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Internal Revenue Code Is Complex…Let’s Begin to Decipher


January 6, 2015
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The Internal Revenue Code is complex

The fact that various internal revenue code sections are enacted into law does not necessarily mean that every nuance has been explored in crafting language. Often times, the collateral consequences of a new statute upon other areas of the internal revenue code is not considered. All too often the clean-up work of pruning obsolete regulations and drafting new ones for recently enacted statutes takes years.

Sometimes, it does not take place at all.

Consider the interaction between self-employment taxes (SET) and the form of business. In the past, partnerships were either general or limited. Two other species of partnership, the limited liability partnership (LLP) and the limited liability limited partnership (LLLP) were introduced. Tax concepts must be extended to apply to the new forms of business and this is not always easily done. It is generally accepted that a general partner is properly considered to be self-employed for SET purposes. Most people contend that a limited partner’s distribute share is not subject to SET. There are, however, regulations to the contrary, 1.1402-(a)-2(g) and (h), that state that a limited partner must take his or her distributive share of partnership income or loss into account for purposes of SET. In 1977, IRC §1402(a)(13) was enacted and it replaced the statute upon which these regulations were issued.  The two regulations, were promulgated under statutes that were replaced thirty-seven years ago. In all those years, one set of proposed regulations was offered for comment and drew the ire of tax practitioners and has not been adopted. The use of a limited liability company (LLC) by a sole proprietor creates other issues. One issue is whether a member is considered a general or limited partner for SET purposes. Does the proper treatment depend upon whether the member renders services? Another issue arises from the election of S corporation status by a limited liability entity (LLC, LLP or LLLP) electing to be taxed as a corporation.  It appears that 1.1402(a)-2(h) prevents a sole proprietor from avoiding SET through the use of a single member LLC, electing to be taxed as a corporation and electing S status. The question is whether this particular regulation, which should have been withdrawn, is of any force or effect. One suggestion is to use a limited liability limited partnership, where available, to provide the general and limited partners with limited liability while protecting the limited partners from SET on their distributive share of partnership income.  Taxation does not offer clarity in every situation and this one instance where so much confusion could be eliminated. Looking to add any insight to help others understand the internal revenue code?  Feel free to leave a comment below.