United States: Physician's Share Of LLC Income Treated As Passive And Not Subject To Self-Employment Tax

In Hardy v. Commissioner, T.C. Memo 2017-16 (Jan. 17, 2017), the Tax Court held that a physician’s distributive share of income from his interest in an surgical center limited liability company, treated as a partnership for federal income tax purposes, was passive and a separate activity from his medical practice. The Tax Court also concluded that the physician was a limited partner within the meaning of Section 1402(a)(13) and, thus, not subject to self-employment tax on his distributive share from the partnership.

The case involved Dr. Hardy, who was a plastic surgeon conducting his medical practice through Northwest Plastic Surgery his single-member PLLC and his wife, Mrs. Hardy, who was the chief operating officer. Dr. Hardy performed surgeries at various surgical centers, including Northwest Plastic Surgery, MBJ, (in which he owned a minority interest) and at hospitals for more complex surgeries. Dr. Hardy’s patients paid him directly for his fees as a surgeon and would separately pay the surgical centers for the use of the facility. MBJ was an LLC treated as a partnership for federal income tax purposes and was formed by a group of practicing physicians in 2004 for the purpose of operating a surgery center. Dr. Hardy purchased a 12.5% interest in MBJ in 2006.

Dr. Hardy had no day-to-day management responsibilities nor had any input in management decisions in MBJ. MBJ was professionally managed, hired its own employees and did not share any employees with Northwest Plastic Surgery. MBJ directly billed patients for facility fees and did not pay physicians for their procedures. Although Dr. Hardy sometimes performed surgeries at MBJ, he received distributions from MBJ regardless of whether he performed any surgeries at the surgery center and his distributions were not dependent on the number of surgeries he performed there.

For 2006 and 2007, the Hardys reported their income from MBJ as nonpassive because their tax preparer relied on the Schedule K-1 received from MBJ. The Schedule K-1 indicated that the income was from a trade or business and included self-employment tax. The Hardys also reported passive activity loss limitations from an unrelated activity on Form 8582 of $58,786 for 2006 and $119,615 for 2007, which included the carry-over loss from 2006. In 2008, after learning that Dr. Hardy was not involved in the management of MBJ and was not liable for the debts of MBJ, the Hardys’ tax preparer determined that the income from MBJ was passive by going through a checklist of passive activity criteria and obtaining corroborating information from the Hardys.

The Hardys did not amend their returns for 2006 or 2007 because their tax preparer believed the change was immaterial. Rather, the Hardys reported the income from MBJ as nonpassive beginning in 2008. In 2008 and 2009, the Hardys netted their passive income against their passive activity losses, including the carry-over losses of $119,615 from previous years. Additionally, they reported self-employment tax from the income Dr. Hardy received from Northwest Plastic Surgery and MBJ. The IRS issued a notice of deficiency for years 2008 through 2010, disallowing the Hardys’ passive activity loss deduction.

The Tax Court considered whether the Hardys properly reported Dr. Hardy’s income from MBJ as passive. The IRS argued that the income from MBJ was nonpassive and could not take a deduction for their passive activity losses because they had no passive income against which to take the deduction. The IRS also asserted that the Hardys had in prior years grouped their MBJ activity with Dr. Hardy’s medical practice and could not regroup those activities in subsequent years.

The Tax Court concluded that the Hardys did not meet the material participation test under Section 469 and, thus, the income from MBJ was passive. The Tax Court dismissed the IRS’ argument that the Hardys attempted to regroup their activities under Section 469. Relying on the testimony of the Hardys’ return preparer, the Tax Court determined that the activities had not been previously grouped together. The return preparer explained that he did not group the activities and had originally determined that the income from MBJ was nonpassive by “applying his knowledge and experience”and by relying on the reporting from the Schedule K-1. Additionally, the Hardys did not explicitly group their activities and were not required to do so in those tax years. Thus, the Tax Court concluded that there was no evidence that the Hardys had previously grouped MBJ and Northwest Plastic Surgery and had consistently treated them as separate economic units. The Tax Court also held that the IRS could not regroup the Hardys’ activities under Treas. Reg. Sec. 1.469-4(f) because the Hardys’ original grouping was reasonable and did not have a principal purpose of circumventing Section 469.

Despite finding that the income from MBJ was passive, the Tax Court ultimately concluded that the Hardys were not entitled to the full passive activity loss deductions claimed in 2008 and 2009. In making this determination, the Tax Court examined the passive activity loss carryovers from prior years. Because the Tax Court had already found that the income from MBJ was passive, it noted that the Hardys had erroneously treated the MBJ income as nonpassive in 2006 and 2007. If the Hardys had properly reported the MBJ income as passive for 2006 and 2007, their passive activity losses would have been fully absorbed by their passive income in those years and, therefore, no passive activity loss would have been available to carry forward to 2008.

Another issue considered by the Tax Court was whether the Hardys overpaid their self-employment tax. The Tax Court looked to Section 1402(a)(13), which excludes the distributive share of any item of income or loss of a limited partner from net earnings from self-employment subject to self-employment tax, in order to determine whether Dr. Hardy’s income from MBJ was subject to self-employment tax. The Tax Court cited Renkemeyer, Campbell, Weaver, LLP v. Commissioner, 136 T.C. 137 (2011), in which the Tax Court examined the legislative history of the statute to interpret the meaning of limited partner for purposes of Section 1402(a)(13) and found that the intent 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 Renkemeyer decision held that because revenue was derived from services performed by partners in their capacity as partners, they were not acting as investors of the partnership and, thus, the partners were liable for self-employment tax. In distinguishing Hardy from Renkemeyer, the Tax Court noted that although Dr. Hardy performed surgeries at MBJ, the distributive share of income and distributions that he received from MBJ was not for services he performed for MBJ, but rather from fees that patients paid to use the facility. Furthermore, the Tax Court underscored that Dr. Hardy was not involved in the operations of MBJ as a business. Thus, the Tax Court held that Dr. Hardy’s distributive share of income from MBJ was not subject to self-employment tax because he received his share of income from MBJ in his capacity as an investor. The Hardy case shows that for purposes of Section 469, a taxpayer may group activities in any reasonable manner as long as his principal purpose for the grouping is not to avoid the underlying purposes of Section 469. Additionally, taxpayers are seemingly not bound to determinations made in prior tax years as to whether income is passive or nonpassive.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
 
In association with
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Check to state you have read and
agree to our Terms and Conditions

Terms & Conditions and Privacy Statement

Mondaq.com (the Website) is owned and managed by Mondaq Ltd and as a user you are granted a non-exclusive, revocable license to access the Website under its terms and conditions of use. Your use of the Website constitutes your agreement to the following terms and conditions of use. Mondaq Ltd may terminate your use of the Website if you are in breach of these terms and conditions or if Mondaq Ltd decides to terminate your license of use for whatever reason.

Use of www.mondaq.com

You may use the Website but are required to register as a user if you wish to read the full text of the content and articles available (the Content). You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these terms & conditions or with the prior written consent of Mondaq Ltd. You may not use electronic or other means to extract details or information about Mondaq.com’s content, users or contributors in order to offer them any services or products which compete directly or indirectly with Mondaq Ltd’s services and products.

Disclaimer

Mondaq Ltd and/or its respective suppliers make no representations about the suitability of the information contained in the documents and related graphics published on this server for any purpose. All such documents and related graphics are provided "as is" without warranty of any kind. Mondaq Ltd and/or its respective suppliers hereby disclaim all warranties and conditions with regard to this information, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. In no event shall Mondaq Ltd and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use or performance of information available from this server.

The documents and related graphics published on this server could include technical inaccuracies or typographical errors. Changes are periodically added to the information herein. Mondaq Ltd and/or its respective suppliers may make improvements and/or changes in the product(s) and/or the program(s) described herein at any time.

Registration

Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:

  • To allow you to personalize the Mondaq websites you are visiting.
  • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our information providers who provide information free for your use.

Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.

If you do not want us to provide your name and email address you may opt out by clicking here .

If you do not wish to receive any future announcements of products and services offered by Mondaq by clicking here .

Information Collection and Use

We require site users to register with Mondaq (and its affiliate sites) to view the free information on the site. We also collect information from our users at several different points on the websites: this is so that we can customise the sites according to individual usage, provide 'session-aware' functionality, and ensure that content is acquired and developed appropriately. This gives us an overall picture of our user profiles, which in turn shows to our Editorial Contributors the type of person they are reaching by posting articles on Mondaq (and its affiliate sites) – meaning more free content for registered users.

We are only able to provide the material on the Mondaq (and its affiliate sites) site free to site visitors because we can pass on information about the pages that users are viewing and the personal information users provide to us (e.g. email addresses) to reputable contributing firms such as law firms who author those pages. We do not sell or rent information to anyone else other than the authors of those pages, who may change from time to time. Should you wish us not to disclose your details to any of these parties, please tick the box above or tick the box marked "Opt out of Registration Information Disclosure" on the Your Profile page. We and our author organisations may only contact you via email or other means if you allow us to do so. Users can opt out of contact when they register on the site, or send an email to unsubscribe@mondaq.com with “no disclosure” in the subject heading

Mondaq News Alerts

In order to receive Mondaq News Alerts, users have to complete a separate registration form. This is a personalised service where users choose regions and topics of interest and we send it only to those users who have requested it. Users can stop receiving these Alerts by going to the Mondaq News Alerts page and deselecting all interest areas. In the same way users can amend their personal preferences to add or remove subject areas.

Cookies

A cookie is a small text file written to a user’s hard drive that contains an identifying user number. The cookies do not contain any personal information about users. We use the cookie so users do not have to log in every time they use the service and the cookie will automatically expire if you do not visit the Mondaq website (or its affiliate sites) for 12 months. We also use the cookie to personalise a user's experience of the site (for example to show information specific to a user's region). As the Mondaq sites are fully personalised and cookies are essential to its core technology the site will function unpredictably with browsers that do not support cookies - or where cookies are disabled (in these circumstances we advise you to attempt to locate the information you require elsewhere on the web). However if you are concerned about the presence of a Mondaq cookie on your machine you can also choose to expire the cookie immediately (remove it) by selecting the 'Log Off' menu option as the last thing you do when you use the site.

Some of our business partners may use cookies on our site (for example, advertisers). However, we have no access to or control over these cookies and we are not aware of any at present that do so.

Log Files

We use IP addresses to analyse trends, administer the site, track movement, and gather broad demographic information for aggregate use. IP addresses are not linked to personally identifiable information.

Links

This web site contains links to other sites. Please be aware that Mondaq (or its affiliate sites) are not responsible for the privacy practices of such other sites. We encourage our users to be aware when they leave our site and to read the privacy statements of these third party sites. This privacy statement applies solely to information collected by this Web site.

Surveys & Contests

From time-to-time our site requests information from users via surveys or contests. Participation in these surveys or contests is completely voluntary and the user therefore has a choice whether or not to disclose any information requested. Information requested may include contact information (such as name and delivery address), and demographic information (such as postcode, age level). Contact information will be used to notify the winners and award prizes. Survey information will be used for purposes of monitoring or improving the functionality of the site.

Mail-A-Friend

If a user elects to use our referral service for informing a friend about our site, we ask them for the friend’s name and email address. Mondaq stores this information and may contact the friend to invite them to register with Mondaq, but they will not be contacted more than once. The friend may contact Mondaq to request the removal of this information from our database.

Security

This website takes every reasonable precaution to protect our users’ information. When users submit sensitive information via the website, your information is protected using firewalls and other security technology. If you have any questions about the security at our website, you can send an email to webmaster@mondaq.com.

Correcting/Updating Personal Information

If a user’s personally identifiable information changes (such as postcode), or if a user no longer desires our service, we will endeavour to provide a way to correct, update or remove that user’s personal data provided to us. This can usually be done at the “Your Profile” page or by sending an email to EditorialAdvisor@mondaq.com.

Notification of Changes

If we decide to change our Terms & Conditions or Privacy Policy, we will post those changes on our site so our users are always aware of what information we collect, how we use it, and under what circumstances, if any, we disclose it. If at any point we decide to use personally identifiable information in a manner different from that stated at the time it was collected, we will notify users by way of an email. Users will have a choice as to whether or not we use their information in this different manner. We will use information in accordance with the privacy policy under which the information was collected.

How to contact Mondaq

You can contact us with comments or queries at enquiries@mondaq.com.

If for some reason you believe Mondaq Ltd. has not adhered to these principles, please notify us by e-mail at problems@mondaq.com and we will use commercially reasonable efforts to determine and correct the problem promptly.