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.

Grace Kim
Principal, Washington National Tax Office
+1 202 521 1590

Jose Carrasco
Senior Manager, Washington National Tax Office
+1 202 521 1552

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