In episode 64 of How Tax Works, Matt Foreman discusses the Second Circuit’s recent decision in Soroban Capital Partners, the Fifth Circuit’s withdrawn opinion and newly-issued opinion in K Alain (formerly Sirius Solutions), what to look for in the First Circuit’s (hopefully) pending decision in Denham Capital Management, and why it may not reach the Supreme Court for a while, if at all.

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How Tax Works, hosted by FRB Partner Matthew E. Foreman, Esq., LL.M., delves into the intricacies of taxation, breaking down complex concepts for a clearer understanding of how tax laws impact your financial decisions. Through this, listeners are treated to a comprehensive breakdown of entity structures, from the robust shield of C corporations to the flexibility of partnerships and LLCs. Foreman navigates through the maze of tax considerations, shedding light on entity-level taxation, shareholder responsibilities, and nuanced tax strategies. Foreman shares valuable insights and practical advice, emphasizing the need for informed decision-making and consultation with tax professionals. From qualified small business stock to state and local tax considerations, no stone is left unturned in this illuminating exploration of tax law and entity selection.

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Transcript:

**This transcript has been prepared automatically by AI and may contain inaccuracies**

Matthew Foreman [00:00:07]:
Welcome to the 64th episode of How Tax Works. I’m Matt Foreman. In this episode, I will discuss self-employment taxes under Section 1402 of the Internal Revenue Code, focusing on the Second Circuit’s recent decision in Sorbonne Capital Partners, The Fifth Circuit’s recent re-decision, reissued decision, I don’t know, in what is now known as K. Lane, formerly Sirius Solutions, and the First Circuit’s upcoming, hopefully, maybe soon decision in Denim Capital Partners. How Tax Works is meant for informational and entertainment purposes only. This may be attorney advertising and it is not legal advice. Please hire your own attorney. How Tax Works is intended to help listeners navigate the intricacies and complexities of tax law, regulations, case law, and guidance to demystify how taxes shape the business and financial decisions that we all make.

Matthew Foreman [00:00:59]:
Before we get started, a few administrative things. New episodes every 2 weeks. The next one is going to be an interesting one, a pretty different one, but I, I’ve been sort of toying with the idea of doing it for a while and I’m just going to kind of do it. And it’s about what is a tax and whether pass-through entity tax payments are correctly deductible under the Internal Revenue Code with a discussion of Star Wars. Just to throw it in there because it’s— why not? It’s my podcast. Upcoming webinars and speaking engagements are on the How Tax Works landing page on the FPP website. I have 6 coming up in the fall that are free. Price is really good, which is basically opportunity cost of showing up.

Matthew Foreman [00:01:35]:
Pass-through losses and credits under— they’re November 3rd through the 15th. There’s 6, 3 weeks on Tuesdays from 1 to 2 PM. And then they take a break. There’s a break right in the middle of that bad boy for Thanksgiving, and then 3 more. So 3, week, then 3 every Tuesday. Passive— sorry, November 3rd, Passive Activity Losses and Credit Limitations Under Section 469, What to Expect When You’re Selling a Business. Then any selection, which is, you know, a lot of this similar one of the Silver Bond Capital Partners and things like that. Week off.

Matthew Foreman [00:02:04]:
Then we’re going to get this Opportunity Zones 2.0, Qualified Small Business Stock, an update. And then finally, equity incentives in partnerships, LLCs, structuring profits, interest, capital interest, and options. All right. Episode 64, Soroban and Sirius, now K. Lane. In episode 55, I discussed the Fifth Circuit’s decision in Sirius Solutions. They must have heard me calling their analysis lazy. I’m sure that’s what it was.

Matthew Foreman [00:02:33]:
They definitely listened to this because they withdrew their opinion and substituted to a new one. What happened? I don’t know. The IRS— I should say the DOJ. I’m going to probably keep saying the IRS, but it’s actually the DOJ doing the litigation here. But basically what happened was they asked for an en banc hearing, which is, for those of you who don’t pretend to speak Latin, which lawyers all do, is when you try to get the entirety of a circuit to hear a case. So instead of a 3-judge panel, yet you had all of them in there. And they are granted in certain circumstances, and they’re kind of rare in other ones, but it’s definitely an interesting thing. So instead of granting it en banc, they denied it, and they issued a new opinion.

Matthew Foreman [00:03:17]:
I was having a conversation with my father-in-law and brother-in-law, both of whom are commercial litigators in different contexts, but they’re litigators. And I asked them about sort of what happened mechanically, and they were like, oh, that’s Really interesting. I’ve never heard of that happening before. So cool, I guess. You know, whatever. But this whole underlying topic, if you’ve never listened to me talk about this before, I’m going to politely ask you go back, listen to episodes 11 and 12, where I discuss the background, go through the law. I talk about the tax court’s case. And at that time, it was we were waiting for the decision in the Second Circuit.

Matthew Foreman [00:03:53]:
I think they had just gone through briefing. I don’t think they had the hearing. Hearing yet, that in episode 55, just, just a couple months ago, I talked about the previous First Circuit decision. I was not gentle, but it’s about the definition of, and I’m quoting, limited partner, comma, as such. So formerly Sirius Solutions, now K. Alain. I don’t know how to pronounce it. I don’t know if it’s Alan or Alain.

Matthew Foreman [00:04:15]:
I had a friend in law school whose name, he went by Alan, but it was spelled A-I-N. My understanding, it is a French variation of an name Alan, which in English is Alan, and his name was probably technically Elaine or something like that, but he just went by Alan. So I’m going to call it Elaine because I actually think that’s how you pronounce it, but I don’t know. The holding, which they do not bury the lede on, we hold that ordinary public meaning of this phrase is a partner who plays no significant role in the managing or running of the business. The prior holding was basically if your title is limited partner, you’re a limited partner. This is effectively the same holding as Sorbonne Capital Partners in the Second Circuit. But I kept reading the case of— because of course, plus I didn’t get to this reading this for a couple days, and by then there was already a decent amount of legal press. There was already a decent amount of legal press on it being like, did they just reverse themselves but come to the same conclusion? And it’s really interesting.

Matthew Foreman [00:05:11]:
But, you know, the key is the control of partnership affairs. Some participation is allowed. You know, I think it’s important to note, and I talked about this in Episodes 11 and 12 a bunch. But what’s really important to note is that when 1402 was passed, and it was originally 1402, and then they kind of restructured, rejiggered it a little bit. But 1402, people were trying to get Social Security. And it’s not that people don’t want Social Security, it’s that the rate is much, much, much higher. That was the ’70s. They kicked up the rates a lot during Reagan.

Matthew Foreman [00:05:46]:
and come up. So now even more is subject to it than it used to be. And the rate of return is not that much better at the high end. It’s much worse now at the high end. So because of that, people now want to avoid it entirely because it’s not a good return, whereas previously they wanted to be in it. They wanted Social Security, they wanted to pay it and get it and maximize it. Right. So first, you know, in the decision in Kayleigh in the Fifth Circuit, it says, you know, they sort of took a moment to tell the tax court that only federal courts can interpret law.

Matthew Foreman [00:06:15]:
Bold for a per curiam decision that isn’t signed, which means that the 2 judges who came to the majority— there was a dissent from the 3rd— neither of them were actually willing to sign it and say, I wrote this, which is, I don’t know, man, it’s kind of weak. It’s like throwing a snowball as a statement, but then hiding behind a tree. Like, you’re going to do it, man. Do it. Also, tax courts are federal courts, so I didn’t really totally get that. I appreciate that they’re not from the same article. One’s Article 1, one’s Article 3. So they’re different.

Matthew Foreman [00:06:44]:
But, you know, I think they’re a little snippy about it. I think they got called out a bit, and I thought that was a thing. So anyway, I do know the author isn’t Judge Graves, who wrote the dissent, as he did in the original Fifth Circuit opinion. But the opinion says the plain language is sufficient, but keeps ignoring the as such when the limited partner as such, which it did in the original opinion. So the plain language controls. But in the analysis, they ignored part of the language, which is just chef’s kiss. It’s chef’s kiss beautiful. It’s a little grumpy.

Matthew Foreman [00:07:18]:
I didn’t like it. They then, you know, the decision then goes through, and I’m quoting here, decades— I wrote this down— decades of IRS-approved guidance. I don’t know what that means. It’s the kind of thing that people aren’t tax practitioners say. But the majority already said that only federal courts could interpret law. Now they’re saying the IRS apparently can, which is okay. It cites instructions to partnership returns, which cannot— for those who don’t know, tax returns, information returns, and the instructions cannot be relied upon per IRS guidance. There’s also case law on this, but doesn’t mention that at all.

Matthew Foreman [00:07:50]:
So it’s saying, well, look at this and don’t look over here and ignore the man behind the curtain. And obviously I was not a fan of this decision either, even though I actually agree with the overall conclusion. I think it overstates the IRS’s position generally, specifically how little or how much limited partner can do to retain limited partner status. So I’m not going to go too much into that decision. I thought it was kind of, eh, it was a little grumpy, it was a little angry. And the worst opinions are always the one where the opinions seem to just be saying the dissent is wrong. I’ve always found that if your position is strong enough, you really don’t need to address the dissent except in passing, or if you like the Latin, again, in passim, P-A-S-S-I-M. Maybe it’s passim.

Matthew Foreman [00:08:32]:
I don’t know. I didn’t take Latin. I took Spanish. So here we are, which derives from it, but whatever. So Justice Graves’ dissent, I actually thought it was pretty interesting. I’m going to talk about it for about a second and a half. But, you know, the thing about Justice Graves’ dissent was that his basic position is that because some— is that because limited partners are not functioning as passive investors. Certain limited partners are not functioning as passive investors.

Matthew Foreman [00:08:58]:
They are not limited partners, comma, as such. He repeatedly uses limited partners as such, which the majority doesn’t use. The majority keeps saying limited partners, limited partners, limited partners. But the important language, and I actually think both the taxpayers and the IRS or DOJ agree on this, that the as such is really important, right? Because otherwise you’re only looking at part of the statute. And the majority just doesn’t use it. I don’t get it. The majority is answering, in my view, the wrong question. They’re like, well, what is a limited partner? And I’m like, as such, as such is a limited partner in what they do in their actions.

Matthew Foreman [00:09:35]:
And the majority in the Second Circuit, which I’ll get to in a second, in the Tax Court case and the dissent from Justice Graves— Judge Graves, excuse me— really wants to do a functional test. Which I am of the position that is required. It’s required that the function is more important than the title. And I think that that’s really what the majority in this one whiffs on. Anyway, so it cites Rankmeier, Hardy, and Castiglione. Castiglione, get that right. I think it’s Rankmeier that’s like the law firm, you know, so certain businesses really you can never be a limited partner, but You know, Kay Lane, Sorbonne, Denham are funds. You can absolutely have limited partners.

Matthew Foreman [00:10:17]:
I think law firms, you can probably theoretically have a limited partner, which is basically a retired partner who still gets a draw of some sort because they own it. So you probably can, but they’re rare. Most of the time when law partners exit, they exit, they’re out. You know, I know there’s some sort of like trailing stuff. If there’s debt under 752, it’s handled under 736 for exiting. But that’s kind of a— that’s not what we’re talking about here. It also points out in the dissent, you know, that Plastil, which the majority cited, has— the majority cited it for a definition of limited partner. But Plastil is not a tax case and it’s a state law case.

Matthew Foreman [00:10:56]:
And the majority says, no, no, we have to look at federal tax law and only I can interpret it. So they’re kind of saying like, only I can do this. I’m so wonderful. And then they’re like, ah, but look over here. Right. So I don’t, I don’t know. I don’t get it. I didn’t like it.

Matthew Foreman [00:11:10]:
Let’s, let’s take a quick music break. Then we’re going to get to the Second Circuit’s decision in Sorbonne Capital Partners, which I’ll talk about and have a nice little somewhat off-topic rant, but it’ll be funny. Okay, we’re back. Let’s talk about the Second Circuit’s decision in Sorbonne Capital Partners. The holding is simple. Affirmed the tax court case. It says the principals are not limited partners under Section 1402 of the code. Remember, and this is important, the beneficial owners of the general partnership, okay, the general partner, I should say, wasn’t a partner.

Matthew Foreman [00:12:22]:
Well, it’s a tax partnership, but it was an LLC. The beneficial owners of the GP are the exact same people as the beneficial owners of the LP in this context. There are actual LPs. They don’t pay payroll taxes. They’re not, they’re not at issue here. It’s only the people who are GPs and LPs. That’s the thing we’re talking about. So I had a client say to me, geez, are they saying that like it’s not possible to be a limited partner and avoid payroll taxes? I’m like, no, just don’t participate, right? You can participate a little.

Matthew Foreman [00:12:54]:
There’s some voting stuff and limited partners can do certain things. But, you know, don’t be the active— don’t be the CEO of the company and then be like, oh, I’m also a limited partner. No, you’re not. Right. That’s what’s going on. That’s the functional test we’re going for. Unlike the Fifth Circuit, the Second Circuit went through the facts of the case and the roles of the owners. The Fifth Circuit said activities don’t— did not— the Fifth Circuit just said the activities did not exceed what would be A limited partner, but never really discussed the activities.

Matthew Foreman [00:13:22]:
And I felt that the lack of facts and details is suggestive of the fact that they wanted a result and they were going to get it, dang it. But then they sort of had to realize that, well, we have to kind of agree on the test. And, you know, just calling you a limited partner is sort of— it’s a bit much. It’s strong or weak, however you want to call the position. Either a strong position is sarcastic or weak position being direct. Right. Right? They actually use the same definitions of limited partner generally. 1979 Black’s Law Dictionary.

Matthew Foreman [00:13:51]:
I want to point out that before, like 20-something years ago, Black’s Law Dictionary was actually red. It wasn’t black. They changed the color. I think they went with a pun, which is fine, whatever. But that sort of fascinated me anyway. They also included 1976 Webster’s Third New International Dictionary. They contrasted limited partner with special partner. They also analyzed state laws.

Matthew Foreman [00:14:14]:
They just said, we’re going to talk about all the definitions that existed at the time historically and things like that. So I really appreciate when a court goes through what I’m going to politely call a rigorous analysis of what exists. I’ll admit that they largely had this analysis sitting there for them because the Tax Court kind of did it, but they went into good detail. So that was helpful. They discussed the use of the phrase as such, which follows limited partner directly in 1402. And what they said is the phrase is limited partner, comma, as such. And they said that as such means in that capacity. Okay.

Matthew Foreman [00:14:56]:
And the Second Circuit, in my view, is clearly responding to the Fifth Circuit here, particularly in the initial decision that was withdrawn. And the reissued decision. This is where I’m going to go on a bit of a rant here. But one thing you learn in law school in particular, but I think is done anytime anyone construes a statute or reads something critically, you are told to think about what they’re trying to say. And the general rules of statutory construction are that you can’t have superfluous language, right? The language has to be— you have to look at the whole thing. And if there’s— you change the meaning by eliminating a clause, you can’t eliminate that clause unless the clause is irrelevant to it. So, right, so if you were to say, have a list of 5 things, it’s similar to 1 through 3, 4, or 5, and they’re very different things, right? If it’s similar colors to red, green, or blue, right, obviously those are kind of similar, right, in their own way, but especially green and blue. But what I would say is, is it similar to red at all? No, it’s like a cyan.

Matthew Foreman [00:15:59]:
And you’re gonna say, well, cyan’s actually very similar to blue, right? Because, because the regular blue and cyan, slightly same, slightly different, right? And so you can ignore the red or green, but you can’t blue it. You can’t ignore it. And I think what they were really saying, and then this is where I— why I come to the conclusion I come to, I think, is that I think I’m of the opinion that they just totally— the Fifth Circuit just completely ignores as such. Because their decision does not make sense in my view. At least the first one definitely didn’t. The second one does a little bit. If you— it makes perfect sense if it just says a limited partner, right? But it doesn’t. It says limited partner as such.

Matthew Foreman [00:16:41]:
So what’s happening is you can’t eliminate superfluous language and interpret it in a way that would be different than how you interpret it if that language were still there. That’s clearly related. Limited partner, comma, as such. Is clearly related to someone. I don’t know if you can— so a big reason why I didn’t like the Fifth Circuit’s decision, and it’s not because I disagree with the conclusion, it’s because I actually think they didn’t give an opportunity properly to go through what is too much for a limited partner to do because it didn’t provide any analysis when they held. The Second Circuit says, look, this is what they did. These are the activities. That’s too much.

Matthew Foreman [00:17:18]:
Because they’re a general partner or beneficial owner of the general partner and, and they are a limited partner, they can’t be both for payroll tax purposes. As such, they didn’t do anything in their role as limited partners. They did everything in their role as GPs. And so the allocations get blown up. You can only have one. That’s it. They also talked about, this is a really interesting sort of side point in the Second Circuit. Which talked about guaranteed payments.

Matthew Foreman [00:17:48]:
And what they said is if a limited partner gets a guaranteed payment, that payment is for non-limited partner activities. Therefore, and as you know this, but guaranteed payments are subject to payroll taxes, right? So what they’re basically saying is if your activities are for things that exceed your role as a limited partner, they should be subject to it. That’s the whole guaranteed payment thing. So if a limited partner doesn’t own a GP but provides some services, the guaranteed payments are the portion of their compensation or allocable share, distributed share, whatever it is, that is subject to payroll taxes. However, if you’re a GP and an LP, right, then that muddies the water a little bit and you have to watch out what you’re doing. People have asked me, you know, what if I use a different entity and I do this? And I’m like, well, Kind of what Sorbonne did, and it didn’t work out so well. So I think that it’s important to say, look, if you’re a GP, boy, you might just be getting hammered on payroll taxes, and we should talk about structure because there may be ways to avoid it, may not be. So that’s really important.

Matthew Foreman [00:18:51]:
Although, you know, maybe that’s how we fund Social Security for the next 20 years, so maybe it’s not so bad for the world. All right, so let’s get some music in here. We’re gonna take a quick pause, and then we’re gonna talk about, well, What’s next? And I think that that’s, that’s an important point. Okay, so we’re back. So what, what’s next, right? What’s the next step? The 5th and 2nd Circuit actually agree on the test, which is the functional test. There are different results under different facts, so maybe a different application, but I don’t think there’s actually a circuit split here. I said it, I posted on LinkedIn some quick thoughts on it. So I don’t think there’s an actual circuit split.

Matthew Foreman [00:20:04]:
So I don’t think at this point the Supreme Court would take it up because as much as the Fifth Circuit tried to create a circuit split, I don’t think they did. People may think they did because they’re like, well, you know, they analyzed it differently, but there’s really only a circuit split on different results. If, if there’s 2 different tests and they just constantly come out to the exact same result, I don’t know. Supreme Court really need to take it. Do we really want the Supreme Court getting involved in tax, that generally doesn’t enter well— end well. So let’s enter Denham Capital Management, right, from the top rope. First Circuit case, oral arguments were in February. February.

Matthew Foreman [00:20:40]:
We’re getting on, you know, I’m recording this the very end of September. I know this won’t air until the middle, middle end of October, but that’s a hot minute right there, right? I assume we’ll get the decision in the next few weeks. It might come out before this comes out, which will be awesome. Great job, Matt. But if the First Circuit picks apart either decision or disagrees regarding the test, then there may be a circuit split. You know, I read the briefs, the updated briefs from the DOJ and the taxpayer. DOJ, which is the IRS as well, said, look, look at the Tax Court. I’m sorry.

Matthew Foreman [00:21:10]:
Yeah, they said, look at the Tax Court, look at the Second Circuit, look at the Fifth Circuit. What are we doing here? We win. Taxpayer says, they’re idiots, they’re morons. How can they get this so wrong? We need the, we need the First Circuit to come across as right. We’re suing you. We’re getting our money back. First Circuit, come and save me. Right.

Matthew Foreman [00:21:27]:
And then that’s, that’s really what’s going on there. I don’t know. I mean, it’s kind of the only argument they have in a lot of ways that, that, you know, the Second Circuit’s idiots, which true, everyone’s an idiot. So it works out. I can’t see the Supreme Court granting cert right now. Like I said, the Second Circuit, you know, in Sorbonne can grant an en banc hearing, which I think is going to happen and it’s going to be next. 5th Circuit in LA, they can now— so an en banc has been re-requested. Requested? I don’t know.

Matthew Foreman [00:21:58]:
I’m not— again, you know, I’m totally not totally sure of this posture here because I don’t really do motion practice and federal litigation like this. I only do the technical stuff behind it. So— and I’ve never gone anything beyond petitioning tax court. So I don’t totally understand how en banc works. I think they— I mean, I’m pretty sure they requested it. I actually think they’ll get it. I think there’ll be another hearing in the Fifth Circuit. I think there’ll be another hearing at the Second Circuit, but I think that the First Circuit will rule prior to the en banc.

Matthew Foreman [00:22:29]:
But I got to tell you, if the First Circuit and Second Circuit agree, Second Circuit might just deny en banc. Fifth Circuit might do it anyway, just for funsies, see what happens. So we’ll go there. So what’s the conclusion here as I try to wrap this bad boy up, right? I think the IRS largely won. I don’t count out taxpayers, you know, because they’re taking a very literal and direct and narrow position, and the Supreme Court loves those lately, man, do they ever. So I think that’s really an important one to really go through and think about, like, how does this work? What are we trying to do here? So that was the 64th episode of How Tax Works. Hope you learned something. Hope you enjoyed it.

Matthew Foreman [00:23:07]:
I’ll be back in 2 short weeks, 65th episode. I’m going to talk about What is a tax? Whether a pass-through entity, pass-through entity tax payments are correctly deductible under the Internal Revenue Code. Thank you.