A taxpayer’s liability for self-employment tax related to income from working interests in oil and gas wells was the issue in the case of Methvin v. Commissioner, T.C. Memo 2015-81, affd CA10, Case No. 15-9005, AFTR 2d ¶2016-809.
This is a case we first visited back in April of 2015 when the taxpayer lost in Tax Court. But now we have the results of the taxpayer’s appeal to the Tenth Circuit.
This is not a case of David being out there drilling for oil—rather, he had simply been acquiring working interests in several oil and gas ventures as investments. His interests were never more a small amount in each venture. David’s interactions were basically to invest funds and then receive his checks for his share of revenues less expenses. He did not perform any services with regard to the wells.
He had an agreement with the operator of the interests where that organization managed the operations of the various wells for David and all other interest holds, and then allocated to David his portion of the income and expenses incurred on the well.
The owners of the interests had elected to be excluded from Subchapter K pursuant to IRC §761(a) since their situation was one of those eligible for that election. In 2011 David was allocated $10,797 in revenues and $4,037 in expenses on his wells. The operator of the wells reported the income to David on Form 1099-MISC, indicating the payment was for nonemployee compensation.
While David reported the income on his Form 1040 for the year, he did not report the amount as subject to self-employment tax. In prior years the IRS had conceded the issue administratively when the issue arose, accepting David’s position that he did not owe self-employment tax. But in 2011 the IRS did not cave in and so the matter went to trial.
David’s position was simple—he was merely a passive investor who was not himself engaged in a trade or business related to oil and gas and, due to the election under IRC §761(a), was not a partner in a partnership.
In order for income to be self-employment income, generally, it must fall under the definition found at IRC §1402(a) which provides:
The term “net earnings from self-employment” means the gross income derived by an individual from any trade or business carried on by such individual, less the deductions allowed by this subtitle which are attributable to such trade or business, plus his 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;…
As you will note, that definition has two clauses—to be self-employment income, the income must either arise from a trade or business that David carries on or be his share of income from a partnership of which he is a member that is carrying on a trade or business.
David pointed out that he has no knowledge of the oil and gas industry, his interests were very small minority interests and he had no involvement in the day-to-day operations of the wells. The Tax Court agreed that all of that was true, but noted:
However, a taxpayer who is not personally active in the management or operation of a trade or business may be liable for self-employment tax if the trade or business is carried out on his behalf through his agents or employees or constitutes his distributive share of income from a partnership in which he was a member. Sec. 1402(a); Cokes v. Commissioner, 91 T.C. 222 (1988); Perry v. Commissioner, T.C. Memo. 1994-215; Moorhead v. Commissioner, T.C. Memo. 1993-314; secs. 1.1402(a)-2(b), 1.1402(c)-1, Income Tax Regs.
The Tax Court noted that the Cokes case involved a similar situation—the taxpayer held a percentage working interest in oil and gas wells via an agreement and did not directly get involved in the operation of the well—basically, the taxpayer provided money and got checks. In that case, the Court noted, the taxpayer was found liable for the self-employment tax.
David argued that he was different because he held a much smaller interest than the taxpayer in Coke and his agreement allowed the interest holders less control. But the Tax Court found neither of those were relevant—rather the issue is whether David was a member of a partnership or joint venture. His ability (or lack thereof) to control the venture is not a relevant point.
But, David argued, the entity had elected out of Subchapter K—therefore he was not a partner. However the Tax Court noted, citing back to the Cokes case, that this election does not change the nature of the entity for self-employment tax purposes. There is still a partnership (it simply doesn’t file a Form 1065) and thus, when looking at the rules under IRC §1402(a), David is treated as a partner receiving an allocation of income conducted by the partnership. The proper test is whether the agreement David entered into meets the broad definition of partnership found at IRC §7701(a)(2) which the Court found it did.
David, not happy with the Tax Court result, took his case on appeal to the Tenth Circuit Court of Appeals. But David fared no better there. The appellate panel included a footnote to their opinion that described how a partnership is determined, noting:
The existence of a partnership depends on the parties’ intent, which is discerned from all the facts. Comm'r v. Culbertson, 337 U.S. 733, 741-42 (1949); Comm'r v. Tower, 327 U.S. 280, 286-87 (1946). The Tax Court has recognized multiple considerations bearing on this issue, including
[t]he agreement of the parties and their conduct in executing its terms; the contributions, if any, which each party has made to the venture; the parties’ control over income and capital and the right of each to make withdrawals; whether each party was a principal and coproprietor, sharing a mutual proprietary interest in the net profits and having an obligation to share losses, or whether one party was the agent or employee of the other, receiving for his services contingent compensation in the form of a percentage of income; whether business was conducted in the joint names of the parties; whether the parties filed Federal partnership returns or otherwise represented to respondent or to persons with whom they dealt that they were joint venturers; whether separate books of account were maintained for the venture; and whether the parties exercised mutual control over and assumed mutual responsibilities for the enterprise.
Luna v. Comm'r, 42 T.C. 1067, 1077-78 (1964). Although the Tax Court did not expressly apply each of these considerations, either in Cokes or in this case, the Tax Court's findings sufficiently encompassed the required analysis.
Note that this may surprise many CPAs—after all David didn’t do anything. True, but this provision of the IRC doesn’t require him to do anything at all so long as he is a partner. This is the reason why there is a special exception granted to limited partners in IRC §1402(a)(13)—but David wasn’t a limited partner.
But what about the fact that the IRS had administratively agreed that David wasn’t subject to self-employment tax in prior years? Can the IRS really change positions like this? Doesn’t fairness demand the IRS be consistent in its application of the rules in David’s case?
Whether fair or not, the answer is no. As the Tax Court notes “It is well established that the Commissioner’s administrative concession of an issue for one tax year does not preclude his pursuing the same issue for a different tax year. See Burlington N. R.R. Co. v. Commissioner, 82 T.C. 143, 146 (1984).”
And, frankly, this shouldn’t be surprising as the same is true for taxpayers. AICPA Statements on Standards for Tax Services No. 5 specifically allows a CPA, in most cases, to argue a position contrary to one previously administratively conceded by the taxpayer in prior years, noting that a concession may be made for reasons unrelated to the issue of whether the taxpayer would have prevailed had he/she taken the matter all the way through the courts.