Davis - Techniques for Reducing SE Tax & NIIT.pdf

Techniques for Reducing Self-Employment Tax and Net Investment Income Tax

OR “But I don't want to

go among mad people,” said Alice. “Oh, you can't help that,” said the cat.

“We're all mad here.”

Tax Section of the Dallas Bar Association May 2, 2016

C. CLINTON DAVIS, JR. Krage & Janvey, L.L.P.

2100 Ross Avenue, Suite 2600 Dallas, Texas 75201 ccdavis@kjllp.com

OVERALL GOAL

DON’T PAY: 1. The 3.8% Net Investment Income

Tax [NIIT]; or 2. The Self-Employment Medicare Tax

totaling up to 3.8%

COMPUTATION OF THE NET INVESTMENT INCOME TAX (NIIT)

The 3.8% NIIT is levied on the LESSER of: 1. Net Investment Income [NII]; or 2. Excess of:

a. MAGI [MAGI = AGI unless you have foreign earned income; then add back § 911 excluded income and expenses] OVER

b. the Taxpayer’s Threshold Amount: ($250,000 joint; $200,000 single; $125,000 married filing separately)

NIIT N/A WHERE THE SE TAX APPLIES.

AVOIDING NIIT—INCOME PLANNING APPROACH

• Net investment income amount lower than your excess MAGI amount? • Focus initially on strategies that reduce net

investment income. • Excess MAGI amount lower than your net investment

income?

• Focus initially on strategies that will reduce MAGI.

ADVANCE PLANNING IS KEY

Become MORE ACTIVE in closely held businesses in which you are currently passive. [Reduces NII]

• NOTE THAT THIS DID NOT SAY MATERIALLY PARTICIPATE.

See http://www.thetaxadviser.com/issues/ 2015/feb/tax-clinic-08.html

• Material participation is best BUT Temp. Regs.

Sec. 1.469-2T(f)(2) creates a special rule for significant participation. • If passive income arises from an activity in which the

taxpayer significantly participates (but does not materially participate), then that income is recharacterized as nonpassive.

ADVANCE PLANNING IS KEY

• Take losses in investment assets when you have recognized gains. [Reduces both NII and MAGI]

• Give appreciated securities to public charities, not cash from sale of those securities. [Reduces both NII and MAGI]

• Defer gains using installment sales or like-kind exchanges. [Reduces both NII and MAGI]

ADVANCE PLANNING IS KEY

• Manage your MAGI through income and deduction planning. • Defer income to reduce MAGI to the MAGI threshold. • Maximize deductions to retirement plans and IRAs. E.g.,

establish a spousal IRA to reduce MAGI . • Accelerate income into the current year up to the MAGI

threshold to limit tax in future years. • Manage your MAGI through selection of investments. (For

example, life insurance and tax-exempt bonds.)

ADVANCE PLANNING IS KEY

• MAJOR PROBLEM: Getting the client to focus on advance tax planning.

• Little planning may be available for 2016 when your client doesn’t see you until 2017 when it’s time to prepare the returns.

MINIMIZING NIIT AND MEDICARE TAX WITH STRUCTURE

The answer is: “Philandering Presidential Candidates Saving Taxes”

WHAT IS THE “NEWT GINGRICH/JOHN EDWARDS LOOPHOLE”?

SENATE DEMOCRATS HAVE UNSUCCESSFULLY TARGETED

S CORPS WITH 3 OR FEWER SHAREHOLDERS

THE “NEWT GINGRICH/JOHN EDWARDS LOOPHOLE”

SHAREHOLDERS

Reasonable Comp/ Subject to Employment Taxes (IRS can challenge)

Allocable Income Share •Not SE Taxable •Not NII to Active SH

S CORPORATION

BUT NII to Passive SH

So, what are the rules on determining reasonable

compensation? •NO, paying the social security max

[$118,500 for 2016] is not a safe harbor. • Drawn largely from C Corporation cases where

taxpayers tried to strip earnings using bonuses. • No real bright line objective test--IRS has not

published criteria to determine what a reasonable salary or salary range might be for any given position.

Regulation §1.162-7

“The test of deductibility in the case of compensation payments is whether they are reasonable and are in fact payments purely for services.”

[Emphasis added]

Regulation §1.162-9

“Bonuses to employees will constitute allowable deductions from gross income when such payments are made in good faith and as additional compensation for the services actually rendered by the employees.”

Regulation §1.1366-3

“…if an individual, who is the member of the family of one or more shareholders…renders services…without receiving reasonable compensation…the Commissioner shall prescribe adjustments…to reflect the value of the services rendered….”

5TH CIRCUIT FACTORS

The employee’s qualifications; The nature, extent and scope of the employee’s work; The size and complexities of the business; A comparison of salaries paid with gross income and net income; The prevailing general economic conditions; Comparison of salaries with distributions to stockholders; The prevailing rates of compensation for comparable positions in comparable

concerns; and The salary policy of the taxpayer as to all employees.

THE INDEPENDENT INVESTOR TEST

WOULD A HYPOTHETICAL INVESTOR BE SATISFIED WITH THE RETURN ON INVESTMENT THAT RESULTED FROM THE EMPLOYEE/SHAREHOLDER’S MANAGEMENT ACTIVITIES?

SINGLE OWNER PROFESSIONAL ENTITIES

The best evidence of services provided in a professional personal service corporation is the profit made by the corporation.

Thomas A. Curtis, M.D., Inc. v. Commissioner

Idea for improving your [reverse] reasonable compensation position

• Look to C corporation reasonable compensation cases like Pediatric Surgical Associates, P.C. v. Commissioner of Internal Revenue, TC Memo 2001-81 • Taxpayer and IRS positions are reversed in an S corporation

situation;

• Look for non-shareholder income producing units like other service providers and sales of product (for example, Rx food in a veterinary office) to support S corporation distributable income.

QUERY:

• Is it better to be a limited partner in a partnership rendering services? OR

• Is it better to be a limited liability company member in an LLC rendering services? OR

• Are they the same risk?

Let’s look at the LLC first: SOME might say convert to an S

corporation John, General Partner Mary, Limited Partner

LLC

Disadvantages of S Corporations

• No step up in inside basis of assets for a buyer of S corporation shares because Code Sec. 754 is not available.

• Inability to withdraw assets from the business without recognizing gain. • Strict per share per day allocation rules—lack of flexibility. • Difficulty in issuing an incentive interest to employees without tax

versus relative simplicity under Subchapter K.

WE CAN STRUCTURE AROUND THESE BUT IT OFTEN REQUIRES COMPLEX MULTI-TIER

STRUCTURES.

BUT, S CORPORATIONS DON’T FACE: Riether v. Commissioner,

919 F. Supp. 2d 1140 (D. N.M. 2012)

• In Riether, a New Mexico district court granted the government’s motion for summary judgment on the issue of whether LLC members were subject to self-employment income on their distributive share of the LLC’s income.

• LLC members paid themselves a salary and received a W-2 from the LLC.

Riether v. Commissioner, 919 F. Supp. 2d 1140 (D. N.M. 2012)

• The court ruled that the exception found in IRC Section 1402(a)(13) did not apply to the LLC members because they “are not members of a limited partnership, nor do they resemble limited partners, which are those who lack management powers but enjoy immunity from liability for debts of the partnership.”

Riether v. Commissioner, 919 F. Supp. 2d 1140 (D. N.M. 2012)

• Would the court’s reasoning always result in self-employment tax on LLC members because they are not in a limited partnership?

• Note that Riether apparently only had one class of LLC interests—More on that in a moment.

Chief Counsel Advice 201436049 (Relying on Riether v. Commissioner)

• The members (partners) of a management limited liability company did not meet the "limited partner" exception under Section 1402(a)(13) with respect to self-employment taxes notwithstanding the fact that they paid themselves salaries.

Will We See Someone Attempt This [Problematic?] Variation to Avoid Riether?

John, Member / Manager Mary, Member

LLC 1 interest class

S CORPORATION BLOCKER S CORPORATION BLOCKER: BUT WHAT IS THE PARTICIPATION LEVEL?

Now look at the LP: John 100% 99% LP INTEREST 1% GP INTEREST

RENKEMEYER SAYS TO TREAT THE LP INTEREST AS

PRODUCING SE TAX FOR A SERVICE ENTITY

SERVICES LIMITED PARTNERSHIP

S CORPORATION

Renkemeyer, Campbell, & Weaver LLP, 136 T.C. 137 (2011)

• The intent of Section 1402(a)(13) was to ensure that individuals who merely invested in a partnership and who were not actively participating in the partnership's business operations would not receive credits toward Social Security coverage.

• The legislative history of Section 1402(a)(13) did not support a holding that Congress wanted to exclude partners who performed services for a partnership in their capacity as partners (i.e., acting as self-employed persons) from liability for self-employment taxes.

But . . .

• In Frank Sands v. Commissioner, Docket 5650-15, May 8, 2015, the IRS answered that a proposed assessment of self-employment taxes against a limited partner of a management company was in error.

What about this structure? FRANK SANDS INTEREST $6.5 MILLION WAGES GP INTEREST

SCM, LLC

SCM, LP [NO VOTE]

SANDS FAMILY TRUST, LLC

DRE

LP INTEREST

LP INTEREST

DON’T GET TOO HAPPY WITH SANDS

• Distributive share through Sands Capital Management, LP escaped SE Tax, BUT

• Year in question was 2012 when there was no net investment income tax.

• Leaves a lot of questions unanswered. • Is not precedent.

PICK YOUR POISON?

• Is the limited partner exception in self-employment tax statute not applicable to service businesses, SO SE Tax could apply {so NIIT would not} OR

• If you win that, you are still in a state law limited partnership where 469(h)(2) generally treats the interest as passive producing potential NIIT {so another fight potentially}.

Is Riether at variance with the Proposed 1402 Regulations? Consider this structure…

John, Member / Manager Mary, Member

CLASS A CLASS B INTERESTS INTERESTS* ≥ 20% overall *All Class B interests have the same rights and obligations

LLC

Active LLC Members are not tested as limited partners for PAL

purposes

The IRS has acquiesced, in result only, in the Court of Federal Claims' decision in Thompson v. U.S., (Fed. Cl. 2009) 104 AFTR 2d 2009-5381, which concluded that a taxpayer's interest in a limited liability company (LLC) was not a “limited partnership interest” for purposes of Reg. § 1.469-5T(e)(3)(i).

An acquiescence in result only means that the IRS accepts the holding of the court in the case and that the IRS will follow it in disposing of cases with the same controlling facts. However, an acquiescence in result only indicates that the IRS either disagrees or has concerns with some or all of the court's reasoning.

IRS lost 5 times

• Gregg v. U.S., 87 AFTR 2d 2001-337 • Garnett v. Commissioner, 132 T.C. No. 19 (2009) • Thompson v. U.S., 103 AFTR 2d ¶2009-5124 (Ct. Fed. Cl. [2009]) • Newell v. Commissioner, T.C. Memo 2010-23 • Hegarty v. Commissioner, T.C. Summary Opinion 2009-153

Garnett v. Commissioner, 132 TC No. 19 (2009)

• Members of LLPs and LLCs, unlike limited partners in State law limited partnerships, aren't barred by State law from materially participating in the entities' business. – Accordingly, the Court says that it cannot be presumed that

they do not materially participate. – Rather, it is necessary to examine the facts and

circumstances to ascertain the nature and extent of their participation.

• The Court found that the Garnetts held their ownership interests in the LLPs and the LLCs as “general partners” within the meaning of the Temporary Regs.

– While the taxpayers' status in these entities differed significantly from the

status of general partners in State law limited partnerships, the Court recognized that their status also differed significantly from that of limited partners in State law limited partnerships.

From Garnett : Because the taxpayers didn't hold their interests in LLPs or LLCs in agribusiness entities as limited partners in a limited partnership, these interests weren't subject to the Code Sec. 469(h)(2) rule treating limited partner income and loss as generally passive.

From Garnett : The Court found that the IRS's view overlooked the fact that the operative condition for applying Code Sec. 469(h)(2) wasn't simply that there be an “interest in a limited partnership” but rather that there be an “interest in a limited partnership as a limited partner.” The Court rejected the IRS's approach as narrow and literal.

From Garnett : The Court reasoned that if the general partner rule in Reg. § 1.469-5T(e)(3)(ii) applied, then an ownership interest can't be treated as a limited partnership interest. Members of LLPs and LLCs, unlike limited partners in State law limited partnerships, aren't barred by State law from materially participating in the entities' business.

From Garnett : Accordingly, the Court says that it cannot be presumed that they do not materially participate. Rather, it is necessary to examine the facts and circumstances to ascertain the nature and extent of their participation. The Court concluded that this factual inquiry was appropriately made pursuant to the general Code Section 469 tests for material participation.

There shall be excluded [from net earnings from self-employment] the distributive share of any item of income or loss of a limited partner, as such, other than guaranteed payments described in Section 707(c) to that partner for services actually rendered . . . .

The IRS rules for the first time that an unincorporated entity can have no one who is liable on entity debts and still be treated as a partnership under the IRC.

Wyoming is the first state to adopt a limited liability company statute.

Colorado soon follows.

Treat the following LLC members as subject to self-employment taxes:

Managers; Members of an LLC engaged in a business that could not be

operated by a limited partnership; Members who would not be limited partners under state law;

and All members of member-managed LLC's.

Classify the following as general partners: Persons who participate in the trade or business for more than

500 hours during the taxable year; Persons who have personal liability; Persons having authority to contract on behalf of the entity; or Persons who provide services as part of the LLC trade or

business of health, law, engineering, architecture, actuarial science or accounting.

CONGRESS PASSES A ONE-YEAR MORATORIUM ON THE 1997 REGULATIONS BEING FINALIZED.

THEORY: CONGRESS NEEDS TIME TO LEGISLATE. ◦ It’s now 28 YEARS since the first LLC statute—not enough time???

RESULT: REGULATIONS NEVER FINALIZED/STILL IN PROPOSED FORM.

WHAT CAN BE ATTEMPTED USING LLCs TO LIMIT BOTH

SE TAX AND NIIT? Old proposed 1402 regulations never finalized:

“Exception for holders of more than one class of interest. An individual holding more than one class of interest in the partnership who is not treated as a limited partner under paragraph (h)(2) of this section is treated as a limited partner under this paragraph (h)(3) with respect to a specific class of partnership interests held by such individual if, immediately after the individual acquires that class of interest –

WHAT CAN BE ATTEMPTED USING LLCs TO LIMIT BOTH SE TAX AND

NIIT??

• Limited partners own a substantial, continuing interest in

that specific class of partnership interest; and

• The individual’s rights and obligations with respect to that

specific class of interests are identical to the rights and

obligations of that specific class of partnership interest held

by the [above] limited partners.”

REVIEW John, Member / Manager Mary, Member

CLASS A CLASS B INTERESTS INTERESTS* ≥ 20% overall *All Class B interests have the same rights and obligations

LLC

Is it possible to have an LLC interest that is all active under the PAL rules

but bifurcated into general and limited for SE Tax purposes?

ADMITTEDLY AN ODD RESULT BUT

MAYBE under the Proposed Regs. BUT Riether v. Commissioner would seem to

say NO

54

Another Idea: Others John WITH MATERIAL PARTICIPATION John and Family RENTAL DOLLARS

TRUE LEASE

S CORPORATION OR LLC OR LP

Rental LP or LLC

If rental income is treated as non-passive: (A) by reason of Reg. § 1.469-2(f)(6) when the taxpayer

rents the property for use in an activity in which the taxpayer materially participates, or

(B) because the rental activity is properly grouped with a trade or business activity under Reg. § 1.469-4(d)(1) and the grouped activity is a non-passive activity,

then, the gross rental income is deemed to be derived in the ordinary course of a trade or business.

Furthermore, in both of these instances, the final regulations provide that any gain or loss from the assets associated with that rental activity that are treated as non-passive gain or loss will also be treated as gain or loss attributable to the disposition of property held in a non-passive trade or business.

So, self-charged rental income gets excluded from

NII when the taxpayer materially participates. Self-charged rental loss stays passive and, in the

absence of other passive income, cannot reduce portfolio interest and dividends included in NII because the passive loss is currently suspended. You need other passive income to use the suspended self-

charged passive losses for purposes of the NIIT.

Assume a self-charged rental that produces a loss. Assume also that the rental activity is grouped with a business in which the taxpayer materially participates. Result—the loss which would have been passive is now

out of the NII computation altogether because it is now part of a non-passive activity.

So, because of this grouping election, the otherwise passive loss that might have eventually reduced NII from another source will never do so.

59

Now, what can you do with this? John, Member / Manager (active) Mary, Member (passive)

REAL ESTATE OPERATIONS

LLC

LET’S DISTRIBUTE THE REAL ESTATE HOLDINGS (PARTNERSHIP DIVISION)

John, Member / Manager Mary, Member

LLC

RE LLC

708 Review: Partnership Divisions: Assets Over (Default Form)

• Where at least one resulting partnership is a continuation of the prior partnership: • The divided partnership contributes some assets and liabilities to recipient

partnership(s) in exchange for interests in recipient partnership(s).

• Immediately after, the divided partnership distributes the interests in recipient partnership(s) to some or all partners in partial or complete liquidation of the partners' interests in the divided partnership.

Which is a Continuation of the Prior Partnership?

• If the members of a resulting partnership had an interest of more than 50% in the prior partnership, the resulting partnership is treated as a continuation of the prior partnership.

• It is possible for more than one resulting partnership to have this 50% continuity. More than one resulting partnership may be a continuation of the prior partnership.

AND EXECUTE A FMV OPERATING LEASE

John, Member / Manager Mary, Member

OPS LLC RE LLC

LEASE $$$$

AND INTRODUCE A BLOCKER S CORP

John, Member / Manager Mary, Member

Compensation

OPS LLC RE LLC

LEASE $$$$

S CORPORATION BLOCKER

WHAT DID THIS DO?

John, Member / Manager Mary, Member

Compensation

OPS LLC RE LLC

LEASE $$$$

S CORPORATION BLOCKER

1. RE LLC REDUCES TAXABLE INCOME OF OPS LLC AND CONVERTS TO SELF CHARGED RENTAL FOR ACTIVE OPS LLC MEMBERS

2. S CORP BLOCKER ALLOWS USE OF THE GINGRICH/EDWARDS LOOPHOLE FOR ACTIVE OPS LLC MEMBERS

AVOIDING NIIT--OTHER IDEAS: SELF-CHARGED INTEREST

UNDER REG. § 1.1411-4 In the case of self-charged interest received from a non-passive entity, the amount of interest income excluded from net investment income will be the taxpayer’s allocable share of the non-passive deduction. Exception: The special rule does not apply to a situation where the interest deduction is taken into account in determining self-employment income tax.

SELF-CHARGED INTEREST

UNDER REG. § 1.1411-4

EXAMPLE: TP owns 25% of an S corporation in which he materially participates. He loans $200,000 to the S corporation at 10% interest and collects interest income of $20,000 per year. The S corporation has a $20,000 deduction. RESULT: Of the $20,000 in annual interest income, 25% [$5,000] is excluded from investment income. The remaining 75% [$15,000] is subject to taxation under the NIIT.

SELF-CHARGED INTEREST

UNDER REG. § 1.1411-4

So, for a taxpayer owning a substantial percentage of S corporation stock, is a loan bearing a substantial interest rate better than a capital contribution for purposes of the NIIT? DEPENDS

AVOIDING NIIT--OTHER IDEAS: RENTAL INCOME OF A REAL

ESTATE PROFESSIONAL?

2-PART TEST: 1. More than 50% of services performed

during the year are in real estate trades or businesses where taxpayer materially participates;

2. More than 750 hours of services in those.

Real property trades or businesses

A real property trade or business is a trade or business that does any of the following with real property:

• Develops or redevelops it; • Constructs or reconstructs it; • Acquires it; • Converts it; • Rents or leases it; • Operates or manages it; • Brokers it.

IRS INSTRUCTIONS

Safe Harbor for Real Estate Professionals • You qualify for the safe harbor if you are a

real estate professional for purposes of section 469 and you: • Participate in each rental real estate activity for

more than 500 hours during the tax year, or • Participated in a rental real estate activity for

more than 500 hours in any 5 tax years (whether or not consecutive) during the 10 tax years immediately prior to this tax year.

500 hours on EACH rental property?#@!

IRS INSTRUCTIONS

Safe Harbor for Real Estate Professionals

• For real estate professionals with a Regulations section 1.469-9(g) election [election to treat all interests in rental real estate as a single rental real estate activity] in effect, all rental real estate activities constitute a single activity for purposes of applying the 500-hour test.

REAL ESTATE PROFESSIONALS

• 500-hour safe harbor is not the only option. • Final 1411 regulations provide that failure

to meet the 500-hour safe harbor will not preclude a taxpayer from establishing that such gross rental income and gain or loss from the disposition of real property, as applicable, is not included in net investment income.