COMPENSATION & OTHER TECHNIQUES FOR GETTING MONEY OUT OF A CLOSELY HELD BUSINESS

Transcription

1 COMPENSATION & OTHER TECHNIQUES FOR GETTING MONEY OUT OF A CLOSELY HELD BUSINESS First Run Broadcast: February 14, :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

2 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.

3 VT Bar Association Continuing Legal Education Registration Form Please complete all of the requested information, print this application, and fax with credit info or mail it with payment to: Vermont Bar Association, PO Box 100, Montpelier, VT Fax: (802) PLEASE USE ONE REGISTRATION FORM PER PERSON. First Name: Middle Initial: Last Name: Firm/Organization: Address: City: State: ZIP Code: Phone #: Fax #: Address: I will be attending: Compensation & Other Techniques for Getting Money Out of a Closely Held Business Teleseminar February 14, 2012 Early Registration Discount By 2/7/2012 Registrations Received After 2/7/2012 VBA Members: $70.00 Non VBA Members/Atty: $80.00 VBA Members: $80.00 Non-VBA Members/Atty: $90.00 NO REFUNDS AFTER February 7, 2012 PLEASE NOTE: Due to New Hampshire Bar regulations, teleseminars cannot be used for New Hampshire CLE credit PAYMENT METHOD: Check enclosed (made payable to Vermont Bar Association): $ Credit Card (American Express, Discover, MasterCard or VISA) Credit Card # Exp. Date Cardholder:

4 Vermont Bar Association ATTORNEY CERTIFICATE OF ATTENDANCE Please note: This form is for your records in the event you are audited Sponsor: Vermont Bar Association Date: February 14, 2012 Seminar Title: Location: Credits: Compensation & Other Techniques for Getting Money Out of a Closely Held Business Teleseminar 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.

5 SALARY-BASED TECHNIQUES FOR WITHDRAWING MONEY FROM A CLOSELY-HELD BUSINESS Brian J. O Connor, Venable LLP Baltimore, MD/Washington, DC February 14, Venable LLP 1

6 COMMONLY USED COMPENSATION TECHNIQUES FOR CLOSELY-HELD BUSINESSES Corporate employers C corporations S corporations Partnership employers GPs LPs LLCs LLPs LLLPs Venable LLP

7 CORPORATE EMPLOYERS Salary/Bonus Unrestricted Stock Restricted Stock Options Stock Appreciation Rights (SARs) Phantom Stock Venable LLP

8 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 Venable LLP

9 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 Venable LLP

10 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 Venable LLP

11 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 Venable LLP

12 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 Venable LLP

13 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 Venable LLP

14 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 Venable LLP

15 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 Venable LLP

16 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 Venable LLP

17 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 Venable LLP

18 Presenter Contact Information Brian J. O Connor Venable LLP (410) bjoconnor@venable.com 14 BA0/302430v Venable LLP

19 PROFESSIONAL EDUCATION BROADCAST NETWORK Employment Tax Planning Across Business Entities Alson R. Martin LATHROP & GAGE LLP Mastin, Suite 1000 Overland Park, Kansas (o) (913)

20 TABLE OF CONTENTS I. EMPLOYMENT TAX RULES APPLY DIFFERENTLY TO DIFFERENT ENTITIES; C CORPORATIONS, S CORPS, LLCS, AND PARTNERSHIPS A. Concepts Important To Noncorporate Entities & Their SECA Obligations Trade Or Business Rates Guaranteed Payments... 3 B. Partnerships General Partners Limited Partners Of Limited Partnerships C. LLCs & LLPs Taxed As Partnerships IRS Ruling Position Court Position On LLPs & LLCs Proposed Regulations & LLCs and LLPs... 8 a. 3 Tests For Functional Limited Partner b. Application To LLCs c. Application To LLPs d. Second/Multiple Class Exception D. LLLPs E. Lifetime Retirement Payments To Retired General Partner Or LLC Managing/Manager Member General Rule LLP General Partner Qualifies LLC Member Qualifies F. Retirement Payments To Limited Partners G. Corporations S Corporations C Corporations a. Taxation As Separate & Not A Pass-Through Entity b. Social Security and Medicare Taxes and Income Tax Withholding c. Dividends i-

21 TABLE OF CONTENTS (continued) Page II. III. IV. SPECIALPARTNERSHIP ISSUES; DUAL STATUS WORKERS & SPOUSES; FARMING; RETIREMENT PLAN COMPENSATION A. Partnerships Individuals Working In Different Capacities Spouses a. Non-Community Property States; 761(f) Election Eliminates Need To File Form 1065 For Joint Ventures b. No 761(f) Election For LLCs, LLPs Or Other State Law Entities c. Spousal Business In Community Property States Farming Eligibility For CRP Versus Trade Or Business Calculating Earned Income For Retirement Plan Purposes S CORP DISTRIBUTIONS V. EMPLOYEE-OWNER SALARIES; THE RISK OF UNREASONABLY LOW COMPENSATION A. No Compensation & All Distributions Distributions Recharacterized As Wages Due To No (Unreasonably Low) Compensation Applicability Of B. Some Compensation & Large Distributions SITUATIONS WHERE SECA (SELF-EMPLOYMENT TAX) DOES NOT APPLY TO LLC INCOME; PLANNING OPPORTUNITIES A. One Class Of Interest B. Manager Managed LLC; Material Participation Exception C. Two Classes Of Owners Non-Service LLC; Family Members May Play D. Separate Equipment & Real Estate Leasing Entities E. Third Party Manager F. Conclusion V. REAL WORLD LIMITS OF PLANNING OPPORTUNITIES ii-

22 I. EMPLOYMENT TAX RULES APPLY DIFFERENTLY TO DIFFERENT ENTITIES; C CORPORATIONS, S CORPS, LLCS, AND PARTNERSHIPS. Employment tax considerations are but one of a host of considerations in choice of entity planning. This outline will focus solely on the difference an entity type makes regarding employment 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 or business activity is regular, frequent, and undertaken for the primary purpose of profit. An activity 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 the partner's distributive share from any trade or business of the partnership, adjusted for certain items of partnership income that are passive in nature (i.e., rentals of real estate, dividends, and interest are excluded from NESE unless such amounts are received by the partnership in the course of a trade or business as a dealer in the related property). If a general partner's distributive share is a net loss, it is deducted from NESE. Net income from self-employment generally includes active income from self-employment. In the case of a partner in a partnership, the term includes a partner's share (whether or not distributed) 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 true Subchapter 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 partner receives a guaranteed payment. IRC 1402(a)(13). Income that is excluded from the definition of self-employment income is not subject to the self-employment tax and cannot be counted for purposes of calculating allowable contributions to qualified plans. IRC 401(c)(2). A partner 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 (or proprietorships 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 on an information return (Form 1065) and provide each owner with a Schedule K-1 showing that owner 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-employment derived by an individual. 1

23 Section 1402(a) defines an individual s net earnings from self-employment as the gross income derived by an individual from any trade or business carried on by such individual, also with certain limitations. Section 1402(a)(1) generally excludes from the computation of "net earnings from self-employment" rentals from real estate and from personal property leased with the real estate (including such rentals paid in crop shares) together with the deductions attributable thereto, unless such rentals are received in the course of a trade or business as a real estate dealer, with an exception. Under this exception, any income derived by the owner or tenant 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 tenant and another individual, which provides that such other individual shall produce agricultural or horticultural commodities (including livestock, bees, poultry, and fur-bearing animals and wildlife) on such land, and that there shall be material participation by the owner or tenant (as determined without regard to any activities of an agent of such owner or tenant) in the production or the management of the production of such agricultural or horticultural commodities, and (B) there is material participation by the owner or tenant (as determined without regard to any activities of an agent of such owner or tenant) with respect to any such agricultural or horticultural commodity. Section 1402(c) provides that the term trade or business, when used with reference to self-employment income or net earnings from self-employment, shall have the same meaning as when used in 162 (relating to trade or business expenses), less allowable deductions. Reg (c)-1 provides that in order for an individual to have net earnings from selfemployment, he must carry on a trade or business, either as an individual or as a member of a partnership. Whether or not he is engaged in carrying on a trade or business will depend upon all of the facts and circumstances in the particular case. The United States Supreme Court ruled that to be engaged in a trade or business, the taxpayer must be involved in the activity with continuity and regularity, and the taxpayer s primary purpose for engaging in the activity must be for income or profit. A sporadic activity does not qualify. Commissioner v. Groetzinger, 480 U.S. 23, 35 (1987). The question of whether a taxpayer is engaged in a trade or business requires an examination of the relevant facts in each case. Id. at 36. For partners in a general partnership (the typical pass-through entity when 1402(a) was enacted in 1954), each general partner in a partnership involved in a trade or business simply takes his or her allocable share of partnership income and reports the full amount (except for interest and dividend income and other specified items) on Form 1040, Schedule SE, for purposes of computing SECA tax. Similarly, each general partner uses the same amount for purposes of computing his or her qualified compensation base for purposes of making contributions to qualified retirement plans. For a proprietor or partner, the burden for paying employment taxes and prepaying estimated income taxes rests with the individual, not the business. Estimated taxes 2

24 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 federal payroll tax purposes are not subject to any payroll tax withholding or payment liability on the part of the payor. Subject to certain exemption rules, self-employment earnings include income derived by an individual from any trade or business carried on by such individual plus his or her distributive share of partnership income or loss from any trade or business carried on by a partnership in which he or she is a partner. Section 1401 imposes SECA tax on selfemployment income at the rate of 15.3%, a combination of a 12.4% old-age, survivors, and disability insurance (OASDI) tax and a 2.9% Medicare tax. The OASDI tax is only imposed on the first $106,800 of net earnings (which allows for offsets to gross earnings for deductible expenses associated with the creation of the income) for % of the SECA tax payments are deductible. In 2013 and thereafter, as a result of PPACA, the new 3.8% unearned income Medicare tax under Code 1411 is in addition to the new.9% hospital insurance tax under 1401(b) that will apply for post-2012 years on self-employment income and wages in excess of the same thresholds, 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 this additional.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 the employee or his or her spouse, wages earned by his or her spouse (even from the same employer), 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 s wages. As indicated above, these thresholds are not subject to inflation adjustment. This additional.9% tax on wages and self-employment income above the applicable thresholds is not deductible for income tax purposes. For example, a single taxpayer in 2013 with modified AGI of $375,000, self-employment income of $300,000 from an active proprietorship, and net investment income from a passive interest in an LLC would pay an unearned income Medicare tax of $3,800 (3.8% times the lower net 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, a taxpayer who has both high self-employment income and high investment income may be subject 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 is subject to self-employment tax. Rev. Rul However, certain LLC members may not be 3

25 subject to self-employment tax on their distributive share if they would be considered limited partners under state law and if the LLC were a limited partnership instead of an LLC. Prop. Treas. Reg (a)-18. Otherwise, those members who are involved in the management of the business will be treated as general partners for purposes of the self-employment tax. Prop. Treas. Reg (a)-18. B. Partnerships. A partnership is defined in 6(1) of the Uniform Partnership Act as an association of two or more 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 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 , C.B 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 The federal income tax law does not specifically 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 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 General Partners. A general partner in a general or limited partnership conducting a trade or business pays selfemployment tax on the guaranteed payments he receives from the partnership as well as his distributive share of the partnership s income and loss, regardless of whether some of the income is a return on capital contributed. IRC 1402(a). Pursuant to IRC 707(c), guaranteed payments are payments made by the partnership to partners for services rendered to the partnership or for the use of capital, without regard to the partnership's income. Guaranteed payments are considered to be made to a recipient who may or may not be a member of the partnership. 2. Limited Partners Of Limited Partnerships. Section 1402(a)(13) of the Internal Revenue Code excludes from net earnings from selfemployment (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 services actually rendered to or on behalf of the partnership to the extent that those payments are established to be in the nature of remuneration for those services. Unfortunately, Congress failed 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 it applies to LLCs. See Prop. Treas. Regs (a)-18 (issued December 29, 1994), replaced by 4

26 Prop. Treas. Regs (a)-2 (issued January 13, 1997). In 2003, an IRS official stated that if taxpayers conform to the 1997 Proposed Regulations, then the IRS generally will not challenge the 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 even though the regulations have never been finalized. The 1997 proposed regulations apply to all business organizations taxed as partnerships. The Taxpayer Relief Act of 1997 placed a 12-month moratorium on the issuance of final regulations dealing with self-employment income tax until after June 30, Pub. L. No , 935, 111 Stat None have ever been issued. Under the 1997 proposed regulations, which replaced the first, if a membermanager of an LLC (but not LLP) has two distinct interests in the LLC, the member could have two types of income Prop. Treas. Regs (a)- 2(h)(3). The use of a limited partnership or S corporation provides more certainty when it is desired to avoid self-employment income tax. Confronted with the lack of authority on this issue, some tax practitioners have taken the position that all partners in a tax partnership, who are limited partners or partners/members in an LLP 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 net income from self-employment largely depends on whether the partner is a general partner or a limited partner. This raises questions about the appropriate treatment for owners of LLCs and LLPs. Should an owner of an LLC or LLP be treated as a general partner with the consequence that the owner's entire distributive share of LLC income or loss will be treated as selfemployment income? Alternatively, should an owner, due to state law limited liability, be treated as a limited partner with the consequence that the owner's entire distributive share of LLC or LLP income or loss will be treated as excluded from self-employment income unless it constitutes a guaranteed payment? In contrast to general and limited partnerships where at least one partner will have personal liability, 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 net earnings from self-employment for SECA tax purposes should be based on an examination of the role of each individual owner. 1. IRS Ruling Position. PLRs and both involved law firms converting from general partnership to LLC status, with all members of each entity actively performing services and managing the business both before and after the conversion. PLR ruled that nonvoting members of a professional LLC law firm actively engaged in the practice of law who receive compensation guaranteed payments in exchange for services are subject to self-employment tax on that income. 5

27 In PLR , a group of physicians changed their general partnership to an LLC with all of the doctors continuing to provide substantial services and to participate in the daily activities of the business. The Service ruled in all three cases that the LLC members did not qualify for the Section 1402(a)(13) exemption from self-employment tax. Although the Service did not provide any reasoning for its conclusions in PLRs and , PLR was based on: (1) the fact 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 significant services for the LLC and participation in its daily business activities. The service reasoned that Reg (a)-2(f) provides that in determining net earnings from self-employment, a partnership is one which is recognized as such for income tax purposes. Therefore, the classification of the LLC as a partnership under section 7701 means that the members will be partners for SECA tax purposes. In addition, the members' are not limited partners and their distributive 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 each member's net earnings from self-employment. The Service also noted that 1402(b) provides that self-employment income means the net earnings from self-employment of an individual during any taxable year. Section 1402(a) provides that the term net earnings from selfemployment means the gross income derived by an individual from any trade or business carried on by such individual, less the deductions allowed by this subtitle which are attributable to such trade or business, plus his or her distributive share (whether or not distributed) of income or loss described in section 702(a)(8) from any trade or business carried on by a partnership of which he or she is a member. Section 1402(a)(13) provides that there shall be excluded from net earnings from self-employment the distributive share of any item of income or loss of a limited partner, as such, other than guaranteed payments under 707(c) to that partner for services rendered to or on behalf of the partnership where those payments are remuneration for those services. Similarly, PLR ruled that an active member in an accounting firm LLP who carries management rights and actively participates in the accounting business of the firm will have NEFSE on his entire distributive share of income from the firm, and that none of his income will be excluded under 1402(a)(13) as payments to a limited partner. This indicates that an active member of an LLP (which is treated as a general partnership for state law purposes) is neither a limited partner nor treated as a limited partner for purposes of See Shop Talk, "Are Retirement 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 that Congress did not intend for active service partners, such as the LLP partners, to be exempt from self-employment taxes. Specifically, the court referred to the partners' minimal LLP capital contributions in exchange for their interests in LLP as indicating that the partners' distributive share of income arose from the legal services performed on behalf of LLP and "not... as a return on the partners' investments and... not [as] 'earnings which are basically of an investment nature.'" (citing the Section 1402(a)(13) legislative history). Additionally, Renkemeyer indicated 6

28 that the same rationale could be applied to prevent members of an LLC from qualifying as Section 1402(a)(13) limited partners. The same considerations will apply to an LLP as to an LLC. The partners of a service provider established 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 received in respect of their services. Renkemeyer, Campbell & Weaver, LLP v. CIR, 136 T.C. No. 7, 2011 WL (2011). The LLP partners could not avail themselves of the exemption from SECA for nonguaranteed service payments to limited partners. State law entity and limited liability classifications did not shield owners from SECA tax. The three partners produced the bulk of the law firm's revenues in their capacities as law firm partners. They each contributed a nominal amount ($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' investment and were not "earnings which are basically of an investment nature." Instead, the attorney partners' 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) the special allocation of the LLP s (a law firm treated as a partnership for federal income tax purposes) distributive share of income to its partners and (2) the treatment of the LLP distributive share allocations of business income to its service partners (law partners) as being exempt from SECA tax. After ruling in favor of the IRS on the allocation issue because the petitioner could not produce a partnership agreement supporting the challenged special partnership allocations, the court turned to the SECA tax issue. The LLP partners argued that the limited partner exemption should apply because (1) the LLP organizational documents designated their interests as limited partnership interests and (2) they enjoyed limited liability under state law. The Tax Court disagreed, reaching the result that would have been required under the 1997 temporary regulations. Noting that Congress passed the limited partner exemption prior to the state law advent of LLPs and LLCs, the court reviewed the exemption s legislative history and determined that the impetus for the exemption was not a limited partner s individual protection from the partnership s liabilities, but instead its status as a non-service investment partner in a traditional limited partnership. The court ruled that the partners distributive shares were subject to the self-employment tax because the law firm s fees were part of the partners 702(a)(8) distributive share and the partners did not constitute limited partners. Therefore, the exception to self-employment tax for limited 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 the phrase, the history of the regulatory interpretation of the exception, and the legislative history of the exception. The court stated that the legislative history provides that limited partners of a limited partnership are akin to passive investors in that they lack management powers and their distributive shares arise as a return on invested capital and constitute investment-type earnings. In contrast, the three law partners of the LLP enjoyed limited liability protection, had management powers and performed services that generated the LLP s income. Accordingly, the court concluded that the investment partners of the LLP were not the same as limited partners. 7

29 Renkemeyer demonstrates that service providers to tax partnerships (including LLCs and LLPs taxed as partnerships) in which they are equity partners have self-employment income subject to SECA 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 partners and that members of entities treated as partnerships for federal income tax purposes (passthrough entities) are subject to an "all-or-nothing" approach. Under this approach, the performance of services for an entity will subject the service-providing partner s entire distributive share to the self-employment tax, regardless of whether such partner has invested capital in the entity or not Proposed Regulations & LLCs and LLPs. State law distinctions between limited partners, general partners, and members of limited liability companies do not have any effect on the manner in which a partner would be taxed for purposes of SECA under the 1997 proposed regulations. Where substantially all of the activities of a partnership involved the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, or consulting, the1997 proposed regulations provide that any individual providing more than a de minimis amount of services to or on behalf of the partnership would not be treated as a limited partner. The 1997 proposed regulations contain three functional tests that apply to all unincorporated non-service organizations taxed as partnerships, namely, general partnerships, limited partnerships (LPs), LLLPs, LLPs, and LLCs and permit interests owned by an individual to be those 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 the following three tests: (1) the liability test (whether the owner has personal liability under state law for the obligations of the business); (2) the management test (whether the owner has authority to make contracts on behalf of the business); or (3) the participation test (whether the owner participates in the business for more than 500 hours in a year). However, notwithstanding satisfaction of these tests, a separate superimposed rule provides that a service partner (subject to a de minimis exclusion) in a service partnership may never be considered a limited partner. See 1997 Prop. Reg (a)-2(h)(5). The three functional tests clarify when the distributive share of an entity's non-managing members of non-service entities will not be subject to the self-employment tax. The distributive share of an LLP's partner will likely always be subject to self-employment tax regardless of the degree 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 owner will be considered a limited partner for purposes of the SECA tax. Under the functional tests, any owner 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 be considered a limited partner for purposes of the SECA tax. Finally, in some entities, there may not be any limited partner not subject to the SECA tax. For example, since all partners in general 8

30 partnerships and LLPs have either actual or apparent authority to make contracts for the partnership, no partner of an LLP will be considered a limited partner under the functional test of the 1997 Regulations. In order meet the liability test and be liable for the SECA tax, an owner must be personally liable for partnership obligations and the personal liability must be created by state law imposing liability solely due to being an owner Prop. Reg (a)-2(h)(2)(i). Owner liability for an 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 the partnership as determined by the law where formed Prop. Reg (a)-2(h)(2)(ii) states: Has authority (under the law of the jurisdiction in which the partnership is formed) to contract 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 (a)-2(h)(2)(iii). Persons desiring to qualify as functional limited partners under the three functional tests should be careful to document that they devoted no more than 500 hours to the business activities of the partnership. Additionally, they should avoid dealing with third parties on behalf of the entity or its activities to avoid the possibility that they will have apparent authority to represent the business. 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 the potential second class of functional limited partner interests. Therefore, unlike a single member S corporations, the sole member of a single member LLC cannot under these proposed regulations avoid the SECA tax on any of the company's income, regardless of whether the company 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 functional limited partner because of the retention of the statutory power to bind the LLC. Since this power cannot be divested by the private operating agreement among the members, such members can never qualify as functional limited partners even if they otherwise satisfy the liability and participation tests. In addition, as discussed below, the dreaded retention of statutory apparent authority to represent the LLC also means that the second class exception will never apply to a member-managed LLC because, no matter that different rights are created in different classes of interests, each class will always possess such statutory apparent authority under the 1997 Regulations. Manager Managed. Members who are also not managers can be functional limited partners if they do not participate in the business for over 500 hours per year and the company is not a service LLC. Any guaranteed payment for services received by the non-managing member will, however, be subject to the SECA tax. A guaranteed payment is one determined without regard to the net income of the partnership. Rev. Rul No one need guaranty the 1 The term guaranteed payment encompasses more than just salary payments made to partners. It includes certain payments made to a partner for the use of capital and these payments are similar to interest. A guaranteed payment is deducted in the computation of partnership income if it is ordinary and reasonable under IRC section 162. A guaranteed payment is an amount paid to a partner that is determined without regard to the partnership 9

31 payment. A payment for services is a guaranteed payment because it is paid regardless of whether the entity has net income. Manager Managed. Managers of a manager-managed LLC cannot be functional limited partners because of their statutory authority to bind the company. Thus, their distributive shares and all guaranteed payments to them are subject to the SECA tax. Bifurcated Interests; Manager Limited Partner Interests. If (1) the manager also owns a nonmanaging interest in the same company and (2) other members who are functional limited partners own at least 80 percent of that class of interest, then the manager can avoid SECA tax on 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 on any partnership income from its trade or business. Regardless of the number of classes of interests held by such a member (and the authority rights that attend those interests), there can be no other members without statutory apparent authority who may qualify as functional limited partners 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, or participation tests, the 1997 proposed regulations contain a second or multiple class exception that provides a method whereby an owner not considered a functional limited partner may nevertheless attempt to avoid SECA tax on a portion of that owner's distributive share of income for non-service entities. The owner may do so only with regard to that portion of distributable income properly allocable to a second class of ownership interest meeting several tests. See Prop. Reg (a)-2(h)(6)(i): 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. An individual who is a service partner in a service partnership may not be a limited partner under this separate class exception. See Prop. Reg (a)-2(h)(6). The four second/multiple class exception requirements are as follows: The separate ownership interest must be considered a second class [Prop. Reg (a)-2(h)(3) (first sentence), (a)-2(h)(6)(i)]; That second class must be owned at least in part by others who are considered functional limited partners (i.e., those satisfying the three functional liability, management, and participation tests) [Prop. Reg (a)-2(h)(3)(i)]; Functional limited partners must own at least a substantial and continuing interest in the second class, which 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. [Prop. Reg (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 as an 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 payments per IRC 707(c) (if not based on partnership income). See IRS publication Partnerships Audit Technique Guide (ATG) (Sept. 2002). 10

32 The multiple class owner's rights and obligations with respect to the second class must be identical to the rights and obligations of the other functional limited partners in the second class (excluding the mere receipt of a guaranteed payment). See Prop. Reg (a)-2(h)(3)(ii). Under the proposed regulations, a second class of ownership exists when all the owners' rights and obligations are not identical. Any difference, no matter how small, in ownership rights and obligations creates a second class. See Prop. Reg (a)-2(h)(6)(i). For example, even though all LLC and LLP owners share a common owner liability shield, two classes of ownership interest will exist where state law vests contractual authority in some but not all owners. In manager-managed LLCs, two classes of interests are created by a statutory management designation of managers and members. The different management rights create two separate interests. In member-managed LLCs and LLPs, different rights must arise by contract rather than statute through the operating or partnership agreement other than management rights because all owners will have apparent authority. Thus, that class must have attributes other than management rights in order to satisfy the second/multiple class exception. The second/multiple class also must be owned in part by persons considered functional limited partners. Prop. Reg (a)-2(h)(3)(i). At least one owner (excluding multiple owners not treated 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 limited partners) must own a substantial and continuing interest in the second class. Prop. Reg (a)-2(h)(3)(i). Continuing is not defined term but substantial includes a safe harbor test of 20 percent or more of the second class. Prop. Reg (a)-2(h)(6)(iv). Thus, in order to satisfy the safe harbor standard, functional limited partners (excluding second/multiple class owners) must own at least 20 percent of the second class. Stated another way, second/multiple class owners not considered functional limited partners may not own more than 80 percent of the second class. Additionally, a second/multiple class owner's (not considered a functional limited partner) ownership rights in the second class must be identical to those owned by the functional limited partners in the same class. Prop. Reg (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 by creating different management rights in an operating agreement because they will have apparent authority and thus will not have any functional limited partners and that second class cannot satisfy 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 unless they participate in the business for more than 500 hours per year. The income attributable to their non-manager interest is not subject to the SECA tax although any guaranteed payment remains subject to the tax. Material participation exception. Manager-members of a manager-managed LLC can never be functional limited partners because of their statutory management authority. Consequently, all income attributable to that interest, as well as any guaranteed payments, is subject to the SECA 11

33 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 limited partners, and (ii) own at least 20 percent of the aggregate class of non-manager interests, a manager's income attributable to that qualifying second class of interest may avoid the SECA tax. Generally, an owner who participates in an entity's business for more than 500 hours in a taxable year cannot be considered a functional limited partner because of the failure of the participation test. However, a participating partner may nevertheless qualify as a limited partner if the following four tests are satisfied: (1) the partner is not considered a functional limited partner only because of failing the participation test; (2) there are other functional limited partners satisfying the three functional tests (including the participation test); (3) the functional limited partners (excluding the participating partner) own a substantial (20 percent or more) and continuing interest in the same class of partnership interest; and (4) the participating partner's rights and obligations with respect to the class are identical to the rights and obligations of the other functional limited partners in the same class (excluding the mere receipt of a guaranteed payment). Thus, a non-manager member in a manager-managed LLC receiving a guaranteed payment for more than 500 hours of service (i.e., a participating member) is subject to the SECA tax on all of the guaranteed payments and also the trade or business income attributable to the member's ownership interest. However, where the company also has functional limited partners (nonmanager members not providing in excess of 500 hours of service) that own at least 20 percent of those interests, the participating member may nevertheless avoid the SECA tax on the company income attributable to the ownership interest. This flexibility permits some of nonmanager 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 the authority to bind the LLC and participation tests. Nevertheless, this does not prevent the manager from qualifying a second class under the second/multiple class exception discussed above for the benefit of another participating member. Generally, this requires that the allocation be consistent with the underlying economic arrangements of the members, and that the nontax economic effect of the allocation be substantial. An allocation will be considered to have an economic effect if the LLC maintains its book capital accounts in accordance with IRC 704(b), makes distributions in accordance with positive capital accounts, and requires LLC members to restore deficits in their capital accounts upon liquidation of their interest. The economic effect of the allocation will be considered substantial if a reasonable possibility exists that the allocation will significantly change the income 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 benefit partners in an LLP because there are no functional limited partners because there are no partners who lack apparent authority. Consequently, all LLPs will be treated exactly like general partnerships even though no partner is personally liable for any partnership obligation and some partners may not actively participate in management. Unlike LLCs, however, the traditional involvement of an LLP in the provision of services would likely prevent these partnerships from 12

34 qualifying anyway, at least with regard to all partners providing more than a de minimis amount of services. As a result, the draconian residual results of applying the functional limited partner test 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 create a second class of ownership interest. Prop. Reg (a)-2(h)(6)(i) (last sentence). Accordingly, an owner receiving a guaranteed payment for less than 500 hours of service to the entity (to satisfy the participation test and who satisfies the remaining liability and authority tests) may be considered a functional limited partner. Thus, the receipt of a guaranteed payment for less than 500 hours of service will not prevent a non-manager-member of a manager-managed LLC from avoiding the SECA tax on the income attributable 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 in qualifying any second member s interests as a second class, provided the functional limited partner owns, along with other functional limited partners, at least 20 percent of the class. The second/multiple class owner will not violate the identical rights clause of the second class requirement because of the presence of a guaranteed payment. Additionally, the manager s receipt of a guaranteed payment does not disqualify the manager from owning a second class of interest. (iv) Service Partnerships. A service partner in a service partnership is prohibited from becoming a functional limited partner under the functional tests or any one of the discussed exceptions. Prop. Reg (a)- 2(h)(5). A service partnership is one in which substantially all the activities involve the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, or consulting. Prop. Reg (a)-2(h)(6)(iii). However, a person is not a service partner if the person provides only a de minimis amount of services. Prop. Reg (a)-2(h)(6)(ii). It is not clear whether the de minimis rule applies on an annual basis. In the unlikely event that it does, the provision of more than a de minimis amount of services in one year would permanently make the partner a service partner. Nevertheless, persons performing more than a mere de minimis amount of services can take advantage of the SECA tax exclusions by using two or more entities. For example, a second entity could own and lease equipment or real estate. All separate entity activities should be supported by a separate business purpose and contain arm's-length economic arrangements to avoid a substance over form application of the de minimis exception. Because LLP partners and member-managed LLC members can never avoid the SECA tax on any trade or business income, the benefit from application of this service rule will be to those manager-managed LLCs involved in the provision of services. However, non-manager members providing more than a de minimis amount of services will not be able to avoid the SECA tax on income attributable to their ownership interest. Under the functional limited partner rules discussed above, they could provide up to 500 hours of service (expanded under the participation exception) and still avoid the SECA tax. However, where the LLC is a service LLC, these members will be subject to the SECA tax on their entire share of company income. The only way 13

35 such a member in a service company may avoid the SECA tax is to provide no more than a de minimis 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 family members, provided that the overall allocation of income has a substantial economic effect and satisfies the requirements of IRC 704(b). This strategy has the advantage of providing non SE income to one spouse and also spreading income across tax rates when children or other family members are in lower tax brackets. Any allocation of income to the members of the LLC must have a substantial economic effect and satisfy the requirements of IRC 704(b) for it to be respected by the IRS. D. LLLPs. A limited liability limited partnership (LLLP) is a limited partnership which registers with the secretary of state as an LLLP. The effect of registration is to limit the vicarious liability of the general partners in the same fashion that registration as an LLP limits the liability of the general partners of a general partnership. Income from an investment LLLP, an entity permitted in many but not all states, would not be subject to SE tax except for any payments for services. The ethical rules 2 now permit operating businesses, including professional practices, to use the LLLP form where permitted by state law. 3 2 Over forty years ago, in the ABA's Committee on Ethics and Professional Responsibility informally opined that law practice could not be conducted in limited partnership format. However, ABA Formal Opinion (8/2/96) issued by the ABA's Ethics Committee reversed its 1965 position, and concluded that the Model Rules of Professional Conduct permit lawyers to practice in an LLP or LLLP if the applicable law provides that the lawyer rendering legal services remains personally liable to the client, the requirements of the law of the relevant jurisdiction are met, and the form of business organization is accurately described by the lawyers in their communications. The ABA Formal Opinion makes no reference to the Committee's prior informal opinions to the contrary prohibiting practice in limited partnership form. 1 Opinion assumes there is compliance with applicable state statutes and other controlling law, and does not purport to indicate appropriate choice of law rules involving multi-jurisdictional law firms. The ABA Opinion states that a requirement of any ethically permissible business form for lawyers is that the lawyer rendering the legal services to the client must be personally responsible to the client. The Opinion states the understanding that all of the LLP and LLLP laws (then enacted) of the various states meet this requirement. The ABA Opinion concludes that lawyers can avail themselves of the LLP (or LLLP) business form without that constituting an agreement with a client prospectively limiting the lawyer's liability to a client for malpractice within the scope of Model Rule 1.8, because LLPs and LLLPs do not insulate a lawyer from liability for his own negligence. Rather, the limitation on vicarious liability created by LLPs and LLLPs derives solely from state law, not from an agreement between a lawyer and his client. Notwithstanding the green light given by the ABA Opinion, law firm and other professional LLLPs and limited 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

36 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 "limited partner" are not. "Partnerships" and "partners" are included in Section 761 and Reg by reference to the Regulations under Section Section 7701(a) defines "partner" to include a member in a syndicate, group, pool, joint venture or other unincorporated organization. Self Employment Income. Payments to general partners in an LLLP operating a trade or business 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 selfemployment (NEFSE)? Section 1402(a)(13) provides that the distributive share of any item of income or loss of a limited partner is excluded from the computation of NEFSE, other than guaranteed payments for services to the limited partner. If so, the professionals who are limited partners in an LLLP would not pay SE taxes on their distributive share of partnership income and those amounts would not be eligible for retirement plan contributions, eliminating social security and 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 of whether a limited partnership's trade or business is imputed to "active" limited partners is not settled. Butler v. CIR, 36 TC 1097 (1961), acq., held that a lawyer who was an "active" limited partner in a business limited partnership could deduct his unpaid loan to the LP as a business bad debt. Imputation to "active" limited partners in a professional service LLLP would seem to be similarly appropriate. However, TAM held that the partnership's trade or business should not be imputed to limited partners, but only to general partners, in connection with the attempted deduction of legal fees incurred by a limited partner in a lawsuit against the general partner, thereby resulting in a Section 212 itemized deduction rather than a Section 162 above-the-line deduction. The Service limited Butler to its facts because Butler was more than a passive investor he was a key member 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 a service LLP, and thus imputation of trade or business status may be appropriate, even under TAM The approach of the proposed 1997 regulations is likely to prevail more than a de minimis amounts of services will result in self-employment income and the payments are likely to be classified as guaranteed payments as payments for services. E. Lifetime Retirement Payments To Retired General Partner Or LLC Managing/Manager Member. 1. General Rule. 3 Where permitted, existing pass-through entities except S corporations could convert without tax liability. Rev. Rul 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 particular form used to convert the general partnership into an LLC did not affect the tax consequences (effectively, permitting the substance of the conversion to control over the form). Similarly, Rev. Rul ruled that the registration of a general partnership as an LLP pursuant to that state's law was a Section 721 transaction based on Rev. Rul and Rev. Rul There appears to be no reason why the IRS would not apply a similar favorable Section 721 analysis to conversions into LLLPs. 15

37 This 1402(a)(10) exclusion from SECA is not available to severance payments to shareholderemployees of corporations or limited partners. Under IRC 1402(a)(10) and Reg (a)- 17(c)(1), exclusion of payments to general partners from self employment tax is an all-ornothing proposition as to whether payments on account of retirement received by a retired partner during the tax year of the partnership are excluded. A general partner can exclude from NEFSE (income subject to self-employment tax) amounts received if the requirements of IRC 1402(a)(10) and Reg (a)-17 are met, namely: The payments must be received by the partner pursuant to a written plan of the partnership. The payments must be made on account of retirement, on a periodic basis, to partners generally or to a class or classes of partners, with the payments continuing at least until the partner's death. These payments can be front loaded. See PLR , where most of the payments were made in the first 5 years after retirement and $100 a year thereafter. The partner must render no services with respect to any trade or business carried on by the partnership during the tax year of the partnership in which the amounts were received. No obligation may exist as of the close of the partnership's tax year from the other partners to the retired partner except with respect to retirement payments under the plan. The partner's share, if any, of the capital of the partnership must have been repaid in full before the close of the partnership's tax year in which such amounts were received. The retired partner must have no financial interest in the partnership except for the right to retirement payments. If payments are not made to the retired partner on a periodic basis that continue at least until the partner's death but rather terminate after a fixed number of years, the former general partner will include the retirement payments in NEFSE. If the partner has a right to a fixed percentage of any amounts collected by the partnership after the date of retirement that are attributable to services rendered prior to her retirement to clients of the partnership, the payments received by her for that tax year are not excluded from NEFSE since, as of the close of the partnership's tax year, an obligation (other than an obligation with respect to retirement payments) exists from the other partners to the retired partner. See Reg (a)-17(c)(2), Example (3). 2. LLP General Partner Qualifies. PLR holds that payments made on account of a retired partner of an LLP that meet the requirements of 1402(a)(10) will be excluded from NEFSE. 16

38 3. LLC Member Qualifies. PLR ruled that 1402(a)(10) relief is available for payments to an attorney who was a retired member of an LLC classified as a partnership for federal income tax purposes. The LLC maintained 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 retired partner relinquishes her interest in the LLC, in exchange for the balance of her capital account in the firm, the retirement benefits under the nonqualified retirement program, and other benefits payable under the firm's benefit plans. The retired partner is entitled to a retirement payment equal to the sum of the average of the partner's three highest distributions for any previous calendar year. The amount is paid out, without interest, in a series of monthly payments for a period of not less than 60 and not more than 120 months. Thereafter, the retired partner is entitled 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 (a)-17, PLR concludes 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 connection with the requirement that the payments by a partnership must continue at least until the partner's death, the ruling observes that although the payments by the LLC are likely to be reduced after the initial month period, the monthly payments thereafter will never fall below $100 per month and will continue until the retired partner's death. The letter ruling is consistent with the Service's position (in earlier letter rulings) involving redemptions of general partners in a general partnership agreement in not requiring level, equal amounts of retirement benefit payments throughout the retired partner's lifetime. A step-down in the amount is permissible as long as the payments 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 of income 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 the extent 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 serious risk of unlimited personal liability for partnership obligations, pursuant to the Revised Uniform Limited Partnership Act) and receives 707(c) guaranteed payments for services determined without regard to partnership income has NEFSE. Any remaining share of income as a limited partner will not be NEFSE. See Code 1402(a)(13); Reg. 1402(a)-1(b). Moreover, if the limited partner does not receive a 707(c) payment, i.e., does not receive compensation determined "without regard to partnership income," but rather merely receives her distributive share of income (e.g., a percentage of net profits) for services, no portion of those payments constitutes NEFSE. Prop. Reg (a)-2 does not permit a service partner in a service partnership to be a "limited partner" for purposes of 1402(a)(13). See 1997 Prop. Reg (a)-2(h)(5). If this proposed 17

39 rule were followed, the pre-retirement payments to such a limited partner would be NEFSE. No cases, 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 from the S corporation or retirement plan contributions. IRC 1402(a)(2). Wages paid by the S corporation to a shareholder/employee are subject to the customary payroll taxes, and the S corporation must pay the employer's share of those taxes. The S corporation determines its tax attributes at the entity level and then allocates them among its shareholders. The S corporation has less flexibility in allocating than the multi-member LLC because the S corporation must allocate tax attributes equally to each share. The S corporation reports its income, expenses, and tax attributes on information return Form 1120-S and provides each owner with a Schedule K-1 showing that owner s allocation of the entity s tax attributes. The owner of an S corporation receives 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 reasonable compensation is subject to Social Security and Medicare taxes in the same way as C corporation employees are taxed. The corporation's portion is deductible and the employee's portion is withhold and paid over to the IRS by the corporation. The shareholder-employee of an S corporation 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. For example, S corporation employees/shareholders can avoid the impact of Social Security and Medicare taxes by receiving both compensation and dividend income from the S corporation. Unless recharacterized as compensation, dividend income is not wages or self-employment income 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 that shareholder-employees of S corporations do not pay SE tax but rather are subject to the withholding requirements for income and payroll taxes. The benefit of the S corporation is: The ability for high income shareholder employees, active in business, to receive dividends not subject to Medicare tax from distributions from business as opposed to investment income. Such distributions are exempt from the new Medicare tax after 2012 on business income paid as a distribution (dividend) but not on investment income paid as a distribution. There is no Medicare tax for owners on employer s retirement plan contributions (applies for shareholder-employees of C corporations also). 2. C Corporations. a. Taxation As Separate & Not A Pass-Through Entity. 18

40 Regular "C" corporations are taxed separately from their shareholders under subchapter C of the Internal Revenue Code. Any reasonable salary and bonus is deductible as a business expense to the C-Corporation. Also, if the C corporation distributes dividends to the shareholders, the dividends are taxed at a special "qualified dividends" tax rate of 15% to the shareholder and are not deductible to the corporation. Thus, dividends from a C corporation are taxed twice, once at the corporate level and again at the shareholder level. Since the corporation has already paid tax on its earnings, this distribution qualifies as a "qualified dividend" to a shareholder and is taxed at the lower 15% tax rate. C corporations are the only business type that can split profits between retained earnings and dividends. S corporations and partnerships must report all profits as a distribution, even if the business has retained some of the cash for next year's operating expenses. The ability to choose when and how much you are taxed by controlling when and how much money is distributed is a crucial tax advantage for C corporations. This means that there is more flexibility with a C corporation 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 and social security (FICA) withholding. Income tax withholding means that the principal receives lower take-home pay and makes monthly instead of quarterly payments on income and social security taxes. The only loss from income tax withholding is the short term interest on the first two 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 of 15.3%. The 1.45% Medicare tax on pay in excess of the taxable wage base is also paid by the employer and employee. The employer s portion is income tax deductible. For those taxed as sole proprietors and partners, the self-employment tax is 15.3% up to the taxable wage base and 2.9% above the wage base, half of which is deductible, so it is comparable to the corporate FICA and 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 income over $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 to shareholders, thereby creating portfolio income as well as savings on social security and Medicare taxes. A C corporation need not pay dividends, except as necessary to avoid the accumulated earnings tax of I.R.C or the personal holding company tax of I.R.C II. SPECIALPARTNERSHIP ISSUES; DUAL STATUS WORKERS & SPOUSES; FARMING; RETIREMENT PLAN COMPENSATION. A. Partnerships. 19

41 1. Individuals Working In Different Capacities. For federal tax purposes, one cannot be both a partner and a common law employee of the same entity at the same time. The IRS has stated this position in Revenue Ruling and solidified that position in other rulings. See, e.g., IRS Legal Memorandum Thus, income from a partnership paid to a general partner (or member of an LLC taxed as a general partner) engaged in trade or business is all self-employment income, except to the extent that this income consists of dividends, interest, capital gains, real estate rentals, or shares of limited partnership income. Norwood v. CIR., T.C. Memo held where a general partnership interest that was subject to self-employment tax, it was irrelevant how much time petitioner devoted to the activity. Likewise, Treasury Regulations Section (c) specifically provides that guaranteed payments cannot be wages, and Reg (a)(13) provides that guaranteed payments to a partner are subject to self-employment tax, even when such payments are made to a limited partner. One technique used by pass-through organizations is to separate their capital and their services into two or more separate entities. In appropriate situations, this can also help accomplish other income tax and estate planning goals. Thus, the equipment and premises used in the activity can be owned by an investment entity and leased to the operating entity. See Edwin D. Davis v. CIR, 64 T.C (1975).] This type of structure should allow the profit of the separate entities to escape self-employment tax. Treasury Regulations Section (c) specifically provides that guaranteed payments are not wages, and Treasury Regulations Section 1.402(a)(13) provides that guaranteed payments to a partner are subject to self-employment tax, even when such payments are made to a limited partner. Other income paid to a limited partner is not self-employment income. IRC 1402(A)(13). An individual working for a corporation or partnership who is not a partner or self-employed can be classified as an employee with respect to one type of service and compensation and as an independent contractor with respect to another type of service and compensation. The IRS Office of the Chief Counsel has advised that because the determination as to whether a worker is an employee or an independent contractor depends on the facts and circumstances of the particular case, it is not possible to provide an across-the-board answer as to which is the proper form on which all of a worker's compensation should be reported. See CCM Spouses. a. Non-Community Property States; 761(f) Election Eliminates Need To File Form 1065 For Joint Ventures Each spouse's share of income or loss from a qualified joint venture is taken into account in determining the spouse's net earnings from self-employment. IRC 1402(a)(17). A joint venture is an undertaking of a business activity by two or more persons where the parties involved agree to share in the profits and loss of the activity. The Internal Revenue Code defines a partnership in a negative manner by describing what is not a partnership. I.R.C. 761(a) and 7701(a)(2). 20

42 A business jointly owned and operated by a married couple, in which both spouses materially participate, is treated as a partnership for federal tax purposes, and the spouses must comply with filing and recordkeeping requirements imposed on partnerships and their partners. See the instructions to IRS Form 1065, where IRS states: Generally, if you and your spouse jointly own and operate an unincorporated business and share in the profits and losses, you are partners in a partnership and you must file a Form However, married co-owners can elect to reporting on a Schedule C, C-EZ or F as well as a separate Schedule SE in the name of each spouse and avoid filing a partnership return. This election permits certain married co-owners to avoid filing partnership returns if each spouse separately reports a share of all of the businesses' items of income, gain, loss, deduction, and credit. Under the election, both spouses will receive credit for social security and Medicare coverage purposes. See IRC 761(f). Section 1402(a)(16) providing that if a taxpayer makes an election to be treated as a qualified joint venture, each spouse's share of the income or loss is to be 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, the election 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 an S or C corporation. The IRS has stated, informally, that no final Form 1065 need be filed where the QJV election is made despite the fact that the spouses had previously filed Form That may create issues with computer-generated notices looking for the Form In general, spouses do not need an Employer Identification Number (EIN) for the qualified joint venture where they make the 761(f) election. An EIN is not needed because an EIN is not required 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 should complete a Form SS-4 and request an EIN as a sole proprietor. If the spouses already have an EIN for the partnership, one spouse cannot continue to use that EIN for the qualified joint venture. The EIN must remain with the partnership (and be used by the partnership for any year in which the requirements of a qualified joint venture are not met). If the business has employees, either of the sole proprietor spouses may report and pay the employment taxes due on wages paid to the employees, using the EIN of that spouse's sole proprietorship. If the business already filed Forms 941 or deposited or paid taxes for part of the year under the partnership's EIN, the spouse may be considered the successor employer of the employee for purposes of determining whether the wages have reached the social security and federal unemployment 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 be subject to self-employment tax because it would be included on Schedule C. The IRS resolved this issue by stating that the election does not convert income derived from a rental real estate business normally excluded under IRC section 1402(a) into net earnings subject to selfemployment tax. See Chief Counsel Advice

43 IRC section 761(f)(1)(B) does not indicate how a spouse's ownership interest in a qualified joint venture 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 report merely states the following: "All items of income, gain, loss, deduction, and credit are divided between the spouses in accordance with their respective interests in the venture." As the qualified joint venture is applied, one may discover taxpayers in separate property states attempting to manipulate their respective ownership interests of the joint venture by creating a greater ownership interest in one spouse, to reduce the amount of income subject to tax because of the limit on wages subject to Social Security taxation (2002 report). The Joint Committee on Taxation addressed the issue of manipulation of net earnings and handling as follows: "The new provision is not intended to prevent allocations or reallocations, to the extent permitted under present law, by courts or by the Social Security Administration of net earnings from selfemployment for the purposes of determining Social Security benefits of an individual" [Joint Committee on Taxation, Technical Explanation of the "Small Business and Work Opportunity Tax 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 state law entity, including a general or limited partnership or limited liability company. According to information on IRS's website, the election can be made only for a business operated by spouses as co-owners that is, or should otherwise be, taxed informally as a partnership. See The legislative history of the act, however, makes no mention of a requirement that a qualified joint venture be unorganized and thereby not an organized entity such as a limited liability company (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 many husband-and-wife businesses are conducted out of LLCs to reduce liability exposure. With creative planning, the section 761(f) election may arguably be achieved through a longer route by forming two single-member LLCs, one for each spouse, that are thereby disregarded business entities for federal tax purposes under Treasury Regulations section (a). c. Spousal Business In Community Property States. Spouses in a community property state can elect whether or not to file Form 1065, the partnership return, at their option where they are the sole owners of the partnership or LLC taxed as a partnership. The IRS allows qualified entities composed of community property to be disregarded, which has the same effect as the 761(f) election. See Rev. Proc limiting in its application to wholly owned spousal community property entities to avoid the possibility of income shifting among spouses in separate property states that do not file a joint return. Reg l(a). IRC section 761(f)(1), however, alleviates the concern over income shifting by requiring that both spouses file a joint return in order to qualify for the election. This prevents a spousal business in a separate property state from filing separate returns and dividing their respective ownership interests in the joint venture in such a way that the taxpayer within the 22

44 higher marginal tax bracket owns the smaller percentage of the entity and the taxpayer with the lower 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, but have only one of them be materially participating in the farming operation for self-employment tax purposes? While the active engagement rules for federal farm program purposes are similar to the rules for determining whether income is subject to self-employment tax, their satisfaction does not control the self-employment tax issue. In Vianello v. CIR, T.C. Memo , the taxpayer was a CPA in Kansas City. In 2001, he acquired 200 acres of cropland and pasture approximately 150 miles from his office. At the time of the acquisition, a tenant (pursuant to a lease with the prior owner) had planted the cropland with soybeans. The tenant provided the equipment and labor and deducted the cost of chemicals and fertilizer from total sale proceeds of the bean and pay the landlord one-third of the net amount. The petitioner never personally met the tenant but the parties did agree via telephone to continue the existing lease arrangement for 2002.The tenant made all the decisions with respect to raising and marketing the crop. As for the pasture, the tenant mowed it and maintained the fences. The lease terminated in early 2003, and the petitioner had another party plow under the fall-planted wheat in the spring of 2004 prior to the planting of Bermuda grass. The petitioner bought two tractors in 2002 and a third tractor and hay equipment in The petitioner did not report any Schedule F income for 2002 or 2003 but did claim a Schedule F loss 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 for the years at issue. The petitioner claimed involvement in major management decisions, provided and maintained fences, discussed row crop alternatives, weed maintenance and Bermuda 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 harvest would 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 for 2002 or The tenant paid all the expenses with respect to the 2002 soybean crop, and made all of the cropping decisions. In addition, the court noted that the facts were unclear as to whether the petitioner was responsible under the lease for reimbursing the tenant for input costs in the event of an unprofitable harvest. Importantly, the court noted that the USDA s determination that the petitioner s revocable trust satisfied the active engagement test and was a co-producer with the tenant for farm program eligibility purposes has no bearing on whether petitioner was engaged in such a trade or business 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 , aff d. without published opinion, 189 F.3d 473 (9th Cir. 1999). The court held that the Regulations under I.R.C make it clear that petitioner s efforts do not constitute production or the management of the production as required to meet the material participation standard. Thus, the petitioner was not 23

45 engaged in the trade or business of farming either for either deduction or self-employment tax purposes. The IRS says that, the mere execution of a CRP contract by a taxpayer means that the taxpayer is engaged in the trade or business of farming. IRS Notice ; CCA 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 in self-employment income. The court concluded that their "agreement... required them to perform several ongoing tasks with respect to the land enrolled in the CRP, the very land they already owned and had previously farmed." The Sixth Circuit noted that the taxpayers were required 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 for the use or occupancy of property and therefore were not rentals from real estate excluded from SECA by 1402(a)(1). The Court observed that the essence of the CRP program is to prevent participants from farming enrolled property and to require the participants to perform various activities in connection with the land continuously throughout the life of the contract with the government's access limited to inspections. Id. at 904. Furthermore, the Sixth Circuit looked to the "substance, rather than the form, of the transaction" in determining that the income derived from 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 excludable portion of payments received under certain conservation programs. Revenue Ruling holds that all or a portion of cost sharing payments received under the CRP are eligible for the exclusion from gross income permitted by 126. The ruling also holds that rental payments and incentive payments received under the CRP are not cost sharing payments and therefore are not excludable from gross income. Vianello also indicates that spouses may be able to qualify for separate person status for USDA payments 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 (or contract) requiring material participation on the landlord s part. Mizell v. Com r, T.C. Memo ; Tech. Ach. Memo (May 1, 1996); but see McNamara v. Com r, 236 F.3d 410 (8th Cir. 2000)(self-employment tax not due if fair market rentals charged), nonacquiescence AOD CC (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 an LLC can contribute to a qualified plan on a member's behalf, are reduced by: (1) the actual amount of the contribution made on behalf of the self-employed individual; and (2) the member's tax 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 a member 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 15 percent in the case of corporate employees (see Panel Publishers, The Pension Answer Book). 24

46 In addition, contributions by a corporation to a pension plan on behalf of a shareholder-employee are not subject to FICA or Medicare tax, whereas all of an LLC's member's distributive share of the LLC is subject to self-employment tax FICA (subject to the annual cap) and unlimited Medicare tax. See GCM 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. There is an incentive to avoid paying payroll taxes (FICA and FUTA) that are imposed on wages by paying a low level of compensation to a shareholder-employee. The same factors used in determining reasonable compensation paid by a C-corporation under 162 will also apply in determining 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 to treat salary as excessive if it wishes to reallocate it to another employee (whose compensation may 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 are unreasonably low. If successful, the IRS collections additional FICA and Medicare taxes, plus interest and perhaps penalties. An S Corporation must pay reasonable compensation (subject to employment taxes) to shareholder-employee(s) in return for the services that the employee provides to the corporation before non-wage distributions may be made to that shareholder-employee. Rev. Rul , C. B. 287 involves two shareholders of an S-corporation who were paid no salary for the express purpose of avoiding the FICA and FUTA taxes. Although the Ruling did not address the definition of what constitutes reasonable compensation, it did hold that the payment of no compensation is per se unreasonable where shareholder-employees provide substantial services to 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 (1972), aff d 474 F.2d 1345 (5 th 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 distribution to 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 failure to 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 the taxpayer was bound by its own characterization. 25

47 The issue in S-corporations is the flip side of the situation that occurs when a C-corporation attempts to disguise profit distributions as salaries. There have been several unreasonable compensation cases where the court has recharacterized part or all of a shareholder-employee s dividend 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 (7 th Cir. 1990). see also Spicer Accounting, Inc. v. U.S., 918 F.2d 90 (9 th 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 (9th Cir. April 12, 2006).. In Radtke, Joseph Radtke, an attorney, was the sole shareholder and sole member of the board of directors of the Taxpayer, Joseph Radtke, S.C., which provided legal services. Under an employment contract with his corporation, Mr. Radtke had received an annual base salary for 1982, determined by the corporation s board of directors, of $0 per year; however, Mr. Radtke received $18,225 in dividends that year, on which he paid income taxes. The Service claimed the dividend distribution should be recharacterized as compensation subject to FICA or FUTA taxes. 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 the year 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 and FUTA taxes by characterizing all of his or her remuneration as something other than wages. Id. at Applicability Of 162. The two-part test under 162(a)(1) requires: (1) the amount of the payment must be reasonable in relation to services performed, and (2) the payment is in fact intended as compensation for services rendered. The argument made by the Service in the S-corporation cases where salaries are unreasonably low is that payments distributed ostensibly as dividends are in fact intended to be 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 which the shareholder-employees performed few services on behalf of the corporation and devoted little time to the corporation s activities. See Trucks, Inc. v. U.S., 588 F. Supp. 638, (D.C. Neb. 1984); and Davis v. Commissioner, 64 T.C (1975). On the other hand, many cases have upheld the IRS s conversion of dividend distributions to compensation. Doctor Kenneth K. Sadanaga, DVM, worked full-time for Bristol- Meyers Squibb Co. in the years 1994, 1995, and Sadanaga, a veterinarian, also offered consulting and surgical services to other veterinarians through his S corporation, Veterinary Surgical Consultants P.C. (VSC). VSC did not pay him a salary. Instead, Sadanaga drew money from the VSC bank account "at his discretion." These amounts were treated as "distributions other than dividend distributions paid from accumulated earnings and profits," while Sadanaga reported on Schedule E of his Form 1040 the VSC net income of $83,995.50, $173,030.39, and $161,

48 for, respectively, 1994, 1995, and In Veterinary Surgical Consultants, P.C., v. Commissioner, 117 T.C. No. 14 (2001), aff d (3d Cir. 2002), VSC argued that Sadanaga received distributions of corporate net income, and not wages. This was, said Judge Jacobs, "a subterfuge for reality." Sadanaga performed substantial services for VSC. "Regardless of how an employer chooses to characterize payments made to its employees," he said, "the true analysis is whether the payments represent remuneration for services rendered." VSC argued that Sadanaga paid the maximum FICA tax required by law each year as an employee 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 each employer." VSC was held liable for the employer FICA tax (both the 6.2 percent old age tax and the 1.45 percent health insurance tax on Sadanaga's drawings up to the FICA maximum in each year, and the 1.45 percent health insurance tax on the excess). Sadanaga was likewise liable for the 1.45 percent health insurance tax on the total amount after offsetting his liability for the old age portion of the FICA with the credit for excess FICA as the result of having two employers. VSC was the first case involving the Tax Court's authority under 7436, as amended in December 2000, to deal with employment tax classification issues. Yeagle Drywall Company, Inc. v. Commissioner, T.C. Memo , aff d (3d Cir. 2002) is another case involving the same issue. Like VSC, Yeagle, an S corporation, treated its sole shareholder as a non-employee. Unlike Sadanaga, John Yeagle had no source of income other than his S corporation, and, like Sadanaga, he withdrew amounts from the corporation at his discretion. Yeagle Drywall made the same arguments as VSC as to why its treatment of John Yeagle's payments was proper, also relying on the 530 argument and the same authorities to establish reasonableness. Judge Jacobs's conclusion was the same in favor of the IRS. In Nu-Look Design, TC Memo , the President and sole shareholder paid all corporate earnings as dividends. The court held he performed services and the distributions were really wages paid to an employee. Nu-Look Design, Inc. is one of six Tax Court memorandum opinions on the question of avoidance of the requirement to pay F.I.C.A. and F.U.T.A. where the taxpayers 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 & Delivery Services, Inc., Superior Proside, Inc., Mike J. Graham Trucking, Inc., and Veterinary Surgical Consultants, P.C. (II), all reported at T.C. Memo (Feb. 26, 2003), have several common 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 , 107 AFTR 2d (S.D. Iowa 12/23/10) ruled that the taxpayer must recharacterize a portion of his S corporation dividends as salary and pay additional employment taxes because his compensation was unreasonably low. This is the second S corporation case to hold compensation is unreasonably low 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, this issue will likely become even more important. The health care reform legislation enacted in 27

49 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 partner in 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 Watson argued that the intent of the corporation determines the classification of salary and dividends and that the intent of the corporation is controlling. The IRS argued that the cases cited by Watson should not apply because his salary was purposely set low so that he could avoid paying employment taxes. Watson's living expenses exceeded his salary. In addition, the median salary for new accounting graduates in 2002 and 2003 was slightly below $40,000 for each of those years. Watson was a highly qualified CPA with an advanced degree and 20 years of experience. An IRS compensation expert, Igor Ostrovsky, an IRS general engineer, who offered testimony at trial regarding the fair market value of Watson's accounting services in 2002 and testified that the fair value of Watson's services was $91,044 for each year. The Court concluded that Watson owed employment taxes on the salary of $91,044 for each of 2002 and The Court rejected Watson s argument that the intent of the corporation controls the breakout between 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 tax deduction 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 what courts may consider a fair ratio of salary to total distributions in an S corporation. Watson argued that 10.5 percent to 12 percent of the total distribution from the S corporation could be classified as salary. The IRS viewed 40 percent to 46 percent as an appropriate proportion. It also imposed additional payroll taxes, penalties, and interest. The analysis in these cases is whether the dividend distribution payments are really remuneration for services rendered. This is a facts and circumstances test. The court provided an illustrative list 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) a comparison of salaries paid with the gross income and the net income; (5) the prevailing economic conditions; (6) comparison of salaries with distributions to stockholders; (7) the prevailing rates of compensation for comparable positions in comparable concerns; (8) the salary policy of the taxpayer to all employees; and (9) in the case of small corporations with a limited number 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. It also cited JD & Associates, Ltd. v. United States, No. 3:04-cv-59 (D.N.D. May 19, 2006), where Jeffrey Dahl, the sole shareholder, officer, and director of an S corporation, received an annual salary of $19, in 1997 and $30, for each of 1998 and Dahl received dividends of $47,000 for 1997, $50,000 for 1998 and The IRS determined that Dahl's salary was unreasonably low, and assessed employment taxes, interest, and penalties against the corporation after recharacterizing portions of the dividend payments as wages to Dahl. Applying an Eighth 28

50 Circuit test from Charles Schneider & Co., Inc. v. CIR, 500 F.2d 148, 182 (8th Cir. 1974) to determine whether Dahl's compensation was reasonable, the district court concluded it was not and upheld the tax assessments against the corporation. While the IRS is able to reclassify distributions as wages, it is unclear as to whether they may successfully assert that compensation (and payroll taxes) should have been paid where the corporation did not make distributions to the shareholder for the year. If so, it would seem any affected shareholders would have a wherewithal-to-pay issue and could raise this as a possible defense. IV. SITUATIONS WHERE SECA (SELF-EMPLOYMENT TAX) DOES NOT APPLY TO LLC INCOME; PLANNING OPPORTUNITIES. A. One Class Of Interest. Under the 1997 Proposed Regulations, Prop. Reg (a)-2,which the IRS has indicated it will respect, an individual LLC member is by default treated as a limited partner in a non-service organization unless the individual: has personal liability for the debts of, or claims against, the partnership by reason of being a partner; has authority to contract on behalf of the partnership under the state entity statute pursuant to which the partnership is organized (such as the Utah Revised Limited Liability Company Act); or participates in the partnership's trade or business for more than 500 hours during the taxable year. Even if none of the above tests are met, self-employment income exists if an individual LLC owner performs services as part of the LLC's trade or business if substantially all of the activities of a partnership (or LLC) involve the performance of services in the fields of 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 to bind the LLC to a contract and does not provide more than 500 hours of service per year to the LLC, the member will be taxed as limited partner and will not have self-employment tax obligations on his or her LLC income allocations unless the individual performs services as part of a service LLC or receives guaranteed payments for services without regard to the entity's net income. 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 partnership but 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 no services. A is a functional limited partner and A s distributive share of income or loss is exempt from SECA tax under 1402(a)(13). B and C receive guaranteed payments for personal services in excess of 500 hours for the year. 29

51 B's guaranteed payment is subject to the SECA tax, but the mere presence of the guaranteed payment does not mean that B's distributive share is also subject to the tax. B's guaranteed payment is SE income but B s distributable share is not be subject to the SECA tax because A is a functional limited partner and A owns 20 percent or more of those interests (25 percent), and B is not a functional limited partner solely because of failing the material participation test (e.g., B is not a manager with authority). Prop. Reg (a)-2(i) (Ex. (iii). C also receives a guaranteed payment subject to the SECA tax. C is not a functional limited partner 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 (a)-2(i) (Ex. (iv)). C. Two Classes Of Owners Non-Service LLC; Family Members May Play Prop. Reg (a)-2 presents small business owners with opportunities to reduce their SE tax for non-service businesses Prop. Reg (a)-2 contains no family-attribution rules applicable to spouses, children, or other relatives. This suggests that the Service will not use a related-party concept to disregard a Prop. Reg (a)-(2)(h)(2) partner because of the rule regarding substantial (20% or more) passive partners. Thus, in order to avoid SE tax, there is no 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 an operating agreement that provides for the two required classes of interest, he or she could easily limit the SE tax to the amount of income the members reasonably want to report as selfemployment income. This tax would be assessed on only the portion allocated to those members with 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 $120,000 after deducting a $30,000 guaranteed payment to the managing member. If the manager's general partner 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 is included. Further, if the income were stable, this could equate to a substantial annual tax reduction because of the lower SE tax. The guaranteed payment should be high enough to be construed as reasonable for the services rendered by the members. A standard for reasonable compensation for a similarly employed S corporation shareholder has been established in S corporation cases, but there is no comparable criteria to determine the sufficiency of an LLC guaranteed payment for similar services. Furthermore, the Service does not have substantial support from other authority to recharacterize any portion of investment class earnings as self-employment earnings. Does this mean that selfemployment income that members should report appears is discretionary? Likely not. Tax practitioners should not be overly aggressive in attempting to minimize the amount of LLC income subject to SE tax. The income tax on the LLC income could also be reduced by allocating a portion to family members who are in a lower tax bracket than the other members so long as the family partnership rules are met. D. Separate Equipment & Real Estate Leasing Entities. 30

52 Tax on SE income can be minimized by having a second entity own and lease equipment and real 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 may allow this second class of ownership to avoid SE tax. Whether an affiliate of a member can be used as manager is not clear. When it is not feasible to have the managing member hold dual interests in the LLC and meet the material participation exception, the managing member s SE tax exposure can still be minimized by naming a manager who is not a member. When this strategy is adopted, none of the LLC members would be subject to SE tax on their distributive share 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 be subject to SE tax on this compensation (unless it were an entity not subject to SE tax, such as a corporate affiliate of an LLC member). In this situation, however, the IRS could treat the use of a related-entity manager as a sham transaction unless the management services were provided at arm s length and with a reasonable business purpose. F. Conclusion. These proposed strategies are not without risk, although all are defensible Prop. Reg (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 LLC members on SE tax if the members and the LLC conform to the proposed regulations. That should eliminate penalties from being imposed. Nevertheless, the IRS could, and probably would, challenge any bifurcation of a managing member s income if it lacked a substantial economic effect or was made without regard to the reasonableness of the member s guaranteed payment. See Robucci v. CIR, T.C. Memo (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 for management services may be exempt from self employment tax except to the extent that they are payments for services. However, there should be economic substance to any arrangement for it to 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 personally owned 95% of the LLC and his PC owned 5%. Dr. Robucci 's 95-percent interest in the LLC was divided between a 10-percent general partner interest and an 85-percent limited partner interest attributable to Dr. Robucci 's personal goodwill. Westsphere was a management corporation wholly 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 (January 24, 2011) holds that (1) the new structure of a sole proprietor psychiatrist s practice should be largely disregarded as without substance, (2) the taxpayer 31

53 continues to be taxable as a sole proprietor, and (3) the 6662 substantial understatement penalty applies. This case follows a much different path than numerous earlier cases upholding conversions of sole proprietorships and partnerships into professional corporations. The entities involved were not implemented properly. The court notes that if they had been, the result might have been different. This reminds us of the early PC days, where the IRS was on the attack and successful 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, both typically 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. Robucci stated that he wanted to do what was best from the standpoint of his own personal tax planning and wanted to minimize the amount of taxes he was paying. Mr. Carson recommended the organizational structure described above. That discussion covered structuring Dr. Robucci's practice 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. Carson provide him with a written explanation of the need to form three separate entities. Carson explained orally to Dr. Robucci that the LLC would conduct the practice, that for reasons not made clear to Dr. Robucci, it needed to have two members (Dr. Robucci personally and Robucci P.C.), and that Westsphere would be a business management corporation and not involved in providing patient care. Failure To Implement Mr. Carson's Recommended Organizational Structure Dr. Robucci was the sole shareholder of both corporations. During that same period, Robucci LLC was 95-percent owned by Dr. Robucci and 5-percent owned by Robucci P.C. The court says that Robucci P.C.'s interest was as a limited partner. This seems to be incorrect, as footnote 4 of the decision notes that Reg (b)(1)(i) states that a multimember LLC that does not 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 general partners for Federal tax purposes if it were respected as a two-member entity. Several court decisions hold that LLC members cannot be limited partners, even if they are merely members in a 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 returns as an 85-percent interest as a limited partner and a 10-percent interest as a general partner. While not noted by the court, many cases hold that LLC interests of members in a manager managed LLC are not limited partner interests but rather general partner interests. Carson based his determination of an 85-percent limited partner ownership interest for Dr. Robucci on the value of Dr. Robucci's goodwill and what would be a reasonable rate of return on that goodwill at the time 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 32

54 a provider of medical services and his 85-percent limited partnership interest represented his interest 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 practice to Robucci LLC. Westsphere executed a loan agreement, whereby Dr. R as an "employee" was authorized to borrow money from Westsphere "from time to time" under specified terms and conditions. Dr. Robucci executed an Employee Business Expense Reimbursement Plan, whereby Westsphere agreed to reimburse its employees for all employment related expenses upon submission of the proof of expenditure documentation specified in the plan. Westsphere also adopted a Medical Reimbursement Plan and a Diagnostic Medical Reimbursement Plan. The Operating Agreement of Robucci LLC designated Robucci P.C. as manager but it was not clear whether it was signed. Dr. Robucci had a limited understanding of the need for the entities formed 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 did not have an employment agreement with any of those three entities, nor did any of them have employees 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 he might 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 what services. Dr. Robucci was aware that Westsphere charged management fees to Robucci LLC but he 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 lease agreement 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 any other 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 small portion 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 corporations reported 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 the following distributions to him of "passive" and "nonpassive" income from Robucci LLC: Year Passive Income Nonpassive Income 33

55 2002 $48,153 $5, ,446 6, , ,193 Dr. Robucci's 2004 return reported this $95,143 amount as nonpassive income on Schedule E, although the 2004 Schedule K-1 from Robucci LLC in connection with his 85percent partnership interest lists $95,143 as the distribution attributable to that (passive) interest, and Dr. Robucci's 2004 Schedule SE, Self-Employment Tax, included only $11,193 as net earnings from selfemployment. 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 his taxes, or altogether avoid them, by means which the law permits, cannot be doubted." Directly after that statement, however, the Court added the admonition: "But the question for determination is whether what was done, apart from tax motive, was the thing which the statute intended." Id. In Chisholm v. Commissioner, 79 F.2d 14, 15 (2d Cir. 1935), Judge Learned Hand elaborated upon the Supreme Court's admonition in Gregory, stating: "The question always is whether the transaction 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 entitled to respect as viable business corporations or whether, as in Judge Hand's description of the facts in Gregory, the incorporator's "intent, or purpose, was merely to draught the papers, in fact not to create corporations as the court * * * [understands] that word." Id. In other words, were Robucci P.C. and Westsphere corporations in fact as well as in form; i.e., were they "the thing which the statute intended" when referring to corporations? A corporation will be recognized as a separate taxable entity if (1) the purpose for its formation is the equivalent of business activity or (2) the incorporation is followed by the carrying on of a business by the corporation. Moline Props., Inc. v. Commissioner, 319 U.S. 436, (1943); Achiro v. Commissioner, 77 T.C. 881, 901 (1981). 6 If neither of those requirements is satisfied, the corporation will be disregarded for Federal tax purposes, and all of its income will be attributed to the true earner. Shaw Constr. Co. v. Commissioner, 35 T.C. 1102, (1961), affd. 323 F.2d 316 (9th Cir. 1963); Aldon Homes, Inc. v. Commissioner, 33 T.C. 582, (1959). The Tax Court held that it need not decide the burden of proof issue under 7491(a) because a preponderance of the evidence supports the resolution of that issue. Therefore, resolution of that issue 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). 34

56 Business Purpose Of The Structure. The taxpayers argue that as "managing member" of Robucci LLC, Robucci P.C. "performed oversight and management" services and that Westsphere was established to (1) "provide oversight, and to manage certain overheads and indirect expenses, including employee benefits such 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 argue that the formation of a multimember LLC, including a corporate member, afforded Dr. Robucci superior protection, under Colorado law, against personal liability for acts of Robucci LLC, and that 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 the corporations"; and (3) taxpayers "did not demonstrate that either corporation engaged in any business 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 "managing member" of Robucci LLC, a role not reflected in Robucci P.C.'s articles of incorporation, which state that its "sole purpose" is to practice medicine "through persons licensed to practice medicine" 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 mean that it performed any function that would warrant its recognition as an entity for Federal tax purposes. 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 Robucci LLC, whereby it was appointed Robucci LLC's "manager," there is no evidence that Robucci P.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 Robucci LLC, 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 the mgmt. 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 to liquidate all of the property of a single-member LLC on behalf of creditors. The Tax Court held that Taxpayers' reliance upon Albright is misplaced. That case does not involve a creditor's right to hold the sole member of a single-member LLC personally liable for the LLC's debts. Rather, it holds 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 in Albright did not attempt to pierce the "corporate" veil to reach the member's personal assets to satisfy the LLC's debts 35

57 The court concluded that Robucci P.C. was not formed for a purpose that "is the equivalent of a business 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 of overhead and indirect expenses, and to form a group for insurance purposes. However, the evidence 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 employment agreement with Dr. Robucci and no employees. Nor did it perform any management or other services for Robucci LLC in the person of Dr. Robucci. Rather, Dr. Robucci continued to conduct his practice as he always had, including the retention of 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 received instructions from Dr. Robucci in letters with a letterhead "Tony L. Robucci, M.D., A Professional 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 its reimbursement of various expenses incurred by Dr. Robucci and Robucci LLC pursuant to the various plans. Dr. Robucci testified that that activity consisted of electronic transfers of funds between bank accounts. Thus, Dr. Robucci continued, as in prior years, to pay the expenses of his 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 to Robucci LLC's account. The bank account statements in the record provide scant evidence that there were, in fact, regular interaccount transfers from Westsphere to Robucci LLC. For example, Westsphere's bank statement dated January 23, 2003, shows debits of $5, and $1, for a 2002 Medical Expenses Reimbursement and a Health Insurance Premium Reimbursement, but the absence of corresponding credits to Robucci LLC's account on the same date or thereafter indicates that the transfer of funds was to Dr. Robucci's personal account. In fact, the bank statements contained no correlation between debits to Westsphere's bank account and credits to Robucci LLC's bank account. Any interaccount transfers, to the extent they occurred, were the equivalent of taking money from one pocket and putting it into another because Dr. Robucci controlled both entities. Such a procedure hardly qualifies as a "business activity" 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 those concerns. The "groups" to be afforded coverage are "groups of persons," generally, under policies 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 (1)(a). It is difficult to see how the organization of Westsphere, which neither is an employee of Robucci LLC nor has employees of its own, could serve to qualify for small group or small employer health insurance. More importantly, there is no evidence that Robucci LLC made any effort to obtain group health insurance for its sole operative, Dr. Robucci. Dr. Robucci or Robucci LLC 36

58 continued to pay premiums for health insurance but it is not clear that the policy differed from the one Dr. Robucci had as a sole proprietor. The court concluded that Westsphere was not organized for a purpose that "is the equivalent of a business 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 a business after incorporation, the second alternative prong for corporate viability under Moline Properties. Because Robucci P.C. and Westsphere served no significant purpose or function other 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 equally applicable to this case: The alleged business purposes impressed us simply as a lawyer's marshaling of possible business reasons that might conceivably have motivated the adoption of the forms here employed but which 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 proprietor for Federal tax purposes, which was his status before the formation of Robucci LLC and the corporations. It follows, and we hold, that the net income arising from his psychiatric practice during the years in issue, including any amounts paid to Robucci P.C. and Westsphere, was selfemployment income of Dr. Robucci subject to self-employment tax under Imposition Of The 6662 Accuracy-Related Penalty The IRS has established that Dr. Robucci's understatements of income tax for the years in issue are substantial as they exceed both 10 percent of the correct tax and $5,000. Therefore, there was no 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 of an underpayment if a taxpayer shows that there was reasonable cause for, and that the taxpayer acted in good faith with respect to, that portion. The determination of whether a taxpayer acted with reasonable cause and in good faith is made on a case-by-case basis, taking into account all pertinent facts and circumstances. Circumstances that may indicate reasonable cause and good faith include an honest misunderstanding of law that is reasonable in light of all of the facts and circumstances, including the experience, knowledge, and education of the taxpayer. Reliance on the advice of a professional tax advisor does not necessarily demonstrate reasonable cause and good faith. Reg (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 "substantial understatement 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 argued that there was no reasonable cause for the positions taken by Dr. Robucci and that he did not act 37

59 in good faith. In the IRS's view, "[p]etitioner should have requested a second opinion after getting advice that was clearly too good to be true". The IRS viewed Mr. Carson as "the promoter of the arrangement, who earned substantial fees for incorporating the various sham entities and preparing the tax returns at issue. Taxpayers denied that Mr. Carson was a promoter and 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 on Mr. Carson's advice. Under those circumstances, Dr. Robucci, even though he was not a tax professional, should have questioned the efficacy of the arrangement that purported to minimize his taxes while effecting virtually no change in the conduct of his medical practice. He should have sought a second opinion. By not doing so, Dr. Robucci failed to exercise the ordinary business care and prudence required of him under the circumstances. See United States v. Boyle, 469 U.S. at 251; Haywood Lumber & Mining Co. v. Commissioner, 178 F.2d 769, (2d Cir. 1950), modifying 12 T.C. 735 (1949), which involve circumstances exemplifying the exercise of ordinary business care 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 implementing Mr. 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 at 234 ("When * * * a taxpayer is presented with what would appear to be a fabulous opportunity to avoid 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 trusted the 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 be true, the court stated that Mr. Carson's goal of directing some of Dr. Robucci's income to a thirdparty corporate management service provider and bifurcating Dr. Robucci's interest in Robucci LLC so that he would be separately compensated for the use of his intangibles was not unreasonable. On the contrary, had it been more carefully implemented, it well might have been realized, at least in part. In footnote 11, the court noted that although it is the IRS's position that profit distributions to service-providing members of a multimember, professional service LLC are never excepted from net earnings from self-employment by 1402(a)(13), which excepts distributions to a limited partner other than sec. 707(c) guaranteed payments for services rendered, 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 out legitimate corporate functions, the fact that they were nothing more than empty shells, devoid of property (Westsphere did have a bank account), personnel, or actual day-to-day activities, i.e., of substance, should have sent warning signals to Dr. Robucci that those corporations were not effecting any meaningful change in the prior conduct of his medical practice. There were also no contracts between the entities or with Dr. Robucci and his PC. Additionally, the LLC paid Dr. 38

60 Robucci for his active services, not his PC, which did not have any activity or even a bank account. While Dr. Robucci may have had some vague notion that he was acting on behalf of Westsphere when performing services other than actual patient care, there is little or no evidence as to the precise nature of those services, the time Dr. Robucci may have spent performing them, or their value. In short, there is no support for any charge from Westsphere to Robucci LLC for such services or for the claim that Dr. Robucci was wearing a Westsphere hat when he performed them. For Dr. Robucci, aside from signing a raft of documents and shifting some money between two new bank accounts, it was business as usual. Although he might have been justified in relying upon Mr. Carson's expert valuation of his intangibles as the basis for the split between his limited and general partnership interests in Robucci LLC, the lack of any formal transfer of those intangibles to Robucci LLC was fatal. 39

61 2/10/2012 Qualified Plans and the Small Business Owner Rick Wagner, J.D., Director Denver Compensation & Benefits, LLC (303) Agenda 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 QualifiedPlansand the Small Business Owner 1 1

62 2/10/2012 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 to the 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. QualifiedPlansand the Small Business Owner 2 Deferring Taxes Through Qualified Plans IRA-Based Plans Key Advantages Easy to set up and avoid many of the administrative requirements of other qualified plans (i.e. defined contribution and defined benefit plans) 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. QualifiedPlansand the Small Business Owner 3 2

63 2/10/2012 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 each eligible employee s compensation (subject to IRS limits). QualifiedPlansand the Small Business Owner 4 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 compensation of $550 for 2010 and 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. QualifiedPlansand the Small Business Owner 5 3

64 2/10/2012 Deferring Taxes Through Qualified Plans IRA-Based Plans (cont d) Maximum Annual Contributions (per participant) Payroll Deduction IRA $5,000 for Additional contributions up to $1,000 can be made by participants age 50 and over. SEPs Up to 25% of compensation (subject to IRS 415 limits) but not more than $50,000 for SIMPLE IRA Plans Employee $11,500 in Additional contributions up to $2,500 can be made by participants age 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 each eligible employee s compensation (subject to IRS limits). QualifiedPlansand the Small Business Owner 6 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 the employee to make the decision about when to be taxed QualifiedPlansand the Small Business Owner 7 4

65 2/10/2012 Deferring Taxes Through Qualified Plans General Defined Contribution and Defined Benefit Plan Rules 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 the employer QualifiedPlansand the Small Business Owner 9 5

66 2/10/2012 Deferring Taxes Through Qualified Plans Defined Contribution Plans (cont d) Contributors to the Plan 401(k) Plans Employee salary reduction contributions and maybe employer contributions. Employee can decide how much to contribute pursuant to a salary reduction agreement. The employer can make additional contributions including matching contributions as set by plan terms. Profit Sharing Annual employer contribution is discretionary, but must not be discriminatory. QualifiedPlansand the Small Business Owner 10 Deferring Taxes Through Qualified Plans Defined Contribution Plans (cont d) Maximum Annual Contributions (per participant) 401(k) Plans Employee $17,000 in Additional contributions can be made by participants age 50 or over up to $5,500. Employer/Employee Combined Up to the lesser of 100% of compensation, or $50,000 for Employer can deduct amounts that do not exceed 25% of aggregate compensation for all participants and all salary reduction contributions. QualifiedPlansand the Small Business Owner 11 6

67 2/10/2012 Deferring Taxes Through Qualified Plans Defined Benefit Plans Key Advantages: Provides a fixed, pre-established benefit for employees. Key Disadvantages: Risk of investment loss is borne by the employer An actuary must determine annual contributions. QualifiedPlansand the Small Business Owner 12 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 3 consecutive calendar years; or $200,000 for QualifiedPlansand the Small Business Owner 13 7

68 2/10/2012 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 a set percentage of eligible employee s compensation. Maximum Annual Contributions (per participant) The lesser of 100% of compensation, or $50,000 in Pre-EGTRRA legislation allowed for higher deduction limits than other defined contribution plans, but that was changed by EGTRRA which largely negated their value QualifiedPlansand 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 employer contributions and interest credits, which is guaranteed rather than being dependent on 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. QualifiedPlansand the Small Business Owner 15 8

69 2/10/2012 Deferring Taxes Through Qualified Plans Hybrid Plans (cont d) Cross Tested Plans Key Advantages Allow the owner or other key employees with a proportionately higher benefit. Contributors to the Plan Annual employer contribution is discretionary. Employer can create separate groups and provide each group with a different allocation. Maximum Annual Contributions (per participant) Up to the lesser of 100% of compensation, or $50,000 for QualifiedPlansand 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 early withdrawal penalty of 10% of the distribution amount applies to Roth IRAs). Vesting Employee salary reduction contributions and employer contributions are immediately 100% vested. QualifiedPlansand the Small Business Owner 17 9

70 2/10/2012 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 withdrawals subject to an additional tax. Vesting Employee salary deferrals are immediately 100% vested. Employer contributions vest according to plan terms, subject to minimum vesting requirements under ERISA (6 year graded or 3 year cliff). Safe Harbor 401(k) Plans Most employer contributions are immediately 100% vested. QualifiedPlansand 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 year cliff). QualifiedPlansand the Small Business Owner 19 10

71 2/10/2012 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 account balances 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 QualifiedPlansand 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 or held by a fiduciary or service provider, or an entity that is 10% or more partner or joint venturer with an entity that is 50% or more owned directly or indirectly or held by a fiduciary or service provider. QualifiedPlansand the Small Business Owner 21 11

72 2/10/2012 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. After which the new plan purchases an ownership interest in a new entity. QualifiedPlansand the Small Business Owner 22 Targeted Investments Using Qualified Plan Assets 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 in the 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 QualifiedPlansand the Small Business Owner 23 12

73 2/10/2012 Targeted Investments Using Qualified Plan Assets 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 them with stock from an ESOP, often at a higher matching level. QualifiedPlansand 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 matching contributions as set by plan terms if combined with a 401(k) Plan (KSOP). Employer contributions can be made in either cash or securities. QualifiedPlansand the Small Business Owner 25 13

74 2/10/2012 Targeted Investments Using Qualified Plan Assets 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 withdrawals subject 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 3 year cliff). QualifiedPlansand the Small Business Owner 26 14