Partnership Bifurcation

In 1994, the IRS released proposed regulations in-tended to clarify when a member of a limited liability company (LLC) would be treated as a limited partner not subject to self-employment (SE) tax. Under the regulations, an individual owning an LLC interest was treated as a limited partner if (1) the member lacked the authority to make management decisions (management test) and (2) the LLC could have been formed as a limited partnership rather than an LLC in the same jurisdiction and the member could have qualified as a limited partner in the limited partnership under applicable state law (limited-partner equivalence test). The intent of the 1994 proposed regulations was to treat owners of an LLC interest in the same manner as similarly situated partners under the various state laws.

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

The proposed regulations contradicted the normal approach of permitting a person who was both a general and limited partner to bifurcate his distributive share of LLC income and exclude the limited partner interest portion from SE tax. Commentators on the 1994 proposed regulations focused on whether the Service would respect the ownership of more than one class of partnership interest for SE tax purposes. The proposed regulations treated an LLC member as a limited partner for his entire interest, or not at all. Commentators, however, pointed to the legislative history of Sec. 1402(a)(13) to support their argument that Congress only intended to tax a partner's distributive share attributable to a general partner interest. Under this argument, a partner with both a general partner interest and a limited partner interest is subject to SE tax only on the distributive share attributable to the partner's general partner interest. This intent also may be inferred from the statutory language of Sec. 1402(a)(13) that the SE tax does not apply to "...the distributive share of any item of income or loss of a limited partner, as such...." Based on this evidence, these commentators requested that the proposed regulations be revised to allow the bifurcation of interests for SE tax purposes.

The proposed regulations were withdrawn on Jan. 13, 1997, and replaced with revised proposed regulations, which replace the management and limited-partner equivalence tests with an approach that depends on the relationship among the partner, the partnership and the partnership business. The new proposed regulations were designed to promote the certainty and fairness of the member limited-partner determination.

The most important change is the proposed revision to Regs. Sec. 1.1402(a)-2(g). As currently stated, the net earnings from a partner's SE include his distributive share of the taxable income or loss, exclusive of items requiring separate computation under Sec. 702, regardless of the nature of his membership. The proposed regulation would change Regs. Sec. 1.1402(a)-2(g) to specifically exclude an individual's distributive share of income or loss as a limited partner described in Regs. Sec. 1.1402(a)-(2)(h). However, guaranteed payments made to the partner for services actually rendered to or on behalf of the partnership engaged in a trade or business or for the use of capital would be subject to SE tax.

Regs. Sec. 1.1402(a)-2(h) provides that an individual is treated as a limited partner unless he (1) has personal liability for the debts of or claims against the partnership by reason of being a partner, (2) has authority under the law of jurisdiction in which the partnership is formed to contract on behalf of the partnership or (3) participates in the partnership's trade or business for more than 500 hours during the partnership's tax year.

The proposed regulation provides two exceptions to the general partner treatment described under Regs. Sec. 1.1402(a)-2(h). The first exception would apply to holders of more than one class of partnership interest (Prop. Regs. Sec. 1.1402(a)-2(h)(3)); the second applies to holders of only one class of partnership interest who would be classified as general partners solely because they participate in the partnership's trade or business for more than 500 hours during the partnership's tax year (Prop. Regs. Sec. 1.1402(a)-2(h)(4)). The exceptions would apply if, immediately after the individual acquires that class of interest, (1) limited partners own a substantial, continuing interest in that specific class of partnership interest and (2) their rights and obligations for that specific class of interest are identical to the rights and obligations of that specific class of partnership interest held by the limited partners. These exceptions are specifically not applicable to service partnerships.

Under the proposed regulations, a substantial continuing interest in a class of partnership interest is determined based on all the relevant facts and circumstances. In all cases, however, ownership of 20% or more of a specific class of interest is considered substantial.

While the regulations are still proposed, they do provide some insight as to the Service's treatment of bifurcated partnership interests.

From Jason Knighton, Leverich Rasmuson Banyard, CPAmerica, Salt Lake City, UT