The Tax Court recently ruled that a taxpayer was liable for self employment tax based on its status as a partner, even though the partnership had elected out of the partnership tax rules. Although the court in Methvin v. Commissioner respected the entity’s Section 761 election out of the Subchapter K partnership tax rules, it concluded that the entity was still a partnership for other purposes of the tax code.
The taxpayer owned a small percentage interest in oil and gas working interests through an operating agreement. Self-employment taxes apply to trade or business income earned directly or through being a partner in a partnership conducting such business. The taxpayer argued that he was not engaged in a trade or business and was not a partner in a partnership, asserting that his minority working interests were merely passive investments. The court disagreed, concluding that the taxpayer was liable as a partner in a partnership that conducted a business. The court cited its 1988 opinion in Cokes v. Commissioner for a similar conclusion that self-employment tax applied in this context, despite the fact that the taxpayer in Methvin had significantly less economic rights and control than the taxpayer in Cokes. The court further concluded that although the IRS had not challenged this issue on prior year audits, that did not prevent the IRS from challenging the issue in the year at issue.
The Methvin case is a warning to taxpayers that the Section 761 election out of Subchapter K does not turn off partnership status for all purposes, which could have implications well beyond self-employment taxes. The case is also a reminder that merely because an issue is not raised on a tax audit in a particular year, there is no precedential value to the prior audit.