An LLC taxed as a partnership with 128 partners failed to file its partnership tax return electronically, resulting in the IRS asserting a penalty of $224,640 under IRC section 6698(a)(1). Partnerships with more than 100 partners are required to file their tax returns electronically under IRC section 6011(e). Williams Parker represented the partnership in connection with a penalty waiver request pursuant to IRS Announcement 2002-3, 2002-1 CB 305 (Jan. 14, 2002). Shareholder Mike Wilson at Williams Parker convinced the IRS that the partnership was entitled to a penalty waiver under the criteria of the Announcement, and therefore the IRS withdrew the entire $226,640 penalty. Information regarding the Announcement criteria and related guidance can be found at irs.gov.
While tax reform has a long march before becoming law, the amended House of Representatives bill passed yesterday swings an ax at lower-tax-rate-capital-gain-eligible “carried” partnership interests, though it swings a smaller ax—like a hand ax rather than a full-sized ax—than proposals in years past.
This latest proposal focuses on limited industries and allows an escape hatch for interests held more than three years. Here are the details:
How Do I Know if I Have a Carried Interest, and Why are Carried Interests Special?
The phrase “carried interest” applies to a partnership interest granted to a partner for services. The idea is that the capital-investing partners “carry” the service partner, who does not make a capital contribution in proportion to the service partner’s interest.
Partnerships often structure carried interests to have little or no value at grant, causing the recipient to recognize little or no wage or other compensation income at that time. Later, if the partnership recognizes long-term capital gain, the partnership allocates part of that gain to the service-providing partner. This results in the service partner paying tax at a tax rate as little as half the rate on wage or compensation income (approximately 20%, as compared to approximately 40%, depending on the circumstances).
Why Change the Tax Treatment of Carried Interests?
Critics complain that carried interest partnership allocations amount to a bonus that should be taxed at the higher ordinary rates, like wage income and other incentive compensation. The most vocal criticism focuses on hedge funds, private equity firms, and real estate investment firms, where critics see carried interest allocations as the equivalent of management fees. Past Congressional proposals would have recharacterized a percentage or all partnership allocations to carried interests as compensation income, without regard to industry.
Carried interest advocates respond that many carried interest holders invest years of effort before receiving an allocation to their partnership interests, and therefore make the equivalent of an investment associated with a capital contribution.
Proposed Changes in the House Bill
The amended House bill takes a middle ground between the current law and prior Congressional proposals to curb the eligibility of carried interests for long-term-capital gain allocations. The bill focuses on carried interests in hedge funds, private equity firms, and real estate investment firms, not traditional operating businesses.
In targeted firms, the bill allows a partnership to allocate long-term capital gain to a carried interest partner who has held his or her partnership interest more than three years. If the partner has held the interest for three years or less, the proposal recharacterizes the allocation as short-term capital gain. In most cases, short-term capital gain characterization results in income taxation at the same rate as wage or other compensation income, but still allows the partner to avoid employment taxes.
It remains uncertain whether this proposal will survive reconciliation with a to-be-passed Senate tax reform bill.
Even if the proposal becomes law, look for motivated taxpayers to form “shelf” entities to begin the running of the three-year holding period while undertaking limited business activity. The taxpayers will then have such partnerships ready to use in the future, when a more substantial opportunity arises. Others will design hybrid debt-equity capital structures such that even service-providing partners’ interests qualify as capital interests rather than carried interests.
During the course of an audit of a partnership for employment tax matters, an issue arose as to whether the tax partnership (which has numerous partners) was subject to the unified partnership audit and litigation provisions of TEFRA (the Tax Equity and Fiscal Responsibility Act of 1982). Representing the partnership, Williams Parker took the position that while the partnership was subject to TEFRA for income tax purposes, it was not subject to TEFRA for employment tax or worker classification matters. Due to the multitude of partners and other factors, being subject to TEFRA would have resulted in the partnership incurring significant expense and headache in trying to comply with the various TEFRA provisions during the course of the audit and any subsequent tax proceedings. Fortunately, the Internal Revenue Service Office of Chief Counsel agreed with Williams Parker in a published ruling, which can be found at the following link: TEFRA Ruling.
In a recent ruling, the IRS confronted a partnership serving as a management company for investment partnerships and funds. Management fees were its sole source of income. The management company paid reasonable compensation subject to employment or self employment taxes to its owner-managers. Following a planning technique available to S corporations, the partnership treated its partner distributions as being exempt from self employment taxes. The IRS disagreed with the partnership’s position. The IRS ruled that the partner distributions were subject to self employment taxes notwithstanding the reasonableness of compensation paid as such to its owner-managers.
The ruling is significant because distributions from an S corporation structured in the same way probably would not have been subject to self employment tax. Indeed, the partnership in question used to be an S corporation, and the IRS specifically held that the S corporation rules do not apply to the new partnership.
The ruling underscores an evolving IRS position that treats service S corporations and service partnerships differently for self employment tax purposes. While technically understandable because different statutory and regulatory provisions govern the different entity types, the differing self employment tax treatment of these entities defies common sense.
Unless a sensible unified self employment tax policy emerges, when possible it remains wise to structure management or service companies either as S corporations or as partnerships with S corporation partners, to take advantage of the more flexible self employment tax planning options available for S corporations.
Here is link to the ruling: http://www.irs.gov/pub/irs-wd/201436049.pdf