Basis and At-Risk Loss Rules Apply in Determining Partner's Self-Employment Tax

(Parker Tax Publishing March 2020)

The Office of Chief Counsel advised that the basis loss limitation under Code Sec. 704(d) and the at-risk loss limitation under Code Sec. 465 apply in determining a general partner's net earnings from self-employment unless a specific exclusion applies under Code Sec. 1402(a). Thus, the Chief Counsel's Office concluded that if the individual share of loss from the partnership is disallowed to a partner under Code Sec. 704(d) or Code Sec. 465 for the tax year, the loss is also generally not taken into account in computing the partner's net earnings from self-employment for that tax year. CCA 202009024.

Background

The Office of Chief Counsel was asked to advise whether the basis loss limitation under Code Sec. 704(d) and the at-risk loss limitation under Code Sec. 465 apply to determining a general partner's net earnings from self-employment (NESE) under Code Sec. 1402 for purposes of the Self-Employment Contributions Act (SECA). The Chief Counsel's Office was asked for advice on the following general fact pattern.

An LLC elected to be treated as a partnership for federal tax purposes. The LLC had three individual members: Member A, Member B, and Member C. All three were general partners of the LLC. The LLC was involved in the single activity of contracting for the production of widgets for customers.

During the tax year, the LLC had a current year operating loss. Net operating loss carrybacks and carryovers were not at issue. All LLC members received guaranteed payments in the tax year. To determine the amount of NESE subject to SECA tax for the tax year, the following occurred: Member A reduced his guaranteed payment by his individual share of the partnership's losses without applying the basis loss limitation under Code Sec. 704(d); Member B reduced his guaranteed payment by his individual share of the partnership's losses without applying the at-risk loss limitation under Code Sec. 465; and Member C had sufficient basis and at-risk amounts to apply his share of the partnership loss against his guaranteed payment. In addition, Member C's share of partnership loss was not limited by the passive activity loss limitation under Code Sec. 469 because Member C materially participated in the LLC.

All the members agreed that the loss limitations applied in determining their income subject to federal income taxes. However, Member A and Member B argued that the basis loss limitation and the at-risk loss limitation did not apply in determining their NESE subject to SECA tax, respectively. Member C's share of the partnership loss was not limited by any of the loss limitations.

Applicable Law

Code Sec. 1401(a) imposes a tax on self-employment income (i.e., the SECA tax). Under Code Sec. 1402(b), self-employment income is defined as NESE, subject to certain exclusions. Code Sec. 1402(a) generally defines NESE as the gross income derived by an individual from any trade or business, less any deductions which are attributable to the trade or business, plus the individual's distributive share (whether or not distributed) of income or loss from any trade or business carried on by a partnership of which the individual is a member.

For general income tax purposes, there are rules that limit the amount of losses a partner is allowed to take on the individual partner's return when the partner incurs losses from partnership activities. These provisions include, in the order in which they apply: (1) the basis loss limitation in Code Sec. 704(d); (2) the at-risk loss limitation in Code Sec. 465; and (3) the passive activity loss limitation in Code Sec. 469.

Analysis

The Chief Counsel's Office advised that the basis and at-risk loss limitations apply in determining a general partner's NESE under Code Sec. 1402 for SECA tax purposes, to the same extent these loss limitation rules apply for income tax purposes, unless a specific exclusion applies under Code Sec. 1402(a). In the above fact pattern, no specific exclusion applied under Code Sec. 1402(a), and therefore, the individual share of the partnership loss of Member A and Member B must be disallowed for both SECA tax and income tax purposes because Member A had insufficient basis and Member B had an insufficient at-risk amount.

The Chief Counsel's Office reasoned that, since the calculation of NESE in Code Sec. 1402(a) specifically incorporates the effect of the Code's income tax provisions in determining deductions from trades or businesses carried on by the taxpayer and the partnership provisions in determining the distributive share of any loss, any loss limitation rule that applies in determining a partner's general income tax liability should also apply for determining a partner's SECA tax liability, unless a particular Code provision or regulation provides otherwise.

Observation: The Chief Counsel's Office observed in a footnote that some taxpayers have erroneously cited to Rev. Rul. 56-675 as authority that NESE is not affected by the loss limitations under Code Secs. 704(d), 465, and 469. The Chief Counsel's Office stated that its position is that this ruling is not an authority on the application of the various loss limitations for SECA tax purposes.

According to the Chief Counsel's Office, specific guidance indicates that the basis loss limitation in Code Sec. 704(d) and the passive activity loss limitation in Code Sec. 469 apply to determine a general partner's NESE. Reg. Sec. 1.1402(a)-2(d) states that an individual's distributive share of partnership income or loss must be determined under Code Sec. 704; thus, the regulation pulls the basis loss limitation under Code Sec. 704(d) into the computation of NESE. In addition, Reg. Sec. 1.469-1T(d)(3) provides that a disallowed passive activity loss is not taken into account for any subtitle A tax (i.e., income tax), which includes SECA tax. The Chief Counsel's Office noted that an example in that regulation does not expressly involve a passive activity loss from a partnership but reasoned that the provision it illustrates makes no distinction between individuals conducting the trade or business individually or as partners in a partnership.

In addition, the Chief Counsel's Office stated that Code Sec. 465 applies in determining the NESE of individuals carrying on a trade or business because Code Sec. 1402(a) expressly takes into account deductions that are allowed by subtitle A with regard to any trade or business carried on by the individual. While the Chief Counsel's Office noted that no guidance specifically states that the at-risk loss limitation also applies for purposes of calculating the NESE of general partners for SECA tax purposes, the Chief Counsel's Office reasoned that applying the at-risk loss limitation rule in determining a general partner's NESE is consistent with considering the basis loss and passive activity loss limitations in computing a general partner's NESE. The Chief Counsel's Office explained that, like Code Sec. 469, Code Sec. 465 determines the extent to which the partner's distributive share of the losses from the partnership in carrying on the trade or business is taken into account in determining the partner's taxable income for the tax year, and its effect is not limited to chapter 1 of the Code (i.e., normal taxes and surtaxes) but generally applies for purposes of the Code, including chapter 2 (i.e., tax on self-employment income).

The Chief Counsel's Office thus concluded that, if the individual share of loss from the partnership is disallowed to a partner under Code Sec. 704(d) or Code Sec. 465 for the tax year, the loss is also not taken into account in computing the partner's NESE for that tax year for SECA tax purposes, assuming there is no SECA provision or regulation that provides otherwise (such as with excluded rental income).

For a discussion of the determination of NESE, see Parker Tax ¶13,120. For a discussion of the individual partner loss limitation rules, see Parker Tax ¶20,550.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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