AICPA Says Proposed Regulations Produce Uneven Results That Depend On State Law.

The American Institute of Certified Public Accountants, Washington, has commented that proposed regs relating to the self- employment tax treatment of members of limited liability companies (LLCs) "unevenly apply section 1402(a)(13) depending on the jurisdiction in which the LLC is formed." The result, the AICPA says, is that members actively involved in management or engaged in personal service activities can avoid the inclusion of their distributive share of net income as self-employment income. Or, the AICPA notes, members of LLCs may unfairly have their income classified as self-employment income simply because a state statute does not allow appointment of LLC managers.

Accordingly, the AICPA recommends withdrawal of the proposed regs and promulgation of new regs that provide a "participation" test for determining whether income should be classified as earnings from self-employment. This test, the AICPA explains, could simply be a cross-reference to the material participation standard provided in temporary reg. section 1.469-5T(a).

The AICPA is also troubled by the language of the regulation preamble, which states that "under applicable law, a limited partner may become liable for the obligations of a limited partnership as a general partner when the limited partner participates in the management or control of the business." This statement, the AICPA says, appears to be in conflict with the Revised Uniform Limited Partnership Act. The AICPA also says that the preamble ignores the legislative history of section 1402(a)(13), which allows a person to be both a general and limited partner, with only the distributive share received as a general partner as self-employment income.

====== FULL TEXT ======

May 15, 1995

The Honorable Margaret Milner Richardson

Re: Proposed Regulations Relating to Self-Employment Tax Treatment of

Dear Commissioner Richardson:

Enclosed are 8 copies of the comments of the Tax Division of the American Institute of Certified Public Accountants on the above- referenced proposed regulations.

The comments were developed by our Partnership Taxation Committee and reviewed by the members of our Tax Executive Committee. We hope they will be useful to you.

If you or others on your staff wish to discuss any aspect of our comments, please contact me at (202) 467-3004 or one of the following individuals:

William T. Carman, Chair, Partnership Taxation Committee (303) 291-9121

or

Denise A. Green, Partnership Taxation Committee (210) 732-4000

or

Stephen C. Moosbrugger, Partnership Taxation Committee (612) 376-4702

Sincerely,

Deborah Walker

Enclosures

* * *

AMERICAN INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS

Comments on Proposed Regulations Section 1.1402(a)-18

Partnership Taxation Committee

Submitted to the Internal Revenue Service

GENERAL COMMENTS

On December 29, 1994, proposed regulations were issued to amend the regulations on the tax on self-employment income under section 1402 of the Internal Revenue Code of 1986. The proposed regulation concerns the treatment of members of certain limited liability companies. Under the proposed regulation, certain members of limited liability companies are treated as limited partners for self- employment tax purposes.

Our primary concern is that the proposed regulations unevenly apply IRC section 1402(a)(13) depending on the jurisdiction in which the LLC is formed. The result is that members who are actively involved in management or actively engaged in personal service activities may avoid the inclusion of their distributive share of net income as self-employment income. Conversely, members may unfairly have their income classified as subject to self-employment taxes simply because the state statute does not allow appointment of LLC managers. We recommend the withdrawal of these regulations and drafting proposed regulations which set forth a "participation" standard test; for example, possibly by cross-reference to the "material participation" standard as outlined in Temp. Reg. section 1.469-5T(a) for determining whether income should be classified as earnings from self-employment.

Additionally, we are troubled by the language of the regulation preamble which states, "under applicable law, a limited partner may become liable for the obligations of a limited partnership as a general partner when the limited partner participates in the management or control of the business." This statement appears to be in conflict with the Revised Uniform Limited Partnership Act.

The preamble further provides that a purpose of the regulation "is to ensure that both a member of an LLC and a limited partner in a limited partnership who participate in the management or control of the entity, to the same extent, are treated in the same manner for self-employment tax purposes." This statement ignores the legislative history of section 1402(a)(13) which allows a person to be both a general and limited partner with only the distributive share received as a general partner as self-employment income [H. Rep't No. 95-702, Part 1, 95th Cong., 1st Sess. 40 (1977), 1978-1 CB 469 at 477.].

SPECIFIC COMMENTS

1. PROP. REG. SECTION 1.1402(a)-18(b)(2)

REQUIRES LEGAL INTERPRETATION. The regulation requires the LLC to express a legal opinion on two matters:

(i) whether the LLC could have been formed as a limited

(ii) whether a member would have qualified as a limited partner

Obviously, these interpretations are beyond the scope of most taxpayers and in any event, taxpayers should not be required to render legal opinions to comply with regulations.

Additionally, this regulation causes the selection of the state of formation of the LLC to dictate the treatment of self-employment income rather than the level of activity engaged in by the LLC member. This would effectively allow taxpayers to "forum shop" and potentially escape self-employment tax on self-employment income by careful selection of the most beneficial LLC statute as applied under this regulation.

2. PROP. REG. SECTION 1.1402(a)-18(c)(3)

STATE OF FORMATION DETERMINES SELF-EMPLOYMENT INCOME. The statutes of certain states, such as Colorado, require all members to be managers. Because managers cannot be treated as a limited partner (Prop. Reg. section 1.1402(a)-18(b)(1)), state statute dictates whether a member's distributive share will be considered net earnings from self-employment.

The regulation stipulates that if there are no elected or designated managers (as so defined) of the LLC, each member will be treated as a manager and, accordingly, the member's distributive share treated as net earnings from self-employment. This inclusion is far too broad and will certainly cause many non-participating members' distributions to be subject to self-employment tax.

* * *

May 15, 1995

The Honorable Margaret Milner Richardson

Re: Proposed Regulations Relating to Rules for Certain Real Estate

Dear Commissioner Richardson:

Enclosed are 8 copies of the comments of the Tax Division of the American Institute of Certified Public Accountants on the above- referenced proposed regulations.

The comments were developed by our Partnership Taxation Committee and reviewed by the members of our Tax Executive Committee. We hope they will be useful to you.

If you or others on your staff wish to discuss any aspect of our comments, please contact me at (202) 467-3004 or one of the following individuals:

William T. Carman, Chair, Partnership Taxation Committee (303) 291-9121

or

Mark Stutman, Partnership Taxation Committee (215) 656-3046

or

Ken Heller, Partnership Taxation Committee (703) 993-1770

Sincerely,

Deborah Walker

Enclosures

* * *

AMERICAN INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS

Comments on Proposed Regulations Section 1.469

Section 469 Working Group

Submitted to the Internal Revenue Service

GENERAL COMMENTS

The proposed regulations meet the important objectives of providing general guidance as to how IRS interprets the new legislation: clarifying the application of the new law with regard to specific issues, e.g., application to holders of interests in real estate through limited partnerships, while doing so in a reasonable, straightforward manner that taxpayers and practitioners should easily understand.

The proposed regulations strike an appropriate balance of providing necessary guidance without being unduly lengthy or complex or resorting to numerous apparently arbitrary limitations, formulas or allocation methodologies. We applaud, in particular, the "fresh start" rules under (Prop. Reg. section 1.469-11(b)(3) that permit regrouping of activities under Reg. section 1.469-4 to the extent necessary for taxpayers to avail themselves of the provisions of Code section 469(c)(7). These rules acknowledge the significance of the change made by Code section 469(c)(7) and will, we believe, assure an orderly transition from previous groupings of activities made by those taxpayers to whom Congress intended to provide relief.

In general, the change made in the 1993 tax act (adding Code section 469(c)(7)) was intended by Congress as a taxpayer-favorable modification for those in the real property trade or business who also had rental real estate activities, the losses from which were subject to the passive-activity loss limitation rules of Code section 469. These rules were considered unduly harsh because they treated rental activities as passive activities without regard to the level of participation by the taxpayer.

The proposed regulations are likely to frustrate somewhat the intent of Congress, however, because they maintain the regulatory rule that, for the most part, prohibits the combination of rental real estate activities and real property trades or businesses (Reg. section 1.469-4(d)(1)). Consequently, the taxpayer who qualifies for the relief intended by Code section 469(c)(7) will often receive no benefit because of inability to establish material participation in specific real estate rental activities, even though material participation exists in the overall real property trade or business. Further changes to existing regulations are needed, therefore, to allow such taxpayers the opportunity for relief intended by Congress.

SPECIFIC COMMENTS

1. METHOD OF ALLOCATION

The election under Prop. Reg. section 1.469-9(g) is binding in all future years that a taxpayer is a qualifying taxpayer, unless there has been a material change in facts and circumstances (Prop. Reg. section 1.469-9(g)(1)). The proposed regulations do not, but should, provide guidance regarding what is considered a material change in facts and circumstances. The proposed regulations only indicate what is NOT so considered (see Prop. Reg. section 1.469- 9(g)(2)).

Also, a clarifying addition to the proposed regulations would be useful to explain the ramifications if, in a subsequent year, the taxpayer is not a qualifying taxpayer. For example, must the taxpayer then allocate any undeducted losses to the various rental real estate interests that the taxpayer holds? Must such allocations be made during years in which the election under Prop. Reg. section 1.469- 9(g) is in effect and the taxpayer is also a qualifying taxpayer, in anticipation of the possibility that the allocation might someday be useful? If not, will any reasonable method of making such allocations be accepted in the future, or will some particular methodology be required? What if one or more properties or interests had been disposed of in the prior years -- how should undeducted losses related to those interests be allocated to the other interests in rental real estate that are treated as a single rental real estate activity?

2. APPLICATION OF PASSIVE ACTIVITY RULES

Prop. Reg. section 1.469-9(e)(2) indicates that a rental real estate activity of the taxpayer is to be treated as a former passive activity if the taxpayer materially participates in that activity and any carryover losses or credits have been allocated to that activity under Reg. section 1.469-9(f)(4). However, no guidance is provided as to how the former passive activity rules do apply. In particular, how do they apply if the taxpayer has made an election pursuant to Prop. Reg. section 1.469-9(g) to treat all interests in rental real estate as a single rental real estate activity?

Presumably, the losses previously allocated to the separate rental real estate interests that had been treated as one or more activities in prior years would be allocated to the single rental real estate activity and would then be considered for the year of the election and all subsequent years as losses allocated to THAT activity, i.e., to the single rental real estate activity. Furthermore, those losses would presumably be deductible to the extent of income from the single rental real estate activity, and there would be no need to determine to what extent a particular rental real estate interest had income for the year.

However, it appears that the taxpayer might still be required in a subsequent year to determine to what extent any carryover losses are allocable to the separate rental real estate interests, This could arise, for example, if the taxpayer fails to be a "qualified taxpayer" in a subsequent year and, therefore, the election made under Prop. Reg. section 1.469-9(g) is not effective for that year. It would be helpful if this would be clarified, preferably by example, in the final regulations.

3. FIVE PERCENT OWNERS

Code section 469(c)(7)(D)(ii) specifies that in testing whether a taxpayer is a "qualified taxpayer," participation as an employee is not to be treated as performed in the real property trade or business, unless the employee is a five percent owner of the employer (within the meaning of Code section 416(i)(1)(B)). While it is possible to determine at any given time during the year whether status as a five percent owner exists, the statute is silent. We can only speculate why Congress decided that five percent owner employees would be considered as being in a real property trade or business.

There is no indication in the statute or otherwise that Congress intended that the individual must be a five percent owner for any particular period of time for services performed during the year as an employee to be eligible as participation in a real property trade or business. We believe that Treasury should adopt a rule consistent with the statute and reasonably in furtherance of its relief purpose, rather than adopt one that would limit an individual's ability to establish status as a five percent owner.

The proposed regulations adopt an extraordinary interpretation of this provision and create an all-or-nothing standard for the entire year -- either participation by an employee is counted during the entire year, or it is not counted at all. This results from the requirement in Prop. Reg. section 1.469-9(c)(4) that the individual be a five percent owner of the real property trade or business for the ENTIRE year; otherwise, no participation as an employee is taken into account.

We see no reason for this all-or-nothing requirement. Code section 469(c)(7) is a remedial modification to the passive-activity loss rules. The proposed regulation undermines this remedial purpose for no apparent reason. The intent of Congress to ignore the services of employees who did not have a minimal ownership interest in their employer can be met by not counting services performed during the portion of the year that the employer is not a five percent owner. It is unduly harsh to ignore all service during the year, and to deny a taxpayer the opportunity to qualify for the relief intended by Code section 469(c)(7), merely because the taxpayer failed to be a five percent owner for as little as one day of the year.

4. EFFECT OF CODE SECTION 469(C)(7) ON OTHER REGULATIONS

The Treasury finalized regulations (Reg. section 1.469-4) relating to the composition of an activity shortly before the proposed regulations were issued. In those final regulations, Treasury made a significant change to an earlier proposed regulation regarding what portion of an activity must be disposed of ("substantial portion" was changed to "substantially all") to be considered a disposition of the taxpayer's entire interest in the activity for purposes of Code section 469(g).

The advisability of the election described in Prop. Reg. Section 1.469-9(g) is significantly affected by this change, yet it is unclear whether the decision to modify the standard for partial dispositions in Reg. section 1.469-4(g) considered the significance of the election and Congressional intent.

In particular, when Code section 469(c)(7) was enacted, it is reasonable to think that Congress expected the relevant standard would be "substantial portion" (the proposed regulations relating to the combination of activities were in effect prior to enactment). This expectation is adversely affected by the subsequent change in the partial disposition standard.

We believe, in light of this and as part of its consideration of the appropriate regulations under Code section 469(c)(7), Treasury should reconsider its final Reg. section 1.469-4(g) to ensure that this new partial disposition standard does not limit the availability of broad relief under Code section 469(c)(7), as intended by Congress.