If It Doesn’t Look Like a Duck or Quack Like a Duck, It’s Probably Not a Duck

One of the most powerful weapons in the Internal Revenue Service’s arsenal is the substance over form doctrine. That is, the form of a transaction notwithstanding, the IRS has the right to look at the substance of the transaction to determine its tax implications. And the chips are, unfortunately, stacked against us, the taxpayers, in our fight against the IRS in that we generally cannot make the same argument. Taxpayers are usually held to their form. In other words, it is very difficult for a taxpayer to argue that the form of a transaction in which it has entered should be disregarded and that the tax effects of the transaction should be based on the substance of the transaction.

A recent Chief Counsel Advice (CCA 20143609) very clearly illustrates the power of the substance over form argument (a CCA is written advice on an issue or transaction prepared by the IRS’s Office of Chief Counsel). While the facts of the CCA involve a partnership engaged in investment management, the CCA’s holding would be equally applicable to a partnership engaged in real estate management.

The facts of the CCA involve Management Company which is one of the general partners of a fund that was engaged in extensive trading and investing activities. The fund has limited partners that are passive investors; in fact, the fund’s limited partnership agreement provides that the limited partners will not take part in the fund’s activities and will also have no right or authority to act for, or bind, the Fund. As a general partner, Management Company has full authority and responsibility to manage and control the affairs and business of the fund, including carrying out the extensive market research, trading and investment activities, such as the purchasing, managing, restructuring, and selling of the fund’s investment assets. Management Company’s primary source of income is from management fees for these services to the fund. In addition to its small ownership interest in the fund, Management Company’s assets consist primarily of cash and equipment.

All of the services performed by Management Company are actually performed by its partners and its employees who work full time for Management Company. Each of the partners of Management Company was classified (in its partnership agreement and on its tax returns) as a limited partner and was also treated as an employee (Management Company issued them W-2 forms).

Under this structure, FICA and Medicare tax were paid on the wages (split equally between the partner/employees and the Management Company). However, the limited partners did not pay self-employment tax on their allocable share of the Management Company’s taxable income. In general, a partner’s share of partnership profits is subject to self-employment tax (unless the nature of the income is specifically excluded from the definition of self-employment income).

However, a limited partner’s share of partnership profits is generally not subject to self-employment tax because a limited partner is generally not active in the operations of the partnership.

In the CCA, the IRS determined that the partners of Management Company weren’t “limited partners” despite the fact that they were classified as limited partners (i.e., the form of the transaction). As such, they were subject to self-employment tax on their distributive shares of profits from Management Company. The IRS argued that the distributive share of profits from Management Company wasn’t income that was basically a return on an investment (which is typically what limited partners get and is the main reason why a limited partner’s share of partnership profits is not subject to self-employment tax). Rather, their distributive share of Management Company’s profits was primarily attributable to the services that the partners performed and therefore should be subject to self-employment tax (i.e., the substance of the transaction).

A couple of side comments: real estate management companies typically are structured in the same way as was the Management Company in the CCA. Thus, similar issues can arise for a real estate management company; also, it should be noted that when it comes to limited liability companies treated as partnerships for income tax purposes, in general, there is little, if any, guidance as to how to determine if a member’s distributive share of profits from the LLC is subject to self-employment tax.