From the September 1997 issue of Entrepreneur

If your business is organized as a limited liability company (LLC) or a limited partnership, the IRS may have some unpleasant news for you. In a move that is already creating an uproar in the small-business community, the IRS is in the midst of issuing a new regulation targeted at these two types of partnerships.

The regulation will not only mean higher taxes, say critics, but a host of burdensome new record-keeping and information-collection requirements. Slated to take effect next year, the regulation is described by critics as a "stealth" tax increase.

With the recent increase in the number of LLCs, particularly among small-business owners, this regulatory push by the IRS is seen as one way to make sure these partnerships pay their fair share. Not surprisingly, this logic has ignited a firestorm of protests among partnerships and small businesses in general. Opponents of the proposal claim the regulation is being erroneously applied to businesspeople organized under this legal structure.

Here's what the new rule proposes: It would require members of LLCs and limited partnerships to pay self-employment taxes on the total amount of their shares of the partnership's or LLC's profits. (This year, the self-employment tax is 15.3 percent on net income up to $65,400 and 2.9 percent on net income above $65,400.)

Currently, limited partners (and certain members of LLCs) do not pay self-employment taxes on the share of partnership income considered a return on investment. Instead, they just pay federal and state income taxes on these distributions.

Under the proposed regulation, however, the IRS would generally require that the self-employment tax be applied to all income, whether it comes from wages or investments, of limited partners and members of LLCs who participate in the partnership's or LLC's trade or business for more than 500 hours per year. (There would be an exception for service partnerships, such as architects, medical professionals and consultants; in these cases, there would be no minimum-hour requirement, so these individuals pay taxes on all income from the partnership or LLC.) Essentially, they'd be taxed the way partners in a general partnership are taxed.

In addition to the 500-hour test, the rule would apply two other parameters to determine when a partnership distribution would be classified as net income from self-employment. These situations are if the individual has personal liability for the debts and claims of the partnership or has contract authority for the partnership.

The IRS maintains that by using these tests, "the proposed regulations ensure that similarly situated individuals owning interests in entities formed under different statutes or in different jurisdictions will be treated similarly."

Passing Judgement

Critics of the proposal contend that limited partnerships and members of LLCs are not general partners and shouldn't be treated as such. "The proposed regulation is flawed because it fails to effectively distinguish income attributable to personal labor from income attributable to capital investment, and thereby improperly imposes the self-employment tax on capital investments," says Jonathan Axelrad, a partner with Wilson Sonsini Goodrich & Rosati, a law firm in Palo Alto, California.

"The proposed regulation appears to reflect a good-faith effort on the part of the IRS to provide a uniform rule for limited partners and members of LLCs," Axelrad says. "Unfortunately, they don't have the authority to reach the right answer [because the underlying statute requires that the regulation be handled by Congress]."

If the proposal is finalized, "a working limited partner in an environmental-testing partnership, for example, will have to pay self-employment tax on his or her entire share of partnership income--even if the limited partner contributed substantial funds to enable the partnership to purchase environmental testing equipment," Axelrad says.

The IRS proposal will seriously hurt professionals who have a substantial investment in capital assets. "The income stream that was formerly treated as a return on investment will now be subject to self-employment taxation," said Russell Orban with the Small Business Administration's (SBA) Office of Advocacy in testimony before the IRS. "The assets controlled by such groups are significant; for example, partnerships related to health care, legal, accounting, consulting, architecture and engineering services control about $48 billion in capital assets."

The impact on these small companies, whose partners have put a good deal of capital at risk, would be disastrous, asserts Sen. Christopher S. Bond (R-MO), chairman of the Senate Small Business Committee. Approximately 10 million people will feel the effects of higher taxes if the regulation is finalized, Bond argues.

In a letter to Treasury Secretary Robert Rubin, Bond noted that Congress expressly declined to adopt legislation proposing a similar tax increase in 1994. "The Congressional Joint Committee on Taxation estimated that the 1994 proposal would have resulted in a tax increase of approximately $500 million per year," Bond wrote. Finally, argues Bond, whether or not this type of tax hike takes effect is ultimately a decision for Congress to make.

To Protect And Serve

Opponents of the proposal have another bone to pick with the IRS. They contend that the IRS is ignoring its obligation under the Small Business Regulatory Enforcement Fairness Act (SBREFA) of 1996 by not determining the proposal's impact on small companies.

SBREFA is designed to protect small business by making sure federal agencies perform comprehensive analyses on the potential impacts of any proposed regulations and to develop ways to reduce any negative impact. Sen. Bond and 18 other senators have complained to Secretary Rubin that no such analysis was performed in relation to the IRS proposal.

"I cannot think of any proposed regulation more in need of thorough procedural review than one involving a stealth tax increase by regulatory dictate," says Bond, who was the author of the small-business regulatory act. There are too many in the bureaucracy, he points out, "who don't realize the [SBREFA] requires them to take additional steps to protect small businesses that would otherwise be run over by the regulatory juggernaut if they did not have this protection."

Not so, says the IRS. It maintains that the proposed regulation doesn't trigger compliance with the SBREFA because it's not an express mandate that requires collection of data on small businesses. In addition, the IRS says the service has the authority to issue what it calls "interpretive" rules (i.e. parameters not spelled out by Congress that must be interpreted by government agencies).

Some argue such interpretation is well within the IRS' domain. "One of the major reasons for the IRS to exist is to interpret what Congress means," says Thomas P. Ochsenschlager, a partner in the Washington, DC, office of accounting firm Grant Thornton LLP. Congress directs the IRS to develop tax regulations and provides the service with broad parameters in which to do so, he explains.

But Orban of the SBA's Office of Advocacy disagrees that this rule is an interpretive one. Instead, he sees it as a legislative regulation and as such, he maintains, the IRS is required to issue a regulatory fairness analysis to explain the rule's impact on small business.

If the required analysis shows that a substantial number of small firms will suffer a negative economic impact as a result of the proposal, then the IRS must give small-business owners an opportunity to participate in the rule-making process. This kind of participation would include public hearings, allowing small-business owners and advocates to argue against enactment of the proposal.

Critics of the proposed regulation are also quick to point out that the paperwork requirements, not only to be in compliance with the rule but to protect a small business in the event of an IRS audit, are too excessive. For example, even if partners were not required to pay self-employment taxes on all their profits, members of LLCs and limited partnerships would still face record-keeping hassles. That's because they would have to be able to show the IRS, in the event of an audit, that they didn't meet the three tests mentioned previously. Records would have to be kept on how many hours the owners work for the partnership, whether they have personal liability, and whether they have the authority to enter into contracts.

Seeking Relief

While the tug of war between Congress and the IRS continues, members of LLCs and limited partnerships have reason to be optimistic. A rescue plan is being worked on by Republican lawmakers, who are urging the IRS to withdraw the proposed rule. Sen. Bond announced that if the IRS tries to move forward with this plan, he will lead the fight to stop the increase. On the House side, Rep. Susan Myrick (R-NC), is the sponsor of H.R. 1247, a bill that would prohibit the Secretary of the Treasury from changing the treatment of partnership distributions to limited partners.

Says Sen. Bond, "It is my hope the IRS will do the right thing and withdraw this ill-conceived tax increase." Only time will tell.

Joan Szabo is a writer in McLean, Virginia, who has reported on tax issues for more than 11 years.

Contact Sources

Grant Thornton LLP, 1707 L St. N.W., Washington, DC 20036, (202) 861-4115.