In Chief Counsel Advice 202009024,[1] the IRS looked into the issue of whether passive activity loss, basis, and at-risk limits impact the ability to use a self-employment loss from a partnership against other self-employment income of a taxpayer for the year in question.

The question posed in the advice is:

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.

The fact pattern presented was the following:

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 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.

The IRS notes in Footnote 2 to the memorandum that it has heard some taxpayers arguing that Revenue Ruling 56-675 allows such losses to be offset against self-employment income even if blocked by another limit in the IRC. But the IRS notes that the ruling never says that the limits don’t apply, and the agency takes the position that silence does not mean they don’t matter.

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.

The memorandum points out the following definition of net earnings from self-employment found in the IRC:

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 individual, less the deductions allowed by subtitle A 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.

The memorandum first looks at the passive activity loss limitations under §469 and concludes that if a loss deduction for income tax purposes is barred by the passive activity rules, it also will not be able to offset self-employment income for the year in question. The memorandum cites an example from Reg. §1.469-1T(d)(3) that specifically provides that the loss is barred:

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).

The memorandum continues to note that the regulation text supports that position with regard to passive losses:

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.

With regard to the basis loss limitations of §704(d), the memorandum observes that:

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.

That is, the basis limitation rules are contained in IRC §704, and the regulations under IRC §1402 specifically look to §704 for a taxpayer to compute his/her income from self-employment.

Finally, the memorandum looks at the at-risk limits found in IRC §465 and concludes that any losses suspended by those rules also will not impact the current year’s self-employment income:

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, 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

The conclusion of the memorandum provides:

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.

[1] CCA 202009024, February 28, 2020, https://www.irs.gov/pub/irs-wd/202009024.pdf (retrieved March 5, 2020)