Fighting for limits on an IRS plan

Nation's Business,  Jan, 1998  by Stephen Blakely

Tags: Internal Revenue Service, tax

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Small-business advocates are preparing for a renewed assault on proposed Internal Revenue Service rules that would increase taxes for many members of limited-liability companies and partners in limited partnerships.

The rules, proposed in January 1997 but not yet finalized, would require millions of those business owners to pay the 15.3 percent federal employment tax on their earnings. They currently pay zero because under a vaguely worded federal law, they are presumed to be passive investors receiving unearned income, not wages, from their partnerships or LLCs.

But the IRS maintains that because of their level of activity in their businesses, their income from those businesses constitutes wages. The proposed rules would clarify the law's intent by creating a stringent three-part test to determine exactly who must pay the employment tax and who is exempt. However, there would be no exemptions for professionals in seven service categories -- health, law, engineering, architecture, accounting, actuarial science, and consulting. They would pay, period.

In May, to block implementation of the rules, the U.S. Chamber of Commerce and 22 other groups formed the Coalition to Stop New Small Business Payroll Taxes. They won a temporary reprieve in the tax-reform law enacted Aug. 5, which included a moratorium that bars the IRS from finalizing the rules until after June 30, 1998.

In the interim, coalition members are developing an alternative proposal for determining which LLC members and partners must pay the self-employment tax. The plan will be presented to lawmakers on the tax-writing House Ways and Means Committee in hopes that Congress will adopt the business-backed alternative before the moratorium on IRS action lapses.

The IRS proposal "is an unjustifiable tax increase on small businesses" and "an uncommonly bad initiative," says Dan Mastromarco, spokesman for the coalition. Mastromarco is an attorney with the Argus Group in Washington, D.C., a law and government-relations firm.

"We don!t want Congress or the IRS to act without having the business community's input on what is the correct approach," says Mastromarco.

How Confusion Developed

The limited-liability company is a relatively new type of business entity whose popularity began to increase early in the 1990s. An LLC is a cross between a corporation and a partnership. Like the officers of a corporation, LLC members are shielded from personal liability. Like members of partnerships, their profits and losses show up on their individual tax returns.

The tax code requires the self-employed to pay the entire 15.3 percent payroll tax -- 12.4 percent for Social Security and 2.9 percent for Medicare. (In comparison, employees pay half the 15.3 percent through payroll deductions, with their employers paying the other half.) The amount of wages subject to the Social Security tax in 1998 is $68,400, up from $65,400 in 1997. Wages subject to the Social Security tax are adjusted each year based on inflation. All wages, however, are subject to the 2.9 percent Medicare tax.

A law passed in 1977, before LLCs became a popular form of business entity, stated that general partners are subject to the self-employment tax and limited partners are exempt. The rationale for the difference is that limited partners typically are passive investors, so their income from the partnership should be considered investment income, not compensation for services.

The law did not refer to LLCs' members, however, thus providing no guidance on how they should be treated for employment-tax purposes. Nor did the law define how passive a partner would have to be to merit the "limited partner" designation and avoid the self-employment tax. Attorneys say the lack of guidance left them guessing about tax treatment, and many concluded that their clients who were LLC members were exempt from the tax. Many also didn't question the exempt status of their clients who were limited partners.

The Three-Part Test

Under the IRS's proposed three-part test for determining LLC members' and limited partners' self-employment tax liability, the tax would apply under any of the following circumstances:

* The person was liable for debts or claims against the partnership.

* The person had the authority to enter into contracts on behalf of the partnership.

* The person participated in the partnership's trade or business for more than 500 hours annually.

Opponents of the rules say the "500-hour" test would force a large number of LLC members and limited partners who do not pay the tax now to begin doing so.

The IRS erred, opponents say, in basing one of the criteria on how active an LLC member or limited partner is. They maintain that the employment-tax status of an LLC member or limited partner should be judged by how much control the individual has over the business, not by how many hours the person devotes to the business.

The 500-hour test would primarily hurt "those business owners who do not earn their living by passive investment but by their own sweat equity," says coalition spokesman Mastromarco.