guaranteed payments for servicesrendered, the Treasury has yet to issue definitive guidance with respect to that issue.
Although Robucci P.C. and Westsphere were properly formed under Colorado law to carry outlegitimate corporate functions, the fact that they were nothing more than empty shells, devoid ofproperty (Westsphere did have a bank account), personnel, or actual day-to-day activities, i.e., ofsubstance, should have sent warning signals to Dr. Robucci that those corporations were noteffecting any meaningful change in the prior conduct of his medical practice. There were also nocontracts between the entities or with Dr. Robucci and his PC. Additionally, the LLC paid Dr.
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Robucci for his “active services, not his PC, which did not have any activity or even a bankaccount.
While Dr. Robucci may have had some vague notion that he was acting on behalf of Westspherewhen performing services other than actual patient care, there is little or no evidence as to theprecise nature of those services, the time Dr. Robucci may have spent performing them, or theirvalue. In short, there is no support for any charge from Westsphere to Robucci LLC for suchservices or for the claim that Dr. Robucci was wearing a Westsphere hat when he performedthem.
For Dr. Robucci, aside from signing a raft of documents and shifting some money between twonew bank accounts, it was business as usual. Although he might have been justified in relyingupon Mr. Carson's expert valuation of his intangibles as the basis for the 85-10 split between hislimited and general partnership interests in Robucci LLC, the lack of any formal transfer of thoseintangibles to Robucci LLC was fatal.
2/10/2012
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Qualified Plans andthe Small Business Owner
Rick Wagner, J.D., Director
Denver Compensation & Benefits, LLC
(303) 779 – 2084
• The Advantages of Qualified Retirement Plans
• The Value of Deferring Taxes in Qualified Plans
• Types of Qualified Retirement Plans
• Deferring Taxes through Qualified Plans
• Accessing Money in Qualified Plans
• Targeted Investments Using Qualified Plan Assets
Qualified Plans and the Small Business Owner 1
Agenda
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Tax Advantages of Retirement Plans• Employer contributions are deductible from employer’s
income.– Employer receives an immediate income tax deduction.
• Employee contributions are not taxed until distributed tothe employee.– No current taxation to the plan participants.
• Money in the Plan grows tax-free.– Earnings on the plan’s investments are not taxed until they are paid
as benefits to the participants.
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Deferring Taxes Through Qualified Plans
• IRA-Based Plans– Key Advantages
• Easy to set up and avoid many of the administrative requirements ofother qualified plans (i.e. defined contribution and defined benefitplans)
– Employer Eligibility• Payroll Deduction IRA & SEPs
– Any employer with one or more employees.
• SIMPLE IRA Plans– Any employer with 100 or fewer employees that does not currently
maintain another retirement plan.
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Deferring Taxes Through Qualified Plans
• IRA-Based Plans (cont’d)
– Contributors to the Plan• Payroll Deduction IRA
– Employee contributions remitted through payroll deduction.
– Employee can decide how much to contribute at any time.
• SEPs– Employer contributions only. Employer can decide whether to make
contributions year-to-year.
• SIMPLE IRAs– Employee can decide how much to contribute.
– Employer must make matching contributions or contribute 2% of eacheligible employee’s compensation (subject to IRS limits).
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Deferring Taxes Through Qualified Plans• IRA-Based Plans (cont’d)
– Minimum Employee Coverage Requirements• Payroll Deduction IRA
– There is no requirement.
– Can be made available to any employee.
• SEPs– Must be offered to all employees who are at least 21 years of age,
employed by the employer for 3 of the last 5 years, and had compensationof $550 for 2010 and 2011.
• SIMPLE IRA Plans– Must be offered to all employees who have earned income of at least
$5,000 in any prior 2 years, and are reasonably expected to earn at least$5,000 in the current year.
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Deferring Taxes Through Qualified Plans• IRA-Based Plans (cont’d)
– Maximum Annual Contributions (per participant)• Payroll Deduction IRA
– $5,000 for 2012. Additional contributions up to $1,000 can be made byparticipants age 50 and over.
• SEPs– Up to 25% of compensation (subject to IRS §415 limits) but not more than
$50,000 for 2012.
• SIMPLE IRA Plans– Employee –
$11,500 in 2012. Additional contributions up to $2,500 can be made by participantsage 50 or over.
– Employer – Either match employee contributions 100% for first 3% of compensation (can
be reduced to as low as 1% in any 2 out of 5 years), or contribute 2% of eacheligible employee’s compensation (subject to IRS limits).
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Deferring Taxes Through Qualified Plans• Roth IRA/401(k)s
– Key Advantages• Qualified distributions are tax-free.
• Can make contributions to Roth IRA after reaching the age of 70 ½.
• Can leave amounts in Roth IRA as long as alive.
– Operate very similar to pre-tax deferrals, but allow theemployee to make the decision about when to be taxed
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Deferring Taxes Through Qualified Plans
• General Defined Contribution and Defined Benefit PlanRules
– Minimum Eligibility Requirement• Statutory maximums are one year of service with 1,000 hours and age
21
– Minimum Coverage Requirement
DCB Title of Presentation Goes Here 8
Deferring Taxes Through Qualified Plans• Defined Contribution Plans
– Key Advantages• 401(k) Plans
– Traditional 401(k) - Permits higher level of salary deferrals by employees.
– Safe Harbor 401(k) - No annual discrimination testing.
• Profit Sharing Plans
– Permits employer to make contributions for employees.
– Investment risk is borne by the participants rather than theemployer
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Deferring Taxes Through Qualified Plans• Defined Contribution Plans (cont’d)
– Contributors to the Plan• 401(k) Plans
– Employee salary reduction contributions and maybe employercontributions.
– Employee can decide how much to contribute pursuant to a salaryreduction agreement.
– The employer can make additional contributions including matchingcontributions as set by plan terms.
• Profit Sharing
– Annual employer contribution is discretionary, but must not bediscriminatory.
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Deferring Taxes Through Qualified Plans• Defined Contribution Plans (cont’d)
– Maximum Annual Contributions (per participant)• 401(k) Plans
– Employee –
$17,000 in 2012. Additional contributions can be made byparticipants age 50 or over up to $5,500.
– Employer/Employee Combined –
Up to the lesser of 100% of compensation, or $50,000 for 2012.
Employer can deduct amounts that do not exceed 25% of aggregatecompensation for all participants and all salary reductioncontributions.
Qualified Plans and the Small Business Owner 11
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Deferring Taxes Through Qualified Plans• Defined Benefit Plans
– Key Advantages: Provides a fixed, pre-established benefit foremployees.
– Key Disadvantages:• Risk of investment loss is borne by the employer
• An actuary must determine annual contributions.
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Deferring Taxes Through Qualified Plans• Defined Benefit Plans (cont’d)
– Contributors to the Plan• Employer funded.
– Maximum Annual Contributions (per participant)• Annual benefit cannot exceed the lesser of:
– 100% of the participant’s average compensation for his highest 3consecutive calendar years; or
– $200,000 for 2012.
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Deferring Taxes Through Qualified Plans• Hybrid Plans
– Money Purchase Pension Plans• Contributors to the Plan
– The employer must make contributions to the plan.
– Amount of employer contribution is determined by the plan according to aset percentage of eligible employee’s compensation.
• Maximum Annual Contributions (per participant)
– The lesser of 100% of compensation, or $50,000 in 2012.
– Pre-EGTRRA legislation allowed for higher deduction limitsthan other defined contribution plans, but that was changedby EGTRRA which largely negated their value
Qualified Plans and the Small Business Owner 14
Deferring Taxes Through Qualified Plans• Hybrid Plans (cont’d)
– Cash Balance Plans• Key Advantages
– Defined benefit plan that uses a hypothetical account balance, made up of employercontributions and interest credits, which is guaranteed rather than being dependenton the plan’s investment performance.
• Contributors to the Plan– Employer makes annual contribution and annual interest credit.– Employer may contribute either a percentage of the eligible employee’s pay or a flat
dollar amount, as determined by a formula specified in the plan document.– The rate of return for the annual interest credit is guaranteed and is independent of
the plan’s investment performance.
• Maximum Annual Contributions (per participant)– Contribution determined by a formula specified in plan document according to the
employee’s age (subject to IRC §415 annual benefit limits).– Employer minimum funding requirements are actuarially determined in accordance
with ERISA § 302 and IRC §§ 404(a)(1) and 412.
Qualified Plans and the Small Business Owner 15
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Deferring Taxes Through Qualified Plans• Hybrid Plans (cont’d)
– Cross Tested Plans• Key Advantages
– Allow the owner or other key employees with a proportionately higherbenefit.
• Contributors to the Plan
– Annual employer contribution is discretionary.
– Employer can create separate groups and provide each group with adifferent allocation.
• Maximum Annual Contributions (per participant)
– Up to the lesser of 100% of compensation, or $50,000 for 2012.
Qualified Plans and the Small Business Owner 16
Accessing Money in Qualified Plans• IRA-Based Plans
– Withdrawals• Withdrawals permitted anytime subject to federal income taxes.
• Early withdrawals subject to an additional tax (additional earlywithdrawal penalty of 10% of the distribution amount applies to RothIRAs).
– Vesting• Employee salary reduction contributions and employer contributions
are immediately 100% vested.
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Accessing Money in Qualified Plans• Defined Contribution and Cross-Tested Plans
– Withdrawals• Plan will specify when withdrawals are available, i.e. not until
retirement or not until employee reaches age 59 1/2
• Plan may permit loans and hardship withdrawals; early withdrawalssubject to an additional tax.
– Vesting• Employee salary deferrals are immediately 100% vested.
• Employer contributions vest according to plan terms, subject tominimum vesting requirements under ERISA (6 year graded or 3 yearcliff).
• Safe Harbor 401(k) Plans – Most employer contributions areimmediately 100% vested.
Qualified Plans and the Small Business Owner 18
Accessing Money in Qualified Plans• Defined Benefit Plans
– Withdrawals• Payment of benefits after a specified event occurs (e.g., retirement,
plan termination, etc.).
• Plan may permit loans; withdrawals before normal retirement age(other than related to a plan termination) subject to an additional tax.
– Vesting• Plan benefits may vest over time according to plan terms, subject to
minimum vesting requirements under ERISA (7 year graded or 5 yearcliff).
Qualified Plans and the Small Business Owner 19
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Accessing Money in Qualified Plans• Hybrid Plans
– Money Purchase Pension Plans• Withdrawals
– In-service withdrawals are not permitted.– Participant loans are permitted (paid back via payroll deductions)– Payment of benefits after a specified event occurs (e.g., retirement, plan
termination, etc.).
• Vesting– Employer contributions vest under defined contribution plan rules
– Cash Balance Plans• Withdrawals
– Employees can receive lump sum payment or annuity of vested accountbalances upon termination and retirement. In service distributions are not permitted. Loans, while permitted, are generally not
provided due to complexity of administration.
• Vesting– Employer contributions vest under defined benefit plan rules
Qualified Plans and the Small Business Owner 20
Targeted Investments Using Qualified Plan Assets
• Self-Directed IRAs
– Mechanics
• IRA owner directs investment to targeted entity.
– Potential Issues
• Special rules under DOL regulations.
– Prohibited transactions with disqualified persons.
i.e., an entity of which 50% or more is owned directly or indirectly orheld by a fiduciary or service provider, or an entity that is 10% ormore partner or joint venturer with an entity that is 50% or moreowned directly or indirectly or held by a fiduciary or serviceprovider.
Qualified Plans and the Small Business Owner 21
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Targeted Investments Using Qualified Plan Assets
• Rollovers as Business Start-Ups (“ROBS”)
– Key Advantages• New business is capitalized with tax-deferred money, avoiding any
taxes that usually apply to a retirement plan withdrawal.
– Mechanics• Individual uses funds accumulated under prior employer’s plan to
contribute to newly created plan in a non-taxable transaction. Afterwhich the new plan purchases an ownership interest in a new entity.
Qualified Plans and the Small Business Owner 22
• Rollovers as Business Start-Ups (“ROBS”) (cont’d)
– Potential Issues• Usually the ROBS arrangement is set up using prototype documents
and the plan is therefore in compliance.
• The operation of the plan, however, may be found non-compliant.
– Nondiscrimination Issues
Timing of a plan amendment to add and remove the opportunity to invest inthe employer securities can be viewed as violating IRC §401(a)(4).
– Prohibited Transaction Issues
Potential self-dealing transaction.
Asset valuation issues may implicate additional prohibited transaction issues.
IRS looks at these types of transactions with a close eye
Qualified Plans and the Small Business Owner 23
Targeted Investments Using Qualified Plan Assets
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• ESOPs– Key Advantages
• Buy shares of a departing owner.– Owners of privately held companies can use an ESOP to create a ready market for their
shares.– The company can make tax-deductible cash contributions to the ESOP to buy out an
owner’s shares, or it can have the ESOP borrow money to buy the shares (see below).
• Borrow money at a lower after-tax cost.– ESOP borrows cash, which it uses to buy company shares or shares of existing owners.– The company then makes tax-deductible contributions to the ESOP to repay the loan,
meaning both principal and interest are deductible.
• Create an additional employee benefit.– Company can simply issue new or treasury shares to an ESOP, deducting their value (for up
to 25% of covered pay) from taxable income.– Or a company can contribute cash, buying shares from existing public or private owners.– In public companies, ESOPs are often used in conjunction with employee savings plans.
Rather than matching employee savings with cash, the company will match themwith stock from an ESOP, often at a higher matching level.
Qualified Plans and the Small Business Owner 24
Targeted Investments Using Qualified Plan Assets
• ESOPs (cont’d)
– Employer Eligibility• Any employer with one or more employees (however, 15 or more
employees are generally needed for an effective ESOP component).
– Contributors to the Plan• Employee can decide how much to contribute pursuant to a salary
reduction agreement.
• The employer can make additional contributions included matchingcontributions as set by plan terms if combined with a 401(k) Plan(KSOP).
• Employer contributions can be made in either cash or securities.
Qualified Plans and the Small Business Owner 25
Targeted Investments Using Qualified Plan Assets
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• ESOPs (cont’d)
– Maximum Annual Contributions (per Participant)• Generally subject to same contribution limits as 401(k) Plans
– Withdrawals• Withdrawals permitted after a specified event occurs (e.g., retirement, plan
termination, etc.) subject to federal income taxes.
• Plan may permit loans and hardship withdrawals; early withdrawalssubject to an additional tax.
– Vesting• Employer contributions may vest over time according to plan terms,
subject to minimum vesting requirements under ERISA (6 year graded or 3year cliff).
Qualified Plans and the Small Business Owner 26
Targeted Investments Using Qualified Plan Assets