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.