IRS Argues Self-Employment Tax Was Partnership Item

SOROBAN CAPITAL PARTNERS LP,
SOROBAN CAPITAL PARTNERS GP
LLC, TAX MATTERS PARTNER,
Petitioner,
v.
COMMISSIONER OF INTERNAL REVENUE,
Respondent.

Motion for Summary Judgment

UNITED STATES TAX COURT

RESPONDENT'S MOTION FOR PARTIAL SUMMARY JUDGMENT

RESPONDENT MOVES, pursuant to the provisions of Tax Court Rule 121, for a partial summary adjudication in Respondent's favor in this case upon the issue of whether Respondent's adjustment was a partnership item pursuant to I.R.C. § 6231 (Respondent's 6231 Motion for Partial Summary Judgment).

IN SUPPORT THEREOF, Respondent respectfully states:

1. This motion is made at least 30 days after the date that the pleadings in this case were closed and within such time as not to delay the trial. Tax Court Rule 121(a).

2. In the Notice of Final Partnership Administrative Adjustment (the “FPAA”) upon which this case is based, Respondent determined Petitioner had additional income subject to self-employment tax for the taxable year 2017. In its petition and in the motion for summary judgment filed on February 7, 2023, Petitioner asserted both that it did not have such income and that if it did the adjustment was not a partnership item that could be adjusted for Petitioner but rather a partner item subject to adjustment at the partner level.¹

4. Concurrent with this motion, Respondent is also filing an objection and response to Petitioner's motion delineating why a trial is necessary to decide the issue of whether Petitioner's income is subject to self-employment tax.

5. Respondent agrees with Petitioner that there are no material facts in dispute on the issue of whether the adjustment is a partnership item.

6. In support of this Motion for Partial Summary Judgment, Respondent relies upon the facts and exhibits outlined in the memorandum filed with Petitioner's Motion for Summary Judgement, pages 2 through 10. Respondent agrees with Petitioner that the listed facts are accurate and not in dispute.

7. Upon the granting of this motion, the following issue remains for trial: whether Petitioner had additional income subject to self-employment tax for the taxable year 2017.

8. Respondent respectfully states that counsel of record has reviewed the administrative file and on the basis of the review of the file and the pleadings, concludes that there remains no genuine issue of material fact for trial upon the issue of whether Respondent's adjustment was a partnership item that can be adjusted through a partnership proceeding under the Tax Equity and Fiscal Responsibility Act of 1982, as codified in sections 6221-6234.

9. Petitioner objects to the granting of this motion.

WHEREFORE, it is prayed that this motion be granted.

DRITA TONUZI
Deputy Chief Counsel (Operations)
Internal Revenue Service

Date: 3/1/2023

By: EMERALD G. SMITH
Special Trial Attorney
(Strategic Litigation)
Tax Court Bar No. SE0666
200 W Adams Street
Suite 2400
Chicago, IL 60606
Telephone: 312-368-8785
Email: emerald.g.smith@
irscounsel.treas.gov

OF COUNSEL:
KATHRYN F. PATTERSON
Division Counsel (Strategic Litigation)
PAUL T. BUTLER
Deputy Division Counsel
NASEEM J. KHAN
Strategic Litigation Counsel
MICHAEL E. WASHBURN
Special Trial Attorney
JONATHAN E. CORNWELL
Senior Attorney (Large Business & International)

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MEMORANDUM OF LAW IN SUPPORT OF
RESPONDENT'S 6231 MOTION FOR PARTIAL SUMMARY JUDGMENT

RESPONDENT SUBMITS this memorandum of law in support of Respondent's 6231 Motion for Partial Summary Judgment filed contemporaneously herewith. In the Notice of Final Partnership Administrative Adjustment (the “FPAA”) upon which this case is based, Respondent determined Petitioner had additional income subject to self-employment tax for the taxable year 2017. In its petition and in the motion for summary judgment filed on February 7, 2023, Petitioner asserted both that it did not have such income and that if it did the adjustment was not a partnership item that could be adjusted for Petitioner but rather a partner item subject to adjustment at the partner level. The issue to be resolved in deciding this motion is whether Respondent's adjustments was a partnership item pursuant to I.R.C. § 6231¹.

Introduction

Respondent agrees with Petitioner that sufficient facts are undisputed to determine whether the adjustment made in the FPAA is a partnership item. Considering the facts in this case, the adjustment made to Petitioner's “net income subject to self-employment tax” is a partnership item.

Treatment as a partnership item is consistent with the structure and language of I.R.C. §§ 1401 and 1402 and its status as a Subtitle A provision. It is also consistent with this Court's treatment in previous cases. In fact, this Court has previously stated that a partnership could characterize its income as includable in net earnings from self-employment even though it was possible that some of that income would not be taxable in the hands of its indirect partners. Olsen-Smith v. Commissioner, T.C. Memo. 2005-174.

Petitioner correctly identifies that Petitioner's partners have affected items related to the partnership adjustment but incorrectly conflates those affected items with the partnership adjustment. Ultimately the comparisons made by Petitioner are not directly applicable and unnecessary given the previous rulings of this Court.

Factual Background

For the purposes of this motion, Respondent has reviewed and agrees with the facts listed by Petitioner in its Statement of Facts, pages 2 through 10 and paragraphs 1 through 33, in its Memorandum in Support of Motion for Summary Judgment.

Most relevant to the issue addressed in this Motion for Partial Summary Judgment:

Legal Argument

I. Partnership Items Generally

The character of any item of income, gain, loss, deduction, or credit included in a partner's distributive share under paragraphs (1) through (7) of subsection (a) shall be determined as if such item were realized directly from the source from which realized by the partnership or incurred in the same manner as incurred by the partnership. I.R.C. § 702(b).

Pursuant to the Tax Equity and Fiscal Responsibility Act of 1982 (“TEFRA”), as codified in sections 6221–6234, all challenges to adjustments of partnership items are made in a single unified partnership proceeding. Under TEFRA procedures, “the tax treatment of any partnership item (and the applicability of any penalty, addition to tax, or additional amount which relates to an adjustment to a partnership item) shall be determined at the partnership level.” I.R.C. § 6221.

II. The Application of § 1402(a)(13) to a Partnership Is a Partnership Item

Petitioner asserts that the amount of income subject to self-employment tax is a partner level inquiry that cannot be determined in a TEFRA proceeding because whether its partners are “limited partners” for the purposes of § 1402(a)(13) should be determined at the partner level. This is incorrect. As detailed in the code, partnership items are:

I.R.C. § 6231(a)(3).

Sections 1401(a) and (b) generally impose Old-Age, Survivors, and Disability Insurance Tax (OASDI) and Hospital Insurance Tax (Medicare) for each taxable year, on the self-employment income of every individual. Section 1402(b) defines the term “self-employment income” generally as the net earnings from self-employment derived by an individual (other than a nonresident alien individual . . .) during any taxable year. Section 1402(a) defines the term “net earnings from self-employment” generally as the gross income derived by an individual from any trade or business carried on by such individual, less certain deductions . . . which are attributable to such trade or business, plus the individual's distributive share (whether or not distributed) of income or loss described in § 702(a)(8) from any trade or business carried on by a partnership of which the individual is a member; except that in computing such gross income and deductions and such distributive share of partnership ordinary income or loss there shall be certain enumerated exclusions and adjustments.

Sections 1401 and 1402 are part of Subtitle A (“Income taxes”). See e.g. Olsen-Smith, Ltd. v. Commissioner, T.C. Memo. 2005-174 at *3 (“Subtitle A requires that a partnership separately state . . . the amount of income that would be NESE in the hands of the ultimate recipients if those recipients were in fact individuals.”).

Petitioner's argument ignores that there are two separate determinations of “net earnings from self-employment” that must be made in the context of a partnership and its partners. First, the partnership must determine the extent to which its income qualifies as net earnings from self-employment and report this determination on its tax return, as well as in its books and records. Second, the partners must determine the amount of self-employment tax they must pay on their distributive shares of the partnership income. I.R.C. § 1402(a); Treas. Reg. § 301.6231(a)(3)–1(b) (as amended in 1986) (providing that the term “partnership item” also includes “the accounting practices and the legal and factual determinations that underlie the determination of the amount, timing, and characterization of items of income, credit, gain, loss, deduction, etc.”). While Petitioner has appropriately identified the amount of self-employment tax a partner will pay on its distributive share of income is an affected item, it has conflated that determination with whether the partnership has income subject to self-employment tax. This allows Petitioner to argue one sole determination must be made at the partner level, but that argument does not account for the factual determinations necessary for the characterization of partnership income as subject to self-employment tax.

That analysis is not in line with how courts have treated affected items in other cases. For example, the Court of Federal Claims has stated that “the partnership prong of an affected item must be resolved in a partnership-level proceeding, as a necessary precursor to the eventual consideration of the nonpartnership prong in a partner-level proceeding.” Keener v. U.S., 76 Fed.Cl. 455, 469 (2007).

The analysis of whether a partnership has self-employment income requires calculating and evaluating multiple potential streams of income and components of the partnership, such as rental income, dividends and their place in the partnership's business, and more. I.R.C. § 1402(a)(1)-(17). Particularly relevant is the instruction that if a partnership and one of its partners have different taxable years, the partner's reporting of its distributive share of the income is dependent on the partnership's calculation. I.R.C. § 1402(a); Treas. Reg. § 1.1402(a)-2(e). Illustrative of this necessary analysis is the worksheet used to calculate the reported SE income included on page 35 of the 2016 Instructions for Form 1065 (attached as Exhibit A).

This Court has considered self-employment income in the context of a partnership before. That a particular partner may have a reason to characterize the income differently than Soroban, i.e., that ultimately taxability of the items varies between parties, does not prevent Soroban's characterization of the item from being a partnership item. See, e.g., Olsen-Smith, T.C. Memo. 2005-174 at *8–9 (holding that a partnership could characterize its income as includable in net earnings from self-employment even though it was possible that some of income, in the hands of its indirect partners, was not ultimately taxable as such).

III. Respondent Appropriately Adjusted Petitioner's Income Subject to Self-Employment Tax in the FPAAs

In two cases addressing self-employment tax in the context of a partnership, this Court has appropriately treated it as a partnership item. In Olsen-Smith v. Commissioner, T.C. Memo. 2005-174, this Court considered whether the petitioner could challenge the partnership's characterization of its income as net earnings from self-employment where petitioner argued the partners were all trusts not subject to self-employment tax. Although the petitioner offered evidence of the identities of partnership's indirect partners, the Court found it was irrelevant to redetermining the adjustments in the FPAA because the partnership was not required to determine the identity of its indirect partners to allocate net earnings from self-employment on its return. Id. at *10–11. How that characterization applied to specific partners was addressed in later partner-level proceedings. See, e.g., Smith v. Commissioner, T.C. Memo. 2008-275 at *11–12 (resolving the partner-level proceedings following Olsen-Smith).

This Court also considered the application of self-employment taxes to a partnership in Renkemeyer v. Commissioner, 136 T.C. 137 (2011). In that case, this Court held that lawyers who were partners in a limited liability partnership operating a law firm were not limited partners for § 1402 purposes because the partnership's revenues were derived from legal services performed by the lawyer/partners and the lawyer/partners made small capital contributions indicating the revenues were not earned from investments. Id. at 150. Renkemeyer considered and determined the application of § 1402 to the partnership's income in the proceedings reviewing the FPAA issued to the partnership, not in individual proceedings for its partners. Id. at 138.

IV. The Cases Petitioner Relies on are Inapposite

A deeper look into the cases Petitioner cites in its own motion for summary judgment reveals the comparisons it makes are flawed. For example, Petitioner cites Estate of Quick for the premise that material participation is not a partnership item, attempting to equate the adjustment in this case to a determination under I.R.C. § 469. Estate of Quick v. Commissioner, 110 T.C. 172 (1998). However, the Court in Quick specifically noted not that there could be no relevant material participation analysis at the partnership level, but rather that “[s]ince no adjustment was made during the partnership-level proceeding as to the character of the activity, respondent is bound by the reporting position of the Partnership.” Id. at 187. Quick rejected the petitioners' contention that “an item on a partner's return can be an affected item if and only if the partner's treatment of that item is dependent, in the first instance, on a partnership item adjustment” and instead noted the term “affected item” means “any item to the extent such item is affected by a partnership item.” Id. at 187-88.

Similarly, Petitioner quotes from Estate of Morgan that “[t]he need for partner-level factual development is enough to except an item from the definition of a partnership item.” Estate of Morgan v. Commissioner, T.C. Memo. 2021-104 at *12 (2021). That quote leaves out a relevant piece of the Court's analysis. The quote is preceded by the line “Nonpartnership items that are dependent on determinations made at the partnership level are “affected item[s]”. Id. (citing I.R.C. § Sec. 6231(a)(5)). An affected item per Estate of Morgan requires a determination at the partnership level first.² As noted in Olson, a case cited by Petitioner, affected items can require two notices — first an FPAA to the partnership and then a deficiency notice (or notice of computational adjustment if no partner-level factual determinations are needed) to the partners. Olson v. U.S., 172 F.3d 1311, 1317 (Ct. App. 1999).

Likewise, Petitioner attempts to compare the adjustment in this case to the task of identifying partners in the partnership, citing Grigoraci for the proposition that determining the identity of partners is a partner-level determination because “[i]tems that merely affect the tax liability of a specific partner, but not the other partners, are not partnership items”). Grigoraci v. Commissioner, T.C. Memo. 2002-202 at *6. Petitioner ignores two important items in this analysis. First, Grigoraci considered both the effect on the total distributions and the availability of information in its analysis — specifically noting that in the specific circumstances of that case the information necessary to determine the identity of a partner was not available to the partnership. Id. at *7. Second, partner identity has been considered a partnership item in other circumstances where it would affect the “partnership aggregate” or “each partner's share of . . . income, gain, loss, deductions, or credits of the partnership” by examining the particular facts of the case before it. Alpha I, L.P. ex rel. Sands v. U.S., 682 F.3d 1009 (Fed Ct. App. 2012) (citing Grigoraci, T.C. Memo. 2002-202 *6). The aggregate amount of partnership income subject to self-employment tax must be determined before the individual liability of the partners can be.

Russian Recovery Fund Ltd. v. United States, 81 Fed. Cl. 793 (2008), is similarly distinguishable from the circumstances at issue here. In that case respondent adjusted only the amount at risk for a partner in the FPAA. Id. at 797. The Court specifically noted that no numerical adjustment had been made to the partnership's Form 1065. Id. The at-risk amount of an individual partner is not on the partnership return and is not a partnership item, it is an affected item. Id. So, in the case cited by Petitioner, the only thing adjusted in the FPAA was a nonpartnership item, and it made no adjustments to any items on the partnership return. That is in sharp contrast to the FPAAs in this case, in which respondent adjusted the total amount of SE tax reportable by the partnership.³

Conclusion

With all arguments considered, the law supports that the adjustment made by Respondent in this case was a partnership item. It is properly considered in this proceeding. Respondent respectfully requests the Court grant Respondent's 6231 Motion for Partial Summary Judgment for the reasons laid out in this memorandum.