Partnership basis and at-risk limits also restrict self-employment losses

Plain-English summary

Chief Counsel considered whether general partners could use partnership losses to reduce net earnings from self-employment when those losses were disallowed for income tax purposes. The memorandum concluded that section 704(d)'s partnership-basis limit and section 465's at-risk limit apply when calculating self-employment income under section 1402. Because section 1402 incorporates allowable business deductions and a partner's distributive share, a loss disallowed by those limits cannot offset guaranteed payments for Self-Employment Contributions Act tax in that year. The same general approach applies to passive-activity limits under section 469. A different result is possible only when a specific section 1402 exclusion applies.

Ruling snapshot

• Question: Do the partnership-basis and at-risk loss limits apply when a general partner calculates net earnings from self-employment?
• Outcome: advice given
• Key authorities: IRC §§ 465, 469, 704(d), 707(c), 1401, and 1402; Treas. Reg. §§ 1.1402(a)-2, 1.1402(a)-3, and 1.469-1T(d)(3)

Full text (IRS public release)

           Office of Chief Counsel
           Internal Revenue Service
           Memorandum
           Number: 202009024
           Release Date: 2/28/2020
           CC:EEE:EOET:ET1:NPark
           POSTN-130821-18

 UILC:     1402.01-00, 465.00-00

  date:    March 04, 2019

     to:   Timothy A. Lohrstorfer
           Associate Area Counsel
           (CC:SB)

  from:    Michael Swim
           Senior Technician Reviewer
           (CC:EEE:EOET:ET1)


subject:   Whether the Basis Loss Limitation and the At-Risk Loss Limitation Apply in
           Determining a General Partner's Self-Employment Tax

           This Chief Counsel Advice responds to your request for assistance. This advice may
           not be used or cited as precedent.

                                                    ISSUE

           Whether the basis loss limitation under § 704(d) and the at-risk loss limitation under
           § 465 apply to determining a general partner’s net earnings from self-employment
           (NESE) under § 1402 for Self-Employment Contributions Act (SECA) tax purposes.

                                                CONCLUSION

           Unless a specific exclusion applies under § 1402(a) to the facts of a case, the basis loss
           limitation under § 704(d) and the at-risk loss limitation under § 465 apply in determining
           a general partner’s NESE under § 1402 for SECA tax purposes.

                                                  EXAMPLE

           You have asked for advice on the following general fact pattern:

           LLC (“LLC”) elected to be treated as a partnership for federal tax purposes. The LLC
           has three (3) individual members: Member A, Member B, and Member C. All three
POSTN-130821-18                             2

members are general partners of the LLC. The LLC is involved in the single activity of
contracting for the production of widgets for customers.

During the tax year X, the LLC had a current year operating loss. Net operating loss
carrybacks and carryovers are 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: Member A reduced his guaranteed payment by his individual share of the
partnership’s losses without applying the basis loss limitation under § 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 § 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 § 469 because Member C materially
participated in the LLC.

All the members agree that the loss limitations apply in determining their income subject
to federal income taxes. However, Member A and Member B argue that the basis loss
limitation under § 704(d) and the at-risk loss limitation under § 465 do 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.

                                 LAW AND ANALYSIS

Section 1401 of the Code imposes SECA tax for each taxable year on the self-
employment income of every individual for such taxable year. SECA tax consists of
Old-Age, Survivors, and Disability Insurance (OASDI) tax under section 1401(a) and
Hospital Insurance (HI) tax under section 1401(b).

Section 1402(b) of the Code generally defines “self-employment income” as the net
earnings from self-employment derived by an individual during any taxable year; except
that such term shall not include –

      (1) in the case of the OASDI tax imposed by section 1401(a), that part of the net
      earnings from self-employment which is in excess of (i) an amount equal to the
      contribution and benefit base (as determined under section 230 of the Social
      Security Act) which is effective for the calendar year in which such taxable year
      begins, minus (ii) the amount of the wages paid to such individual during such
      taxable year; or

      (2) the net earnings from self-employment, if such net earnings for the taxable
      year are less than $400.

Section 1402(a) of the Code defines the term “net earnings from self-employment” as
the gross income derived by an individual from any trade or business carried on by such
POSTN-130821-18                                    3

individual, less the deductions allowed by subtitle A1 which are attributable to such trade
or business, plus the individual’s distributive share (whether or not distributed) of
income or loss described in section 702(a)(8) from any trade or business carried on by a
partnership of which he is a member, with certain enumerated exceptions.

Section 1.1402(a)-2(d) of the Income Tax Regulations provides that the net earnings
from self-employment of an individual include, in addition to the earnings from a trade or
business carried on by him, his distributive share of the income or loss, described in
section 702(a)(8), from any trade or business carried on by each partnership of which
he is a member. An individual’s distributive share of such income or loss of a
partnership shall be determined as provided in section 704, subject to the special rules
set forth in section 1402(a) and in §§ 1.1402(a)-1 to 1.1402(a)-17, inclusive, and to the
exclusions provided in section 1402(c) and §§ 1.1402(c)-2 to 1.1402(c)-7, inclusive.

Section 1.1402(a)-3 of the Income Tax Regulations provides that for the purpose of
computing net earnings from self-employment, the gross income derived by an
individual from a trade or business carried on by him, the allowable deductions
attributable to such trade or business, and the individual’s distributive share of the
income or loss, described in section 702(a)(8), from any trade or business carried on by
a partnership of which he is a member shall be computed in accordance with the special
rules set forth in §§ 1.1402(a)-4 to 1.1402(a)-17, inclusive.

Section 465(a) of the Code allows any loss from an activity for the taxable year only to
the extent of the aggregate amount with respect to which the taxpayer is at risk (within
the meaning of subsection (b)) for such activity at the close of the taxable year for
individuals and C corporations that meet the stock ownership requirement under
section 542(a)(2) [i.e., five or less individuals owning more than 50 percent in value]
engaged in an activity to which this section applies.

Section 469 of the Code disallows passive activity losses and passive activity credits for
the taxable year for individuals, estates, trusts, closely-held C Corporations, and
personal service corporations.

Section 1.469-1T(d)(3) of the Income Tax Regulations provides that, except as
otherwise provided in regulations, a deduction that is disallowed for a taxable year
under section 469 and the regulations thereunder is not taken into account as a
deduction that is allowed for the taxable year in computing the amount subject to any
tax imposed by subtitle A of the Internal Revenue Code.

The following example in the regulations illustrates the application of § 1.469-1T(d)(3):



1 Subtitle A of the Internal Revenue Code encapsulates §§ 1 through 1564. Section 1.1402(a)-1(a)(1) of

the Income Tax Regulations more specifically references deductions allowed by chapter 1 of the Code,
which includes §§ 1 through 1400Z-2.
POSTN-130821-18                              4

Example. An individual has a $5,000 passive activity loss for a taxable year, all of
which is disallowed under § 1.469-1T(a)(1). All of the disallowed loss is allocated under
§ 1.469-1T(f) to activities that are trades or businesses (within the meaning of
section 1402(c)). Such loss is not taken into account for the taxable year in computing
the taxpayer’s taxable income subject to tax under section 1. In addition, such loss is
not taken into account for the taxable year in computing the taxpayer’s net earnings
from self-employment subject to tax under section 1401. (Emphasis added).

Section 704(d) of the Code provides that a partner’s distributive share of partnership
loss (including capital loss) shall be allowed only to the extent of the adjusted basis of
such partner’s interest in the partnership at the end of the partnership year in which
such loss occurred. Any excess of such loss over such basis shall be allowed as a
deduction at the end of the partnership year in which such excess is repaid to the
partnership.

Section 707(c) of the Code provides a rule with respect to guaranteed payments made
by a partnership to a member of the partnership. It provides that to the extent
determined without regard to the income of the partnership, payments to a partner for
services or the use of capital shall be considered as made to one who is not a member
of the partnership, but only for the purposes of section 61(a) (relating to gross income)
and, subject to section 263, for purposes of section 162(a) (relating to trade or business
expenses).

Section 1.707-1(c) of the Income Tax Regulations provides that guaranteed payments
do not constitute an interest in partnership profits for purposes of sections 706(b)(3),
707(b) and 708(b). In addition, § 1.707-1(c) states that for purposes of other provisions
of the internal revenue laws, guaranteed payments are regarded as a partner’s
distributive share of ordinary income. Section 1.1402(a)-1(b) of the Income Tax
Regulations provides that guaranteed payments are treated as gross income subject to
self-employment tax.

A general partner in a partnership is subject to SECA tax on his or her self-employment
income as defined in § 1402(b). The Code defines “self-employment income” as the
NESE derived by an individual with certain adjustments. NESE as defined in § 1402(a)
takes into account deductions that are allowed by subtitle A with regard to any trade or
business carried on by the individual and includes the partner’s distributive share of the
income or loss from any trade or business carried on by the partnership, subject to the
special rules under §1402. If a partner incurs losses from partnership activities, there
are rules or code provisions that limit the amount of losses a partner is allowed to take
for general income tax purposes on the individual partner’s tax return. These provisions
include, in the order that applies: first, basis loss limitation under § 704(d); second, at-
risk loss limitation under § 465; and third, passive activity loss limitation under § 469.
Since the calculation of NESE specifically incorporates the effect of subtitle A 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,
POSTN-130821-18                                       5

any loss limitation rule that applies for 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.2

Specific guidance indicates that the basis loss limitation under § 704(d) and the passive
activity loss limitation under § 469 apply to determine a general partner’s NESE under
§ 1402 for SECA tax purposes. Stating, in part, that “[a]n individual’s distributive share
of such income or loss of a partnership shall be determined as provided in section 704,”
Treas. Reg. § 1.1402(a)-2(d) pulls in the basis loss limitation under § 704(d) into the
computation of NESE.

Also, Treas. Reg. § 1.469-1T(d)(3) provides that a deduction under § 469 or the
regulation is not taken into account for any subtitle A tax, which includes SECA tax
imposed under §§ 1401 through 1403. Furthermore, the example under that regulation
specifically articulates that “[passive activity] loss is not taken into account for the
taxable year in computing the taxpayer’s net earnings from self-employment subject to
tax under section 1401” when the loss is not taken into account in computing a
taxpayer’s taxable income subject to tax under section 1. Although the example does
not expressly involve a passive activity loss from a partnership, the regulation provision
it illustrates makes no distinction between individuals conducting the trade or business
directly and partners in a partnership conducting the trade or business. 3

Furthermore, § 465 applies in determining NESE of individuals carrying on a trade or
business because § 1402(a) expressly takes into account deductions that are allowed
by subtitle A (which is inclusive of the loss limitation rule of § 465) with regard to any
trade or business carried on by the individual. While there is no similar guidance under
§ 1402 or § 465 that expressly states that the at-risk loss limitation under § 465 also
applies for purposes of calculating NESE of general partners for SECA tax purposes,


2 Some taxpayers have erroneously cited to Revenue Ruling 56-675, 1956-2 C.B. 459, as authority that

NESE is not affected by the loss limitations under §§ 704(d), 465, and 469. It is our position that this
ruling is not an authority on the application of the various loss limitations for SECA tax purposes. Rev.
Rul. 56-675 stated that under § 1.1402(a)-1(a)(2) of the regulations, guaranteed payments are treated as
gross income subject to SECA tax. However, where a partner’s distributive share includes a loss resulting
from the operation of the partnership business, including the deduction for guaranteed payments treated
as a business expense under section 162, the self-employment income is the net amount computed by
applying to the guaranteed payment received by that partner the distributive share of loss. Rev. Rul. 56-
675 did not address the application of loss limitations for SECA tax purposes. Since basis cannot be
negative, the facts implied taxpayer had sufficient basis, so the loss limitation of § 704(d) would not apply.
Also, loss limitations under §§ 465 and 469 did not exist in 1956. Consequently, Rev. Rul. 56-675 is not
applicable to whether and how the loss limitation rules apply in determining NESE under § 1402.
3 TAM 9750001 (August 15, 1997) relied on § 1.469-1T(d)(3) and the example in concluding that the

losses allocable to the partnership’s activity in which he did not materially participate are taken into
account for purposes of the calculation of NESE under § 1402, but only to the extent they are allowable
for income tax purposes and are not otherwise of a character to be specifically excluded from the
calculation of NESE.
POSTN-130821-18                              6

applying this loss limitation rule in determining a general partner’s NESE under § 1402
for SECA tax purposes is consistent with considering the basis loss limitation under
§ 704(d) and the passive activity loss limitation under § 469 in computing NESE for a
general partner. Like the application of § 469, § 465 determines the extent to which the
partner’s distributive share of the losses from the partnership carrying on the trade or
business is taken into account in determining the partner’s taxable income for the
taxable year, and its effect is not limited to chapter 1 of the Code. Section 465 generally
applies for purposes of the Code, including chapter 2.

Thus, if the individual share of loss from the partnership is disallowed to a partner under
§§ 704(d) or 465 for the taxable year, the loss is also not taken into account in
computing the partner’s NESE for that taxable year for SECA tax purposes, assuming
there is no SECA provision or regulation that provides otherwise (such as with excluded
rental income).
                                        CONCLUSION

The basis loss limitation under § 704(d) and the at-risk loss limitation under § 465 apply
in determining a general partner’s NESE under § 1402 for SECA tax purposes, to the
same extent these loss limitation rules apply for income tax purposes, unless a specific
exclusion applies under § 1402(a). In the Example, under that general fact pattern, no
specific exclusion applies under § 1402(a). 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.

This writing may contain privileged information. Any unauthorized disclosure of this
writing may undermine our ability to protect the privileged information. If disclosure is
determined to be necessary, please contact this office for our views.

If you have any questions regarding this memorandum, please contact me or NaLee
Park at (202) 317-6798.




                                      _____________________________
                                      Michael Swim
                                      Senior Technician Reviewer
                                      Employment Tax Branch 1
                                      (Employee Benefits, Exempt Organizations, and
                                      Employment Taxes)