ABA Tax Section Considers Effect of Changing Partnership Ruling

December 9, 2019

Hon. Charles P. Rettig
Commissioner
Internal Revenue Service
1111 Constitution Avenue, NW
Washington, DC 20224

Re: Comments on potential changes to Rev. Rul. 69-184

Dear Commissioner Rettig:

Enclosed please find comments on the impact of potential changes to Rev. Rul. 69-184 and specifically the regulations that would be implicated if “dual status” (treatment of certain partners as employees) is allowed. These comments are submitted on behalf of the Section of Taxation and have not been approved by the House of Delegates or the Board of Governors of the American Bar Association. Accordingly, they should not be construed as representing the position of the American Bar Association.

The Section of Taxation would be pleased to discuss these comments with you or your staff.

Sincerely,

Tom Callahan
Chair, Section of Taxation
American Bar Association
Washington, DC

Enclosure

cc:
Hon. David Kautter, Assistant Secretary (Tax Policy), Department of the Treasury
Jeffrey Van Hove, Senior Advisor, Office of Tax Policy, Department of the Treasury
Krishna P. Vallabhaneni, Tax Legislative Counsel, Department of the Treasury
Bryan Rimmke, Attorney-Advisor, Department of the Treasury
Carol A. Weiser, Benefits Tax Counsel, Department of the Treasury
Hon. Michael J. Desmond, Chief Counsel, Internal Revenue Service
William M. Paul, Deputy Chief Counsel (Technical), Internal Revenue Service
Victoria A Judson, Associate Chief Counsel (Employee Benefits, Exempt Organizations, and Employment Taxes), Internal Revenue Service
Holly Porter, Associate Chief Counsel (Passthroughs & Special Industries), Internal Revenue Service
Janine Cook, Deputy Associate Chief Counsel, Employee Benefits, Exempt Organizations and Employment Taxes, Internal Revenue Service
Stephen B. Tackney, Deputy Associate Chief Counsel, Employee Benefits, Exempt Organizations and Employment Taxes, Internal Revenue Service

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ABA SECTION OF TAXATION
COMMENTS ON REV. RUL. 69-184

These comments (“Comments”) are submitted on behalf of the American Bar Association Section of Taxation and have not been approved by the House of Delegates or Board of Governors of the American Bar Association. Accordingly, they should not be construed as representing the position of the American Bar Association.

Principal responsibility for preparing these Comments was exercised by Leigh Griffith, Kurt Lawson, and Jeanne Sullivan of the Section's Committee on Government Submissions. Substantive contributions were made by Yelena Fertman Gray, Andrew Liazos, Shane Morris, Helen Morrison, Andrew Oringer and Sean Sullivan. The Comments were reviewed by Katherine Kennedy, Jennifer Alexander, and Edward J. Leyden. The Comments were further reviewed by Catherine Engell, Adam M. Cohen, and Eric B. Sloan, Vice Chair for Government Relations for the Section.

Although the members of the Section of Taxation who participated in preparing these Comments have clients who might be affected by the federal income tax principles addressed by these Comments, no such member or the firm or organization to which such member belongs has been engaged by a client to make a government submission with respect to, or otherwise to influence the development or outcome of, the specific subject matter of these Comments.

Contacts:
Leigh Griffith
615-850-8534
Leigh.Griffith@wallerlaw.com

Kurt Lawson
202-637-5660
kurt.lawson@hoganlovells.com

Jeanne Sullivan
202-533-6571
jsullivan@kpmg.com

Date: December 9, 2019

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EXECUTIVE SUMMARY

Many provisions of the Code¹ apply differently to employees and independent contractors. These include most of the employment tax provisions and some of the provisions dealing with employee benefits and executive compensation. However, as the U.S. Department of the Treasury (“Treasury”) has observed, “[c]urrent law does not consistently favor employee or independent contractor status.”²

Employment status for these purposes is determined based on the common law. Partners of a partnership and members of an LLC³ generally are treated as independent contractors under the common law when they perform services for the partnership or LLC, because, in the past, the nature of their relationship with the partnership or LLC made it hard to satisfy the common-law test to be treated as employee. And, at least since 1969, when it issued Rev. Rul. 69-184,⁴ the Internal Revenue Service (the “Service”) has taken the position that this means that bona fide partners cannot be employees of the same business.

Treasury and the Service recently suggested that they are reconsidering the Service's position in Rev. Rul. 69-184, and have requested comments on this issue. In order to provide helpful comments, we have included comments on the regulations that would be implicated if so-called “dual status” (treatment of certain partners as employees) is allowed.

We commend Treasury and the Service for taking this step, and we appreciate the opportunity to provide comments. Specifically, we recommend that Treasury and the Service:

As noted above, individuals who are both employees and partners of the same partnership or LLC are referred to in these Comments as having “dual status.”

DISCUSSION

I. BACKGROUND

A. Provisions of the Code That Apply Differently to Employees and Independent contractors

1. Employment Tax Provisions

a) Social Security and Medicare

(1) In general

An employee is subject to old age, survivors, and disability insurance (“Social Security”) and Medicare hospital insurance (“Medicare”) taxes, if at all, under the Federal Insurance Contributions Act (“FICA”) tax rules.⁵ By contrast, an independent contractor,⁶ including a partner or LLC member, is subject to Social Security and Medicare taxes, if at all, under the Self-Employment Contributions Act (“SECA”) tax rules.⁷

Since 1990, the combined tax rates on employees and their employers, on the one hand, and on independent contractors, on the other, have been virtually identical under both FICA and SECA.⁸ Before 1983, the tax rates on independent contractors were substantially lower, even though they generally were eligible for the same Social Security and Medicare benefits as employees, but legislation in 1983 mostly eliminated the rate differential.⁹

Certain differences remain between employees, on the one hand, and independent contractors, on the other, and in some cases the differences are substantial:

• Some relate to the income on which FICA and SECA taxes are imposed, which is called “wages” in the case of FICA (“FICA wages”) and “self-employment income” in the case of SECA (“SECA income”). For example, unlike a contribution on behalf of an employee, which generally is excluded from the employee's FICA wages,¹⁰ a contribution to a health plan, qualified plan or simplified employee pension on behalf of an independent contractor may not be deducted in computing the individual's SECA income, because it is not considered “attributable to” the individual's trade or business.¹¹ On the other hand, trade or business expenses may be deducted from SECA income but not FICA wages.

• Some relate to the timing of taxation. For example, there is no rule under SECA that is analogous to the special rule for deferred compensation in section 3121(v)(2).¹²

• Another relates to the dollar limit on income subject to Social Security tax. In computing Social Security tax on a new employee's FICA wages, an employer generally may not take into account the fact that the employee already might have received FICA wages in excess of the dollar limit from another employer.¹³ If this results in an overpayment, the employee is entitled to a refund, but the employer is not.¹⁴ Because SECA income is determined entirely at the individual level, there is no similar overpayment problem under SECA.¹⁵

• Another relates to the fact that employees are not subject to income or FICA taxes on the portion of FICA taxes that are imposed on and paid by their employer. Because independent contractors pay all of their own SECA taxes, there is no opportunity for such exclusions. They are entitled to special deductions that are intended to achieve the same economic result as the exclusions, but the deductions are somewhat larger than needed for that purpose.¹⁶

(2) Limited partner issue

The SECA income of a general partner generally includes his or her entire distributive share of partnership income or loss described in section 702(a)(8).¹⁷ This can be true even if he or she does not participate in the management of the partnership, or in any partnership activities, and even if a significant portion of the distributive share represents nothing more than a reasonable return on his or her capital.¹⁸ To this is added any guaranteed payments for services or for the use of capital.¹⁹

By contrast, FICA wages of an employee-shareholder of a corporation are limited to amounts actually paid to him or her as compensation, even if the corporation is an S corporation.²⁰ The employment tax treatment of a limited partner is more similar to that of an employee-shareholder than it is to that of a general partner. Specifically, under section 1402(a)(13) (the “limited partner exception”) self-employment income of a limited partner includes only guaranteed payments for services described in section 707(c), and excludes his or her entire distributive share of partnership income.²¹ The legislative history indicates that the limited partner exception was adopted because some business organizations were soliciting investments in limited partnerships as a means to obtain social security benefits.²² In Options to Improve Tax Compliance, the Joint Committee on Taxation suggested that the limited partner exception “reflects State law at the time it was enacted in 1977, under which limited partners ordinarily were not permitted to participate in management of the partnership's activities without losing their limited liability protection,” and also noted that investors no longer try to join limited partnerships in order to obtain social security benefits because “the wage base and the resulting tax cost to individual taxpayers of accruing benefits has risen, and the value of Social Security benefits to high-income taxpayers has become relatively lower as a percentage of income.”²³

In 1997, Treasury and the Service issued Proposed Regulations²⁴ that generally would have treated members of an entity classified as a partnership (including LLC members) as limited partners under section 1402(a)(13) unless they (1) had personal liability for the debts of the entity, (2) had authority to contract on behalf of the entity, or (3) participated in the entity's trade or business for more than 500 hours during the taxable year (or were service partners, and the partnership performed services in the fields of health, law, engineering, architecture, accounting, actuarial science, or consulting). The Regulations were criticized as a “stealth tax,” and Congress prohibited Treasury and the Service from finalizing them.²⁵

In the absence of guidance, partnerships and LLCs have had to find their own way. Many have concluded that individuals denominated as LLC members may be treated as limited partners under section 1402(a)(13) under some circumstances. The Service appears to take the position that whether LLC members are limited partners for this purpose depends, in part, on their degree of involvement in the management and business activities of the entity.²⁶ Court decisions generally support this position.²⁷ Service officials also have stated that the Service will treat LLC members as limited partners under section 1402(a)(13) if they would have qualified under the 1997 Proposed Regulations.²⁸ On the other hand, Service guidance suggests that limited partners of entities that are organized as state-law limited partnerships always qualify as limited partners for this purpose.²⁹

b) Unemployment Insurance

The first $7,000 of wages paid to an employee generally is subject to tax under the Federal Unemployment Tax Act (“FUTA”) rules.³⁰ Under the integrated federal/state system, part of the tax ordinarily is paid to the state of employment, while part is paid to the federal government; the combined rate is six percent.³¹ Independent contractors, including partners and LLC members, are not subject to FUTA tax, but likewise are not eligible to receive any unemployment benefits.³²

c) Income Tax Withholding

Income taxes on employees are collected mainly through the withholding system, whereas income taxes on independent contractors, including partners and LLC members, are collected mainly through the estimated tax system.³³ Both systems are backed up by information reporting requirements imposed on service-recipients.³⁴

A Partnership might be able to “withhold” income taxes for its partners and members, despite the lack of a legal requirement, by paying estimated taxes on their behalf and reducing their other compensation accordingly.³⁵ State wage payment laws generally apply only to employees,³⁶ so no special election rules need to be followed. One downside of this approach is that the arrangement is not treated as actual wage withholding for purposes of the various Code provisions designed to ensure that the individual receives credit for the withheld amounts³⁷ and that they are, in fact, paid over to the Service.³⁸ The Service has the authority to allow voluntary withholding arrangements under section 3402(p) to be extended to non-wage payments,³⁹ although so far it has not done so for payments to partners.

2. Employee Benefit and Executive Compensation Provisions

For the most part, the rules governing employee benefits and executive compensation are the same regardless of whether employees or independent contractors, such as partners and LLC members, participate in the plan. However, several noteworthy differences remain. In particular, independent contractors cannot participate in a cafeteria plan⁴⁰ or exclude from gross income the value of group term life insurance.⁴¹ These differences are explained in Columns (A) and (B) of Appendix I.

3. Business Expense Provisions

Independent contractors, including partners and LLC members, face fewer restrictions on their ability to deduct trade or business expenses than employees.

• Most importantly, independent contractors' trade or business expenses generally are deductible “above-the-line,” i.e., as a direct reduction to their business income reported on Schedule C and thus line 12 of the Form 1040 (for non-partners) or on Schedule E and thus line 17 of the Form 1040 (for partners and LLC members).⁴² This reduction also applies for alternative minimum tax purposes.⁴³ Employees' trade or business expenses, by contrast, generally are deductible only “below-the-line,” i.e., as itemized expenses reported on Schedule A and thus line 40 of the Form 1040.⁴⁴ Before 2018, itemized expenses generally were deductible only to the extent that these expenses exceeded two percent of the employee's adjusted gross income from all sources. However, Public Law Number 115-97 (the “Act”)⁴⁵ disallowed any deductions at all for miscellaneous itemized expenses for tax years beginning after 2017 and before 2026.

• In addition, unlike independent contractors employees may not deduct interest expense incurred in their trade or business of being an employee: such interest is considered a personal expense.⁴⁶

Home office expenses, and rental and depreciation expenses associated with “listed property” are subject to special deduction limits unless the expenses meet certain business use requirements.⁴⁷ The limits for employees and independent contractors generally are the same except that, in the case of home office expenses, the employee's business use also must be “for the convenience of the employer,”⁴⁸ and, in the case of listed property, such use also must be “required as a condition of employment.”⁴⁹ These standards are difficult for many employees to meet.⁵⁰ On the other hand, the Supreme Court's “principal place of business” test also makes it difficult for independent contractors to establish their home office as their principal place of business if they render services elsewhere.⁵¹

4. Rate of Income Tax

A payment to a partner or LLC member for services that is described in section 707(c) (guaranteed payments) or 707(a)(1) (transactions with partners acting other than as partners) is ordinary income and is taxed at ordinary income tax rates. By contrast, the character of any item of partnership or LLC income that is allocated to a partner or member under section 704(a) generally is determined as if the partner or member had received it directly.⁵² Thus, trade or business income is taxed at ordinary income tax rates, and capital gain is taxed at capital gains rates.

Subject to various restrictions, for tax years beginning after 2017 and before 2026, section 199A provides for a deduction of up to 20% of the “qualified business income” of noncorporate taxpayers other than employees.⁵³ For an estimated several million individual partners, there should be a favorable income tax rate difference between employees and partners for the next few years. However, this deduction does not reduce SECA taxes as it does not reduce earned income.

A few special rules apply if an individual receives a profits interest in exchange for services to or for the benefit of a partnership in a partner capacity or in anticipation of becoming a partner. The Service generally does not treat the receipt of such an interest as a taxable event for the service-provider or the partnership unless the interest relates to a limited partnership interest in a publicly traded partnership, a “substantially certain and predictable stream of income from partnership assets” or the partner disposes of the profits interest within two years of receipt.⁵⁴ In addition, it generally treats an unvested interest as received (and determines whether it is a profits interest) on the date of grant as long as the partnership and the individual treat the individual as the owner of the interest from that date.⁵⁵ The Act did not change these rules. However, in limited circumstances, it requires the recipient of a profits interest in an investment-type fund to treat certain net long-term capital gain realized by the fund or by the recipient when he or she disposes of the interest as short-term capital gain.⁵⁶

B. Use of the Common Law to Distinguish Employees from Independent Contractors

1. General Rules

Unless a statutory exception applies, whether a service-provider is an employee or an independent contractor for tax and employee benefit purposes generally is determined by applying the common law test, which focuses on the service-recipient's level of control over the way the service-provider does his or her job.⁵⁷ Any other approach would be inconsistent with Nationwide Mutual Insurance Co. v. Darden.⁵⁸ In Darden, the Supreme Court held that when a federal statute uses the term “employee” but does not “helpfully define” the term, Congress should be presumed to have intended to refer to “the conventional master-servant relationship as understood by common-law agency doctrine.”⁵⁹

Treasury regulations provide that an individual generally is an employee if, under the common law test, the relationship between the individual and the person for whom he or she performs services is the legal relationship of employer and employee. Such a relationship generally exists if the person for whom the services are performed “has the right to control and direct the individual who performs the services, not only as to the result to be accomplished by the work but also as to the details and means by which that result is accomplished.⁶⁰

Over the years, the Service has identified 20 important factors for determining when the common law test is satisfied.⁶¹ In the 1990s, it began emphasizing that these factors are not the only ones that may be taken into account, or even the best way to approach the classification issue.⁶² It has not departed from the basic common law test, which focuses on control. However, it instructs its agents to take all of the facts and circumstances into account in determining whether sufficient control exists, and to organize them according to whether they relate to behavioral control, financial control or the relationship of the parties.⁶³ Having entrepreneurial risk is one of the most important factors overall to establish partner status.⁶⁴ Whether the worker is told when to work by the service-recipient, works on a full-time basis for the service-recipient, works on the business premises of the service recipient, or works at only one location, are considered less important factors.

2. Treatment of Partners

The courts have considered the substance (and not just the form) of a relationship in determining when an individual is properly treated as an employee. The Supreme Court in Clackamas Gastroenterology Associates, P.C. v. Wells held that whether a shareholder-director of a professional corporation is an employee must be determined based on all of the facts and circumstances, using the common-law test as directed by Darden, in the same way as the test applied for other service-providers. The Court stated that the determination should not be based on the shareholder's similarity to a partner because partners, too, can be employees under that test.⁶⁵

As one example, the Court noted that “[t]oday there are partnerships that include hundreds of members, some of whom may well qualify as 'employees' because control is concentrated in a small number of managing partners.”⁶⁶ However, the Court did not treat participation in management as the touchstone of a partner's or shareholder-director's status as a non-employee. Instead, it described the common-law test as requiring the decision-maker to take into account “all of the incidents of the relationship . . . with no one factor being decisive.”⁶⁷ It also cited with approval the six factors applied by the EEOC, which included not only participation in management (i.e., “to what extent the individual is able to influence the organization”), but also the degree of supervision (i.e., “to what extent the organization supervises the individual's work”) and entrepreneurial risk (i.e., “[w]hether the individual shares in the profits, losses, and liabilities of the organization”).

The tests traditionally applied to determine whether an individual is a bona fide partner take into account some of the same factors.⁶⁸ However, Clackamas clearly indicates that the tests are different and can lead to different outcomes.⁶⁹ Although it dealt with the Americans with Disabilities Act (ADA), the Court's holding and rationale are consistent with the Regulations on the subject under the Code.⁷⁰

3. Ability to Act in Different Capacities

The common law does not prohibit a worker from being treated as both an employee and an independent contractor or other non-employee of the same entity, if the facts support it. The Service has repeatedly recognized this possibility where the entity is a corporation, and the Regulations permit it. For example, in Rev. Rul. 58-505,⁷¹ the Service ruled that officers of an insurance company who sell policies as independent contractors are officers and thus employees only with respect to their officer compensation, and the Regulations under section 3121 state that a director of a corporation acting in his capacity as such is not an employee of the corporation.⁷² Many private letter rulings take the same position.⁷³

Nor does the common law prohibit a worker from being treated as an employee simply because he or she also is an owner of the entity, even though that makes the employee part of the “master” in the master-servant relationship. The Regulations clearly recognize this. For example, the Regulations under section 83 provide that, once a share of stock received for services vests, any dividends an employee receives are taxed the same way as dividends paid to other owners, rather than as employee compensation.⁷⁴ While this might seem to be a natural conclusion in the case of a large entity with multiple owners, because that creates more distance between them and the entity's employees,⁷⁵ the Service has not limited its position to that context. For example, Rev. Rul. 59-221⁷⁶ concluded that compensation paid by an S corporation to its owners is FICA wages, regardless of the size of the entity.⁷⁷

4. Contrast with Service Guidance on Partners

Despite these rules, for 50 years the Service has taken the position that an individual cannot be both a bona fide partner and an employee of the same partnership, even with respect to different services or streams of income. Rev. Rul. 69-184 states that:

[A b]ona fide member[ ] of a partnership . . . who devotes his time and energies in the conduct of the trade or business of the partnership, or in providing services to the partnership as an independent contractor, is, in either event, a self-employed individual rather than an individual who, under the usual common law rules applicable in determining the employer-employee relationship, has the status of an employee.⁷⁸

The references to a “bona fide member of a partnership” and the “conduct of the trade or business of the partnership” suggest that the drafters of the ruling had in mind traditional service partners in traditional partnerships, who share decision-making and receive the bulk of their compensation in the form of a share of profits, for whom such a conclusion might be correct in most situations.⁷⁹ In practice, however, the Service's position seems to be that granting a partnership interest to an individual who will perform any services in a partner capacity prevents the individual from being an employee with respect any compensation or other income he or she receives from the partnership, even if very little of it comprises a share of profits, and even if the individual was historically an employee and continues to receive the bulk of his or her compensation in the form of fixed payments.⁸⁰

As explained in Section C.2, the Proposed Regulations under section 707(a)(2) that were issued in 2015 suggest a greater focus on the substance of an individual's relationship with the partnership. However, Rev. Rul. 69-184 has not been revoked.⁸¹

C. Subchapter K

1. Section 707(a)(1)

Section 707(a)(1) provides that “[i]f a partner engages in a transaction with a partnership other than in his capacity as a member of such partnership, the transaction shall, except as otherwise provided in this section, be considered as occurring between the partnership and one who is not a partner.” Both the House and the Senate reports on the provision, which Congress added in 1954, explain that it represents a deliberate rejection of the “aggregate theory” of partnership in favor of the “entity theory” in cases in which a partner performs services “for” the partnership.⁸² Armstrong v. Phinney⁸³ cites this fact in rejecting the pre-1954 case law holding that a partner cannot be an employee of his partnership under any circumstances, stating “it is now possible for a partner to stand in any one of a number of relationships with the partnership, including . . . employee-employer.”

2. Section 707(a)(2)(A)

Section 707(a)(2)(A) authorizes Treasury to issue Regulations to recast a purported allocation and distribution to a partner related to the partner's performance of services for the partnership that are properly characterized as occurring between the partnership and the partner in a capacity other than as a partner as non-partner payments for services under section 707(a)(1). The legislative history of the provision, which Congress added in 1984, provides guidance on how to draw the distinction between payments made to a member of a partnership in a partner capacity versus in a capacity other than as a partner.⁸⁴ The factors are:

Treasury and the Service issued Proposed Regulations under section 707(a)(2) in 2015.⁸⁵ The Proposed Regulations adopt the five factors from the legislative history and add a sixth factor (the arrangement provides for different allocations or distributions with respect to different services received, where the services are provided either by a single person or by persons that are related and the terms of the differing allocations or distributions are subject to levels of entrepreneurial risk that vary significantly). Consistent with the statement in the legislative history that whether the allocation and distribution is subject to appreciable risk as to amount is the most important factor, the Proposed Regulations provide that if the allocation and distribution lack significant entrepreneurial risk, the allocation and distribution will be treated as a non-partner payment under section 707(a)(1) (however, in the Proposed Regulations the allocation is treated as the distribution). Indeed, the preamble characterizes factors (2) through (6) as “secondary factors.”⁸⁶

3. Section 707(c)

Section 707(c) provides that “payments to a partner for services . . . shall be considered as made to one who is not a member of the partnership” but only for purposes of section 61(a) and, subject to section 263, for purposes of section 162(a), “[t]o the extent [that the payments are] determined without regard to the income of the partnership.” The House report on the provision, which Congress also added in 1954, explained that:

Under present law, fixed payments to a partner are not recognized as a salary but considered as a distributive share of partnership earnings. This creates obvious difficulties where the partnership earnings are insufficient to meet the salary. The existing approach has been to treat the fixed salary in such years as a withdrawal of capital, taxable to the extent that the withdrawal is made from the capital of other partners. Such treatment is unrealistic and unnecessarily complicated. The bill provides that payment of a fixed or guaranteed amount for services shall be treated as salary income to the recipient and allowed as a business deduction to the partnership.⁸⁷

The Senate report added that:

In the case of guaranteed salary payments your committee followed the House bill but made it clear that such income is to be reported for tax purposes at the end of the partnership year in which it is paid and that this treatment is only provided for purposes of the reporting of the income by the partner and the deducting of the payments by the partnership.⁸⁸

4. Distinguishing Services Provided in a Partner Capacity from Services Provided in a Non-Partner Capacity

The preamble to the Proposed Regulations under section 707(a)(2) states that Treasury and the Service have concluded that section 707(a)(2) applies when distributions to the service-provider depend on the income of the partnership (and are treated as payments to a non-partner) and that section 707(c) applies to payments unrelated to partnership income.⁸⁹ This leaves open the question of how to determine whether the services rendered for fixed amounts are rendered in a partner capacity, in which case section 707(c) would apply, or in a capacity other than as a partner, in which case section 707(a)(1) would apply under current law. The preamble also requests comments on how Rev. Rul. 69-184 applies in the context of partners providing services to the partnership.

Rev. Rul. 81-301 found a partner's services to be in a non-partner capacity when the partner was rendering similar services to persons other than the partnership, was supervised by the managing partners of the partnership, could be relieved of its duties and right to compensation on 60 days' notice by the managing partners and was responsible for its own expenses. The facts of this ruling indicate that the Service believed that the partner was acting in an independent contractor capacity because his compensation and services situation looked like that of any other independent contractor providing similar services.

In contrast, if an individual has partner-type rights (such as the ability to examine books and records or the right to vote on extraordinary or all matters) or has waived those rights and retains the right to an economic return that is subject to entrepreneurial risk,⁹⁰ the partner's services are rendered in connection with the partnership's trade or business, and the partner receives a fixed payment for those services, that payment is likely a guaranteed payment under the rules of section 707(c).⁹¹

A subset of “guaranteed payment” is the fixed compensation for services paid to a partner or LLC member who satisfies the control-based definition of a common-law employee — with limited or no management rights and limited rights to vote, if any — with respect to that compensation.⁹² In this case, as discussed more fully below, we believe it is more appropriate that the partner should be treated as acting in an employee capacity in exchange for a salary, rather than as an independent contractor under section 707(a)(1) who has his or her own trade or business, and as a partner with respect to the distributive share of income, gain, loss, and deduction from the partnership.

5. Previous American Bar Association Section of Taxation and New York City Bar Comments

On December 2, 2011, the American Bar Association Section of Taxation submitted “Options for Tax Reform Relating to Partnerships.”⁹³ In that submission, the Section recommended that partners who otherwise would qualify as employees under general principles of tax law and own ten percent or less of the profits and capital of the partnership may be classified by their employer partnership as employees with respect to benefits they otherwise would receive as employees, and that the partnership may make a one-time irrevocable election to treat as wages the guaranteed payments for services provided to the partnership by such partners.

On June 18, 2014, the New York City Bar Committee on Taxation of Business Entities submitted a report entitled “New York City Bar Report Offering New Partnership Guidance on the Treatment of a Partner as an Employee for Federal Tax Purposes.” In this report, the Committee made an extensive analysis of the relevant differences between the taxation of partner “benefits” and those of an “employee,” and recommended that a partnership be allowed to elect to treat an individual partner whose share of partnership profits is ten percent or less as an employee with respect to fixed compensation paid to him or her if, but for such share of partnership profits, the relationship between the partner and the partnership would be that of an employee with an employer. The Committee believed that such changes would not require legislation but could be implemented through Regulations.⁹⁴

II. RECOMMENDATIONS

A. Recognize the Possibility of Dual Status as a General Principle

1. Recommendation

We recommend that Treasury and the Service revoke Rev. Rul. 69-184 and recognize the possibility that an individual can be an employee and a bona fide partner of the same partnership or LLC with respect to different streams of income from the partnership or LLC, where the facts support such treatment. We recommend that the dual-status partner not be treated as two individuals for purposes of the employee benefit and employment tax provisions of the Code, such as the social security wage base rules and the definition of “highly compensated employee,” but rather that those provisions be applied on an aggregated basis to his or her income and benefits.

For provisions that apply differently to employees and partners, such as those governing employer-provided meals and lodging, we recommend that Treasury and the Service allow the dual-status partner's compensation and benefits to be attributed — to the extent such treatment has substance, e.g., is consistent with the applicable plan documents — to his or her services as an employee.

Where an allocation is needed, such as with respect to contributions to a qualified plan, we recommend that the partnership or LLC be allowed to make that allocation — again to the extent such treatment has substance and is appropriate based on the facts and circumstances. In the case of the few employee benefit provisions that treat an individual as exclusively an employee or exclusively a partner, such as the definition of “full-time employee” for purposes of the shared responsibility provisions,⁹⁵ we recommend that Treasury and the Service treat the dual-status partner as an employee or partner depending on which treatment is more protective of employees as a group.⁹⁶

2. Explanation

a) Previous Concerns about Recognizing Dual Status as a General Principle

In Phinney,⁹⁷ the Fifth Circuit held that it was “legally possible for a partner to be an employee of his partnership for purposes of section 119 of the Code,” the exclusion from gross income for employer-provided meals and housing that is limited to common-law employees. As noted above, it rejected the case law interpreting the 1939 Internal Revenue Code, which “held that a partner could not be an employee of his partnership under any circumstances,” because that case law was “grounded on the theory, present throughout the 1939 Code, that a partnership and its partners are one inseparable legal unit.” The Fifth Circuit stated that by adopting section 707(a) in 1954, “Congress rejected this 'aggregate theory' in favor of the 'entity theory' in cases where 'a partner sells property to, or performs services for the partnership'.”⁹⁸

One year later, the Service issued Rev. Rul. 69-184, which rejected the rationale in Phinney. It did so for administrative as much as for legal reasons.

The Service explained the administrative rationale in GCM 34001:⁹⁹

To introduce the possibility of dual “status” into the application of the statutes in question so that the determination of “wages” under I.R.C. § 3121(a) would virtually have to be on a transaction by transaction basis (rather than one based on a single continuing relationship) would render it almost impossible to administer the employment taxes of subtitle C. It is hardly rational to assert that Congress intended or would approve such a result merely because the statute which it wrote did not link up an individual's “status of an employee” with the person for whom the individual performs services. . . .

The Service explained the legal rationale in GCM 34173,¹⁰⁰ in which it took the position that Congress intended section 707(c), which was enacted at the same time as section 707(a), to apply in situations in which a partner receives a salary in addition to a share of partnership income, and that section 707(c) allows the salary to be treated as regular employment income only for very limited purposes – not including the employee benefit provisions of the Code.¹⁰¹

In addition to the concerns noted above, Treasury and the Service have suggested more recently that recognizing dual status, as the Fifth Circuit did in Phinney, might (1) place a significant burden on Treasury and the Service by requiring it to issue additional guidance under various provisions, and (2) increase the potential for tax abuse by encouraging dual-status partners to take the position that they are subject to employment taxes (under FICA) only on their wage-type payments and not on their partnership allocations, similar to the treatment of owner-employees in an S corporation,¹⁰² and giving dual-status partners the “best of both worlds” by allowing them to continue to receive the full range of employee benefits in their roles as employees while still benefiting from the favorable treatment of profits interests in their roles as partners or LLC members. Respectfully, as explained below, we think these concerns are not material enough to justify continued adherence to Rev. Rul. 69-184.

b) Reasons for Recognizing Dual Status as a General Principle

(1) Consistency with Current Law

(a) Common law

We believe that revoking Rev. Rul. 69-184 and recognizing the possibility that an individual can be an employee and a bona fide partner of the same partnership or LLC would be consistent with the common-law standard that is used to determine employment status under the Code. As noted above, a bona fide partner generally cannot qualify as an employee with respect to services he or she performs as a partner under the common law test because the level of entrepreneurial risk and relationship of the parties that distinguish a partner from an employee also are some of the most important factors taken into account under that test. But Congress clearly endorsed the “entity” theory of partnerships when it enacted section 707(a)(1),¹⁰³ and the common law does not preclude an owner of an entity from being an employee of the same entity, or from serving simultaneously as an independent contractor and an employee of the same entity.

Even if the Service's position in Rev. Rul. 69-184 produces the right result in some situations, we believe the “all or nothing” rule it applies is inconsistent with the facts-and-circumstances approach of the common-law test and not reflective of the myriad ways many contemporary partnerships operate and compensate their employees. For example, it immediately treats an employee who receives a partnership interest as a non-employee even if his or her distributive share is a small fraction of the individual's historical compensation received as an employee and the individual's historical compensation and services rendered will continue.

We believe it is more appropriate in such a situation to (1) treat such an individual's compensation pursuant to the partnership agreement as income received by a self-employed person, focusing on the entrepreneurial risk inherent in that compensation — which is a factor taken into account both under section 707(a) and the common-law test — but (2) treat the compensation received by the individual pursuant to whatever schedule of salary and benefits applies to employees as income received by an employee, focusing not only on the lack of entrepreneurial risk inherent in that compensation but also on the other elements of control taken into account under the common-law test, which in all likelihood will continue to exist with respect to that compensation.

(b) Subchapter K

We believe that revoking 69-184 and recognizing the possibility that an individual can be an employee and a bona fide partner of the same partnership or LLC would be consistent with Subchapter K. Section 707(a) expressly acknowledges the possibility that a partner can perform services other than as a partner. Congress did not provide that a partner acting other than in his or her capacity as a partner would have to be treated as an independent contractor. Indeed, the preamble to the Proposed Regulations under section 707(a)(2) makes it clear this means the partner can have the status of an employee.¹⁰⁴ Although the preamble cites Rev. Rul. 69-184 for this principle, it seems contrary to the way Rev. Rul. 69-184 has been applied, namely to require the individual to be a partner for all purposes.

Similarly, we believe that section 707(c) does not require a different result. It deals with amounts determined without regard to partnership income but nonetheless received for services performed in a partner capacity. Neither it nor its legislative history addresses how amounts received for services performed in another capacity should be treated. That issue is addressed in section 707(a)(1). Furthermore, the factors in the Proposed Regulations under section 707(a)(2) appear to make section 707(c) nearly obsolete. Under them, any distribution and allocation for services for which there is no entrepreneurial risk is treated as a payment to the partner for services performed in a non-partner capacity. A payment that is not dependent on the income of the partnership lacks significant entrepreneurial risk under the Proposed Regulations. Accordingly, if that is the universal test for determining whether services are rendered in a partner capacity, section 707(c) can no longer apply to any payments to partners for services in the capacity of a partner. For similar reasons, the Joint Committee on Taxation has stated that “[t]he statutory distinction between guaranteed payments and nonpartner payments has little continuing purpose,”¹⁰⁵ and the Tax Section of the American Bar Association adopted a policy in 1999 recommending repeal of section 707(c). Nevertheless, it is unnecessary to determine whether section 707(c) is (or should be) obsolete for purposes of treating partners who are also common-law employees as being outside the purview of section 707(c) because section 707(c) relates to services performed in a partner capacity, not as a common-law employee.

(2) Lack of Additional Burden on Service

(a) Determination of Employment Status and Employee Compensation

We believe that revoking Rev. Rul. 69-184 and recognizing the possibility that an individual can be an employee and a bona fide partner of the same partnership will not require Treasury or the Service to make more, or more complex, determinations of employment status or the amount of compensation earned from it. Most importantly, we believe that the common-law standard and the evolving rules under section 707(a) regarding when a partner acting is in his capacity as a member of the partnership or LLC already requires those determinations to be made with respect to each type of service and compensation performed and received by a service-provider, just as it does in the corporate context. Treating a dual-status partner as only a partner or an employee effectively avoids, rather than complies with, those standards and rules.

In any event, we believe that revoking Rev. Rul. 69-184 will not impose additional administrative burdens on Treasury or the Service. Most dual-status partners will perform services in their employee capacity that are typical of the services performed by other employees and will receive partnership interests that are similar to those received by other partners or LLC member, so the status of those employees as bona fide employees under the common law as well as the compensation they receive, and the status of the other interests as bona fide partnership interests as well as the income allocated under those other interests, can be used as the benchmark to determine whether the partnership's characterizations are correct. That benchmark may be helpful when new employees are hired and also offered a profits interest as an incentive to help the business venture generate more profits.

The Code already treats taxpayers differently with respect to different streams of income in other contexts,¹⁰⁶ and Treasury and the Service have been able to administer those rules.

(b) Determination of Limited Partner Status

We believe that revoking Rev. Rul. 69-184 will not require Treasury or the Service to make more, or more complex, “limited partner” status determinations. Notwithstanding the dicta in Renkemeyer, we believe that a state-law limited partner clearly qualifies under the terms of section 1402(a)(13). Nevertheless, for other types of partners or LLC members, even under current law, the Service must determine whether an individual classified as a partner under Rev. Rul. 69-184 is appropriately being treated as a limited partner rather than a general partner. Distinguishing the individual's services as an employee could have several effects, depending on how limited partner status is determined, but none of these effects should impose additional administrative burdens on Treasury or the Service.

If “limited partner” status (for members of entities that are not state-law limited partnerships) is determined based on the partner's or LLC member's involvement in management, as discussed in Renkemeyer and Castigliola,¹⁰⁷ that should not involve additional burdens because the services as an employee would not involve him or her in management. If the individual's status is determined based on the partner's or LLC member's level of services as a self-employed person, which was more the focus of ILM 201436049,¹⁰⁸ that should not involve additional burdens because the services as an employee also would be irrelevant. If it is determined based on the partner's or LLC member's hours of service, which was the focus of the 1997 Proposed Regulations and President Obama's budget proposals¹⁰⁹ and to some extent is the focus of the passive activity rules under section 469,¹¹⁰ that should not involve additional burdens because the individual's services as an employee are currently taken into account under section 469.¹¹¹

In other words, determination of a person's status as a “limited partner” (when that person is not a limited partner in a state-law limited partnership) for purposes of section 1402(a)(13) is currently uncertain and depends on a weighing of the facts and circumstances. That uncertainty is not affected by allowing partners to have dual status; rather, the tax impact of that uncertainty is likely to be reduced by the efficient tax-collection associated with employee status.

(c) Employee Benefits and Executive Compensation Guidance

We believe that revoking Rev. Rul. 69-184 will not require Treasury or the Service to issue significant additional guidance under the employee benefit and employment tax provisions of the Code. The need for additional guidance is described in Column (C) of Appendix I. By and large, the only guidance that is needed is confirmation that compensation and benefits of a dual-status partner will be aggregated regardless of whether they are attributable to services as a partner or services as an employee. As noted in Column (C), many of the same complications exist under current law (without regard to dual status) when an individual switches from employee to partner status in the middle of the year.

(3) Benefits to Rank-and-File Workers

The Service's position in Rev. Rul. 69-184 can have a harsh impact on workers historically treated as employees who receive (often small) partnership or LLC interests as compensation for services.

Being transformed into partners and losing employee status can cause such workers to be subject to different employment tax rules with respect to all of their compensation. These include (1) the need to pay estimated taxes on amounts previously received as wages rather than rely on income tax withholding, and the possible noncompliance and consequent underpayment of taxes that can result from that; (2) the need to fill out additional schedules on Form 1040 reporting items of partnership income and loss; (3) the possible need to request extensions of Form 1040 filing deadlines as K-1 forms often are provided later than W-2 forms; and (4) the possible need to file returns in multiple states and/or foreign countries.

Being transformed into partners and losing employee status also can cause such workers to lose some employee benefits. These include (1) the loss of the ability to participate in cafeteria plans, HRAs and FSAs, and to receive employer-provided meals and housing, transportation fringe benefits, and a handful of other nontaxable benefits described in Appendix I, (2) the need to deduct pension contributions and health insurance on Schedule B to the Form 1040, and the loss of the ability to exclude or deduct them for employment tax purposes, and (3) the loss of any employer obligation to provide health insurance under section 4980H.

If the Service's position in Rev. Rul. 69-184 is taken as a statement of the worker's status as an independent contractor rather than a common-law employee for all purposes, there may be a risk that being transformed into partners may alsocause such workers to lose the protection of a large number of laws that also use the common-law standard, including (1) Title I of the Americans with Disabilities Act (ADA),¹¹² (2) the Age Discrimination in Employment Act (ADEA),¹¹³, (3) Title VII of the Civil Rights Act of 1964,¹¹⁴ (4) the National Labor Relations Act (NLRA),¹¹⁵ (5) the Occupational Safety and Health Act (OSHA),¹¹⁶ (6) the Uniformed Services Employment and Reemployment Rights Act of 1994 (USERRA),¹¹⁷ and (7) the Worker Adjustment and Retraining Notification (WARN) Act.¹¹⁸

(4) No Encouragement of Abuse

(a) Employment Taxes

We believe that revoking Rev. Rul. 69-184 and recognizing the possibility that an individual can be an employee and a bona fide partner of the same partnership or LLC will not encourage abuse of the employment tax provisions of the Code. In fact, we believe that it will enhance compliance by ensuring that at least their income attributable to services as an employee will be subject to withholding, while the treatment of their income attributable to services as a partner or LLC member will remain the same.

The principal concern seems to be that dual-status partners will take the position that they are subject to employment taxes (under FICA) only on their income from employment, and not on any of their other income, similar to the treatment of owner-employees in an S corporation. However, that seems to assume that dual-status partners will ignore their tax obligations, which seems no likelier to occur if Rev. Rul. 69-184 is revoked or retained. We believe that Riether¹¹⁹ supports this view. The plaintiffs in that case treated a small amount of their earnings as FICA wages and none of their distributive share as SECA income. The court noted that “[t]he income at issue is not the income they treated as 'wages,' but the income they treated as their distributive share of partnership income. Plaintiffs' characterization of some of the income as wages does not change the character of the remaining income.” The court explained that the plaintiffs cited no authority for excluding the rest of their income from SECA, and made no attempt to fit within section 1402(a)(13). It easily concluded that section 1402(a)(13) did not apply to them because they were not limited partners, in that they “lack[ed] management powers but enjoy[ed] immunity from liability for debts of the partnership.”

Another concern seems to be that revoking Rev. Rul. 69-184 might make it easier for a dual-status partner to argue that he or she is a limited partner for purposes of section 1402(a)(13) despite not being a state law limited partner, because service as an employee is disregarded in determining whether the individual qualifies under standards such as those established in the 1997 Proposed Regulations discussed above. However, that too seems to assume that dual-status partners will ignore their tax obligations. As noted above, services as an employee should matter for this purpose only if the applicable test uses hours of service to make this determination and allows services as an employee to be disregarded. If so, the only way the individual could manipulate that result is by mischaracterizing himself or herself as an employee with respect to those services. If Treasury and the Service believe that excessive numbers of hours of service will be characterized as employment-related, other options are available besides simply retaining Rev. Rul. 69-184. They could, for example, issue guidance providing that services performed for wage income can be ignored only if the service-provider receives the same wage income for those services as similarly situated non-partner employees.¹²⁰

(b) Employee Benefits and Executive Compensation

We believe that revoking Rev. Rul. 69-184 will not result in abuse of the employee benefit provisions of the Code. Most importantly, there are not significant advantages under those provisions to being treated as an employee. The tax-free benefits that can be provided solely to employees — employer-provided meals and housing, transportation fringe benefits, group-term life insurance, retirement planning services, USERRA benefits, VEBAs, and possibly a few others that are restricted to “employees” (but do not define that term) — have limited value to the recipients and, in many cases, are subject to deduction limits under the Act.¹²¹ We agree that there will be situations in which individuals characterize themselves as employees without actually providing meaningful services as employees or without receiving meaningful compensation beyond the benefits themselves or enough compensation to justify providing those benefits, but we believe that can be addressed by making it clear that such a characterization must have some substance in order to be respected.¹²² We do not believe it is necessary to adopt a blanket rule like Rev. Rul. 69-184 just to make sure no such abuses occur.

(c) Profits Interests

We believe that revoking/modifying Rev. Rul. 69-184 and recognizing the possibility that an individual can be an employee and a bona fide partner of the same partnership or LLC is correct as a matter of law given modern partnership arrangements and does not permit abuse of the Service's guidance on the tax treatment of profits interests.¹²³ Most importantly, we note that the use of a profits interest consistent with that guidance allows businesses to incentivize service-providers in a manner that is consistent with subchapter K and is not an abuse. The guidance is a safe harbor that was intended to resolve, as a practical matter, disputes about the nature of profits interests, in particular profits interests received for services, including whether they had anything more than “speculative” value at the time of receipt.¹²⁴ The Act substantially reduced the tax benefits to recipients of certain interests in investment-type funds¹²⁵ but did not eliminate the profits interest as a useful tool for businesses.

Therefore, like previous comments by the American Bar Association Section of Taxation, these Comments do not suggest any change to the treatment of profits interests under that guidance,¹²⁶ at least until a more comprehensive review of the guidance is undertaken, similar to the review that was undertaken in 2005.¹²⁷ However, we recognize that Treasury and the Service have an ongoing concern and obligation to be sure the guidance is used by taxpayers only in situations to which it applies. We also agree that there will be situations in which service-providers may attempt to take advantage of the guidance without actually providing meaningful services in a partner capacity or anticipating ever becoming bona fide partners, but we believe that can be addressed by making it clear that the individual must be a bona fide partner. Treasury and the Service already have taken steps in that direction.¹²⁸ We do not believe it is necessary to retain a blanket rule like Rev. Rul. 69-184 just to make sure no such misuses occur. The requirement in Rev. Rul. 69-184 that the service-provider be treated as a partner for all purposes seems to us to be out of proportion to the requirement in the guidance that there be some nexus between the profits interest and the partnership or LLC.

(d) Section 199A

For similar reasons, we also believe that revoking Rev. Rul. 69-184 will not facilitate the abuse of section 199A and in fact could discourage abuse. If Rev. Rul. 69-184 is retained, an employee who receives a partnership interest in his or her partnership/employer is automatically converted to non-employee status. Regulation section 1.199A-5(d)(3) provides that, solely for purposes of section 199A(d)(1)(B) and the related Regulations, an individual who was treated as an employee for employment tax purposes by the service-recipient and who subsequently is treated as a non-employee by the service-recipient with regard to the same services, is presumed for three years after ceasing to be treated as an employee to be in the trade or business of performing services as an employee. However, this presumption can be rebutted by citing other “Federal tax law, regulations, and principles (including common-law employee classification rules).”

Rev. Rul. 69-184 is a statement of the government's view of the common-law principles as of 1969. Under those principles, if an individual is properly classified as a partner under Federal tax law (because of having partner rights and entrepreneurial risk, for example), the individual cannot be an employee. Thus, the individual may be able to rebut the presumption in the section 199A regulations that he or she is properly treated as an employee.

By contrast, if Rev. Rul. 69-184 is revoked or modified, the worker would have to demonstrate that he or she was not a common law employee with respect to those services provided to the partnership as a partner, based on the substance of the arrangement and current law. And, if our recommendation to allow dual status is accepted, the services provided by a partner as a common law employee could be segregated and treated separately for purposes of section 199A. In any case, retaining Rev. Rul. 69-184 in its unmodified state creates ambiguity with respect to the application of section 199A in these situations.

Finally, taxpayers can enter into arrangements¹²⁹ where Rev. Rul. 69-184 is not applicable because the partner is employed in a separate tax entity and each entity has a business purpose and is respected for Federal tax purposes. In this way, they can allow certain employees to become indirect partners in order to incentivize them by allowing the individual a share in the profits of the enterprise. This structure formally segregates the individuals' Form W-2 wages from their shares of partnership profits. In our view, this is unnecessarily expensive for both taxpayers and the government, and the cost could be avoided by reasonable dual status rules for purposes of section 199A as well as for other purposes of the Code.

B. Alternative Recommendation: Recognize the Possibility of Dual Status for Holders of Small Interests

1. Recommendation

As an alternative, we recommend that Treasury and the Service modify Rev. Rul. 69-184 to recognize the possibility that an individual can be an employee and a bona fide partner of the same partnership only if the individual holds a small interest in the partnership or LLC, and treat a capital or profits interests of less than ten percent as small for this purpose. Because the ten-percent cutoff would be chosen in the interest of administrability but without any direct authority in the Code, we recommend that approach be adopted in the form of the Revenue Procedure attached as Appendix II, which would modify and supersede Rev. Rul. 69-184.

2. Explanation

As a practical matter, individuals who hold small interests in a partnership or LLC are less likely to participate in its management and, by definition, do not receive large profits interests. Comparable employees who hold no interests at all also are more likely to exist. Thus, many of the concerns that Treasury and the Service otherwise might have about recognizing dual status should be diminished. At the same time, these service-providers have less capacity to adapt to the complexities of being treated like partners with respect to all of their income. Thus, the arguments for offering them some relief seem stronger.

This recommendation would be consistent with the comments submitted by the Tax Section on December 2, 2011.¹³⁰

C. Permit Voluntary Withholding on Guaranteed Payments

1. Recommendation

As preliminary step — but not an alternative to the recommendations made in Sections A.1 and B.1 above — we recommend that Treasury and the Service extend voluntary withholding under section 3402(p) to guaranteed payments for services under section 707(c).

2. Explanation

As noted in Section I.A.1.c) above, many partnerships and LLCs already use a variety of “synthetic withholding” arrangements to help their partners and members, but the status of these arrangements is not entirely clear. Extending voluntary withholding under section 3402(p) to guaranteed payments would help address these issues by making the withholding official. It also would be well within the spirit of section 3402(p). The preamble to the Temporary Regulation that preceded the current Regulation¹³¹ stated that:

Expanding the use of voluntary withholding agreements to payments designated by the Secretary as eligible for voluntary withholding will permit taxpayers to use the withholding regime (rather than the estimated tax payment process) to meet their tax payment obligations on a timely basis, minimize the risk of underpayment of taxes, and achieve administrative simplification for taxpayers and the IRS.

Helping partners and members of partnerships and LLCs meet their tax payment obligations is exactly what these arrangements are designed to achieve.

We do not recommend that Treasury and the Service take this step in lieu of revoking or modifying Rev. Rul. 69-184. That is because, as explained the other sections above, doing so would not address the breadth of other issues, such as employee benefits, that turn on various facets of the individual's relationship with the partnership or LLC.