[Federal Register Volume 62, Number 8 (Monday, January 13, 1997)]
[Proposed Rules]
[Pages 1702-1705]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 97-701]



[[Page 1702]]

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DEPARTMENT OF THE TREASURY
26 CFR Part 1

[REG-209824-96]
RIN 1545-AU24


Definition of Limited Partner for Self-Employment Tax Purposes

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking and notice of public hearing.

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SUMMARY: This document contains proposed amendments to the regulations 
relating to the self-employment income tax imposed under section 1402 
of the Internal Revenue Code of 1986. These regulations permit 
individuals to determine whether they are limited partners for purposes 
of section 1402(a)(13), eliminating the uncertainty in calculating an 
individual's net earnings from self-employment under existing law. This 
document also contains a notice of public hearing on the proposed 
regulations.

DATES: Written comments must be received by April 14, 1997. Requests to 
speak and outlines of oral comments to be discussed at the public 
hearing scheduled for May 21, 1997, at 10 a.m. must be received by 
April 30, 1997.

ADDRESSES: Send submissions to: CC:DOM:CORP:R (REG-209824-96), room 
5226, Internal Revenue Service, POB 7604, Ben Franklin Station, 
Washington, DC 20044. Submissions may be hand delivered between the 
hours of 8 a.m. and 5 p.m. to: CC:DOM:CORP:R (REG-209824-96), Courier's 
Desk, Internal Revenue Service, 1111 Constitution Avenue, NW, 
Washington, DC. Alternatively, taxpayers may submit comments 
electronically via the Internet by selecting the ``Tax Regs'' option on 
the IRS Home Page, or by submitting comments directly to the IRS 
Internet site at http://www.irs.ustreas.gov/prod/tax__regs/
comments.html. The public hearing will be held in the Auditorium, 
Internal Revenue Service building, 1111 Constitution Avenue, NW, 
Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the regulation, Robert 
Honigman, (202) 622-3050; concerning submissions and the hearing, 
Christina Vasquez, (202) 622-6808 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Background

    This document contains proposed amendments to the Income Tax 
Regulations (26 CFR part 1) under section 1402 of the Internal Revenue 
Code and replaces the notice of proposed rulemaking published in the 
Federal Register on December 29, 1994, at 59 FR 67253, that treated 
certain members of a limited liability company (LLC) as limited 
partners for self-employment tax purposes. Written comments responding 
to the proposed regulations were received, and a public hearing was 
held on June 23, 1995.
    Under the 1994 proposed regulations, an individual owning an 
interest in an LLC was treated as a limited partner if (1) the 
individual lacked the authority to make management decisions necessary 
to conduct the LLC's business (the management test), and (2) the LLC 
could have been formed as a limited partnership rather than an LLC in 
the same jurisdiction, and the member could have qualified as a limited 
partner in the limited partnership under applicable law (the limited 
partner equivalence test). The intent of the 1994 proposed regulations 
was to treat owners of an LLC interest in the same manner as similarly 
situated partners in a state law partnership.
    Public comments on the 1994 proposed regulations were mixed. While 
some commentators were pleased with the proposed regulations for 
attempting to conform the treatment of LLCs with state law 
partnerships, others criticized the 1994 proposed regulations based on 
a variety of arguments.
    A number of commentators discussed administrative and compliance 
problems with the 1994 proposed regulations. For example, it was noted 
that both the management test and the limited partner equivalence test 
depend upon legal or factual determinations that may be difficult for 
taxpayers or the IRS to make with certainty.
    Another commentator pointed out that basing the self-employment tax 
treatment of LLC members on state law limited partnership rules would 
lead to disparate treatment between members of different LLCs with 
identical rights based solely on differences in the limited partnership 
statutes of the states in which the members form their LLC. For 
example, State A's limited partnership act may allow a limited partner 
to participate in a partnership's business while State B's limited 
partnership act may not. Thus, an LLC member, who is not a manager, 
that participates in the LLC's business would be a limited partner 
under the proposed regulations if the LLC is formed in State A, but not 
if the LLC is formed in State B. Commentators asserted that this 
disparate treatment is inherently unfair for federal tax purposes.
    Some commentators argued for a ``material participation'' test to 
determine whether an LLC member's distributive share is included in the 
individual's net earnings from self-employment. The proposed 
regulations did not contain a participation test. Commentators 
advocating a participation test stressed that such a test would 
eliminate uncertainty concerning many LLC members' limited partner 
status and would better implement the self-employment tax goal of 
taxing compensation for services.
    Other commentators argued for a more uniform approach, stating that 
a single test should govern all business entities i.e., partnerships, 
LLCs, LLPs, sole proprietorships, et al.) whose members may be subject 
to self-employment tax. These commentators generally recognized, 
however, that a change in the treatment of a sole proprietorship or an 
entity that is not characterized as a partnership for federal tax 
purposes would be beyond the scope of regulations to be issued under 
section 1402(a)(13).
    Finally, some commentators focused on whether the Service would 
respect the ownership of more than one class of partnership interest 
for self-employment tax purposes (bifurcation of interests). The 
proposed regulations treated an LLC member as a limited partner with 
respect to his or her entire interest (if the member was not a manager 
and satisfied the limited partner equivalence test), or not at all (if 
either the management test or limited partner equivalence test was not 
satisfied). Commentators, however, pointed to the legislative history 
of section 1402(a)(13) to support their argument that Congress only 
intended to tax a partner's distributive share attributable to a 
general partner interest. Under this argument, a partner that holds 
both a general partner interest and a limited partner interest is only 
subject to self-employment tax on the distributive share attributable 
to the partner's general partner interest. This intent also may be 
inferred from the statutory language of section 1402(a)(13) that the 
self-employment tax does not apply to ``* * * the distributive share of 
any item of income or loss of a limited partner, as such * * *.'' Based 
on this evidence, these commentators requested that the proposed 
regulations be revised to allow the bifurcation of interests for self-
employment tax purposes.
    After considering the comments received, the IRS and Treasury have 
decided to withdraw the 1994 notice of proposed rulemaking and to re-
propose amendments to the Income Tax

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Regulations (26 CFR part 1) under section 1402 of the Code.

Explanation of Provisions

    The proposed regulations contained in this document define which 
partners of a federal tax partnership are considered limited partners 
for section 1402(a)(13) purposes. These proposed regulations apply to 
all entities classified as a partnership for federal tax purposes, 
regardless of the state law characterization of the entity. Thus, the 
same standards apply when determining the status of an individual 
owning an interest in a state law limited partnership or the status of 
an individual owning an interest in an LLC. In order to achieve this 
conformity, the proposed regulations adopt an approach which depends on 
the relationship between the partner, the partnership, and the 
partnership's business. State law characterizations of an individual as 
a ``limited partner'' or otherwise are not determinative.
    Generally, an individual will be treated as a limited partner under 
the proposed regulations unless the individual (1) has personal 
liability (as defined in Sec. 301.7701-3(b)(2)(ii) of the Procedure and 
Administration Regulations) for the debts of or claims against the 
partnership by reason of being a partner; (2) has authority to contract 
on behalf of the partnership under the statute or law pursuant to which 
the partnership is organized; or, (3) participates in the partnership's 
trade or business for more than 500 hours during the taxable year. If, 
however, substantially all of the activities of a partnership involve 
the performance of services in the fields of health, law, engineering, 
architecture, accounting, actuarial science, or consulting, any 
individual who provides services as part of that trade or business will 
not be considered a limited partner.
    By adopting these functional tests, the proposed regulations ensure 
that similarly situated individuals owning interests in entities formed 
under different statutes or in different jurisdictions will be treated 
similarly. The need for a functional approach results not only from the 
proliferation of new business entities such as LLCs, but also from the 
evolution of state limited partnership statutes. When Congress enacted 
the limited partner exclusion found in section 1402(a)(13), state laws 
generally did not allow limited partners to participate in the 
partnership's trade or business to the extent that state laws allow 
limited partners to participate today. Thus, even in the case of a 
state law limited partnership, a functional approach is necessary to 
ensure that the self-employment tax consequences to similarly situated 
taxpayers do not differ depending upon where the partnership organized.
    The proposed regulations allow an individual who is not a limited 
partner for section 1402(a)(13) purposes to nonetheless exclude from 
net earnings from self-employment a portion of that individual's 
distributive share if the individual holds more than one class of 
interest in the partnership. Similarly, the proposed regulations permit 
an individual that participates in the trade or business of the 
partnership to bifurcate his or her distributive share by disregarding 
guaranteed payments for services. In each case, however, such 
bifurcation of interests is permitted only to the extent the 
individual's distributive share is identical to the distributive share 
of partners who qualify as limited partners under the proposed 
regulation (without regard to the bifurcation rules) and who own a 
substantial interest in the partnership. Together, these rules exclude 
from an individual's net earnings from self-employment amounts that are 
demonstrably returns on capital invested in the partnership.

Proposed Effective Date

    These regulations are proposed to be effective beginning with the 
individual's first taxable year beginning on or after the date these 
regulations are published as final regulations in the Federal Register.

Special Analyses

    It has been determined that this notice of proposed rulemaking is 
not a significant regulatory action as defined in EO 12866. Therefore, 
a regulatory assessment is not required. It also has been determined 
that section 553(b) of the Administrative Procedure Act (5 U.S.C. 
chapter 5) does not apply to these regulations, and, because the 
regulations do not impose a collection of information on small 
entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not 
apply. Pursuant to section 7805(f) of the Internal Revenue Code, this 
notice of proposed rulemaking will be submitted to the Chief Counsel 
for Advocacy of the Small Business Administration for comment on its 
impact on small business.

Comments and Public Hearing

    Before these proposed regulations are adopted as final regulations, 
consideration will be given to any written comments (a signed original 
and eight (8) copies) that are submitted timely to the IRS. All 
comments will be available for public inspection and copying.
    A public hearing has been scheduled for Wednesday, May 21, 1997, at 
10 a.m. in the Auditorium, Internal Revenue Service building, 1111 
Constitution Avenue, NW, Washington, DC. Because of access 
restrictions, visitors will not be admitted beyond the Internal Revenue 
Service building lobby more than 15 minutes before the hearing starts.
    The rules of 26 CFR 601.601(a)(3) apply to the hearing.
    Persons that wish to present oral comments at the hearing must 
submit written comments by April 14, 1997 and submit an outline of the 
topics to be discussed and the time to be devoted to each topic (signed 
original and eight (8) copies) by April 30, 1997.
    A period of 10 minutes will be allotted to each person for making 
comments.
    An agenda showing the scheduling of the speakers will be prepared 
after the deadline for receiving outlines has passed. Copies of the 
agenda will be available free of charge at the hearing.

Drafting Information

    The principal author of these regulations is Robert Honigman of the 
Office of Assistant Chief Counsel (Passthroughs & Special Industries). 
However, other personnel from the IRS and Treasury Department 
participated in their development.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

    Accordingly, 26 CFR part 1 is proposed to be amended as follows:

PART 1--INCOME TAXES

    Paragraph 1. The authority citation for part 1 continues to read in 
part as follows:

    Authority: 26 U.S.C. 7805 * * *

    Par. 2. Section 1.1402(a)-2 is amended by:
    1. Revising the first sentence of paragraph (d).
    2. Removing the reference ``section 702(a)(9)'' in the first 
sentence of paragraph (e) and adding ``section 702(a)(8)'' in its 
place.
    3. Revising the last sentence of paragraph (f).
    4. Revising paragraphs (g) and (h).
    5. Adding new paragraphs (i) and (j).
    The revisions and additions read as follows:

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Sec. 1.1402(a)-2  Computation of net earnings from self-employment.

* * * * *
    (d) * * * Except as otherwise provided in section 1402(a) and 
paragraph (g) of this section, an individual's net earnings from self-
employment include the individual's distributive share (whether or not 
distributed) of income or loss described in section 702(a)(8) from any 
trade or business carried on by each partnership of which the 
individual is a partner. * * *
* * * * *
    (f) * * * For rules governing the classification of an organization 
as a partnership or otherwise, see Secs. 301.7701-1, 301.7701-2, and 
301.7701-3 of this chapter.
    (g) Distributive share of limited partner. An individual's net 
earnings from self-employment do not include the individual's 
distributive share of income or loss as a limited partner described in 
paragraph (h) of this section. However, guaranteed payments described 
in section 707(c) made to the individual for services actually rendered 
to or on behalf of the partnership engaged in a trade or business are 
included in the individual's net earnings from self-employment.
    (h) Definition of limited partner--(1) In general. Solely for 
purposes of section 1402(a)(13) and paragraph (g) of this section, an 
individual is considered to be a limited partner to the extent provided 
in paragraphs (h)(2), (h)(3), (h)(4), and (h)(5) of this section.
    (2) Limited partner. An individual is treated as a limited partner 
under this paragraph (h)(2) unless the individual--
    (i) Has personal liability (as defined in Sec. 301.7701-3(b)(2)(ii) 
of this chapter) for the debts of or claims against the partnership by 
reason of being a partner;
    (ii) Has authority (under the law of the jurisdiction in which the 
partnership is formed) to contract on behalf of the partnership; or
    (iii) Participates in the partnership's trade or business for more 
than 500 hours during the partnership's taxable year.
    (3) Exception for holders of more than one class of interest. An 
individual holding more than one class of interest in the partnership 
who is not treated as a limited partner under paragraph (h)(2) of this 
section is treated as a limited partner under this paragraph (h)(3) 
with respect to a specific class of partnership interest held by such 
individual if, immediately after the individual acquires that class of 
interest--
    (i) Limited partners within the meaning of paragraph (h)(2) of this 
section own a substantial, continuing interest in that specific class 
of partnership interest; and,
    (ii) The individual's rights and obligations with respect to that 
specific class of interest are identical to the rights and obligations 
of that specific class of partnership interest held by the limited 
partners described in paragraph (h)(3)(i) of this section.
    (4) Exception for holders of only one class of interest. An 
individual who is not treated as a limited partner under paragraph 
(h)(2) of this section solely because that individual participates in 
the partnership's trade or business for more than 500 hours during the 
partnership's taxable year is treated as a limited partner under this 
paragraph (h)(4) with respect to the individual's partnership interest 
if, immediately after the individual acquires that interest--
    (i) Limited partners within the meaning of paragraph (h)(2) of this 
section own a substantial, continuing interest in that specific class 
of partnership interest; and
    (ii) The individual's rights and obligations with respect to the 
specific class of interest are identical to the rights and obligations 
of the specific class of partnership interest held by the limited 
partners described in paragraph (h)(4)(i) of this section.
    (5) Exception for service partners in service partnerships. An 
individual who is a service partner in a service partnership may not be 
a limited partner under paragraphs (h)(2), (h)(3), or (h)(4) of this 
section.
    (6) Additional definitions. Solely for purposes of this paragraph 
(h)--
    (i) A class of interest is an interest that grants the holder 
specific rights and obligations. If a holder's rights and obligations 
from an interest are different from another holder's rights and 
obligations, each holder's interest belongs to a separate class of 
interest. An individual may hold more than one class of interest in the 
same partnership provided that each class grants the individual 
different rights or obligations. The existence of a guaranteed payment 
described in section 707(c) made to an individual for services rendered 
to or on behalf of a partnership, however, is not a factor in 
determining the rights and obligations of a class of interest.
    (ii) A service partner is a partner who provides services to or on 
behalf of the service partnership's trade or business. A partner is not 
considered to be a service partner if that partner only provides a de 
minimis amount of services to or on behalf of the partnership.
    (iii) A service partnership is a partnership substantially all the 
activities of which involve the performance of services in the fields 
of health, law, engineering, architecture, accounting, actuarial 
science, or consulting.
    (iv) A substantial interest in a class of interest is determined 
based on all of the relevant facts and circumstances.
    In all cases, however, ownership of 20 percent or more of a 
specific class of interest is considered substantial.
    (i) Example. The following example illustrates the principles of 
paragraphs (g) and (h) of this section:


    Example. (i) A, B, and C form LLC, a limited liability company, 
under the laws of State to engage in a business that is not a 
service partnership described in paragraph (h)(6)(iii) of this 
section. LLC, classified as a partnership for federal tax purposes, 
allocates all items of income, deduction, and credit of LLC to A, B, 
and C in proportion to their ownership of LLC. A and C each 
contribute $1x for one LLC unit. B contributes $2x for two LLC 
units. Each LLC unit entitles its holder to receive 25 percent of 
LLC's tax items, including profits. A does not perform services for 
LLC; however, each year B receives a guaranteed payment of $6x for 
600 hours of services rendered to LLC and C receives a guaranteed 
payment of $10x for 1,000 hours of services rendered to LLC. C also 
is elected LLC's manager. Under State's law, C has the authority to 
contract on behalf of LLC.
    (ii) Application of general rule of paragraph (h)(2) of this 
section. A is treated as a limited partner in LLC under paragraph 
(h)(2) of this section because A is not liable personally for debts 
of or claims against LLC, A does not have authority to contract for 
LLC under State's law, and A does not participate in LLC's trade or 
business for more than 500 hours during the taxable year. Therefore, 
A's distributive share attributable to A's LLC unit is excluded from 
A's net earnings from self-employment under section 1402(a)(13).
    (iii) Distributive share not included in net earnings from self-
employment under paragraph (h)(4) of this section. B's guaranteed 
payment of $6x is included in B's net earnings from self-employment 
under section 1402(a)(13). B is not treated as a limited partner 
under paragraph (h)(2) of this section because, although B is not 
liable for debts of or claims against LLC and B does not have 
authority to contract for LLC under State's law, B does participates 
in LLC's trade or business for more than 500 hours during the 
taxable year. Further, B is not treated as a limited partner under 
paragraph (h)(3) of this section because B does not hold more than 
one class of interest in LLC. However, B is treated as a limited 
partner under paragraph (h)(4) of this section because B is not 
treated as a limited partner under paragraph (h)(2) of this section 
solely because B

[[Page 1705]]

participated in LLC's business for more than 500 hours and because A 
is a limited partner under paragraph (h)(2) of this section who owns 
a substantial interest with rights and obligations that are 
identical to B's rights and obligations. In this example, B's 
distributive share is deemed to be a return on B's investment in LLC 
and not remuneration for B's service to LLC. Thus, B's distributive 
share attributable to B's two LLC units is not net earnings from 
self-employment under section 1402(a)(13).
    (iv) Distributive share included in net earnings from self-
employment. C's guaranteed payment of $10x is included in C's net 
earnings from self-employment under section 1402(a). In addition, 
C's distributive share attributable to C's LLC unit also is net 
earnings from self-employment under section 1402(a) because C is not 
a limited partner under paragraphs (h)(2), (h)(3), or (h)(4) of this 
section. C is not treated as a limited partner under paragraph 
(h)(2) of this section because C has the authority under State's law 
to enter into a binding contract on behalf of LLC and because C 
participates in LLC's trade or business for more than 500 hours 
during the taxable year. Further, C is not treated as a limited 
partner under paragraph (h)(3) of this section because C does not 
hold more than one class of interest in LLC. Finally, C is not 
treated as a limited partner under paragraph (h)(4) of this section 
because C has the power to bind LLC. Thus, C's guaranteed payment 
and distributive share both are included in C's net earnings from 
self-employment under section 1402(a).


    (j) Effective date. Paragraphs (d), (e), (f), (g), (h), and (i) are 
applicable beginning with the individual's first taxable year beginning 
on or after the date this section is published as a final regulation in 
the Federal Register.
Margaret Milner Richardson,
Commissioner of Internal Revenue.
[FR Doc. 97-701 Filed 1-10-97; 8:45 am]
BILLING CODE 4830-01-U