My name is Russell Orban. I am appearing on behalf of the Office of Advocacy of the Small Business Administration. My comments today are made pursuant to notice received under section 7805(f) of the Internal Revenue Code which provides the Office of Advocacy with the statutory authority to comment on proposed regulations (*1) and also under general authority of the Office of Advocacy to monitor Agency compliance with the Regulatory Flexibility Act (RFA) (*2) as amended by the Small Business Regulatory Enforcement Fairness Act (SBREFA). (*3) Additionally, the Small Business Act (*4) authorizes the Office of Advocacy to represent the interests of small businesses before federal agencies. The views expressed are solely those of the Office of Advocacy and do not necessarily reflect the views of the U.S. Small Business Administration or any other government agency. On January 13, 1997, the Internal Revenue Service (Service) published a notice of proposed rulemaking (proposed rule) in the Federal Register (62 FR 1702) and withdrew a previous notice on the same subject (59 FR 67293). The Office of Advocacy is aware that the Service has received a number of comments challenging the merits of the proposed regulation. For the most part, the Office of Advocacy will focus its comments primarily on the applicability of the Regulatory Flexibility Act to the proposed rule.
APPLICABILITY OF THE REGULATORY FLEXIBILITY ACT
The 'Special Analyses' section of the proposed rule states as follows: "It also has been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to these regulations, and, because the regulations do not impose a collection of information on small entities, the Regulatory Flexibility Act (5 U.S. C. chapter 6) does not apply." The Office of Advocacy disagrees with the Service's determination that (1) section 553(b) of the Administrative Procedures Act (APA) does not apply, and (2) the regulation "does not impose a collection of information requirement on small entities." We therefore disagree with the IRS conclusion from these two findings that the Regulatory Flexibility Act (RFA) does not apply to the proposed regulation.
Legislative Rule vs. Interpretative Rule A "rule" that is subject to the RFA is any rule "for which the agency publishes a general notice of proposed rulemaking pursuant to section 553(b) of the APA or any other law." (*5) Section 553(b) of the APA provides, "...Except when notice or hearing is required by statute, this subsection does not apply- (A) to interpretative rules..." The Service has steadfastly maintained over the years that the vast majority of its rules are interpretative rules and therefore not subject to the APA or the RFA.
The distinction between legislative and interpretative is important in this case because it is necessary for the Service to first make a decision that a proposed rule is interpretative and therefore not subject to "notice and comment" rulemaking before it can claim exemption from complying with the RFA based on its assertion that no information collection requirement is imposed on small entities. Generally, a determination whether a rule is "legislative" and, therefore, subject in all cases to the RFA, or "interpretative" and, therefore, not subject to the RFA unless there is an information collection requirement, has rested on whether the rule is the "product of an exercise of delegated legislative power to make law through rules (and therefore a legislative rule), (*6) the degree of discretion left to the IRS to fashion a rule and the scope of the rule that was fashioned. (*7) To find out how much direction was given and discretion was exercised, one must look to the underlying law and compare it with the proposed rule. The proposed rule under consideration is based on IRC (1402 (a)(13) which defines net earnings from self-employment and generally excludes earnings from limited partnerships "other than guaranteed payments ... to that partner for services actually rendered to or on behalf of the partnership to the extent that those payments are established to be in the nature of remuneration for those services." (*8) (emphasis added) The proposed rule is the Service's attempt to establish as directed by Congress the boundaries of "in the nature of remuneration" within the context of the statute. The discretion used by the IRS to establish and carry out Congress' intentions in (1402(a)(13) is far-ranging and required the Service's particular expertise. The reach of the statute needed to be stretched to cover a multitude of partnership arrangements, each of which is covered by a different, controlling state law. That difficulty is compounded by the proliferation in the past few years of limited liability corporations (similar to partnerships), which were barely contemplated when the (1402(a)(13) became law. Limited liability corporations, for example, did not even show up in the Statistics of Income records of the Service until 1993, when 17,000 limited liability corporations were listed. In 1994, the year for which the latest data are available, the number more than doubled, to 48,000. That growth has continued at a remarkable rate.
In the first effort to put a structure to what Congress intended in (1402(a)(13), the Service tried to establish the exact boundaries of 'remuneration subject to self-employment tax' and separate it from return on investment based on each state's partnership law. That standard proved difficult at best and seemed to require different treatment of similarly situated individuals (*9). We share the view that such a system would have been difficult. The new proposed rule establishes a standard using functional tests to determine when a partnership distribution to an individual will be classified as net income from self-employment. For example, under the proposed rule, distributions to a partner are net income if: 1. the individual has personal liability for debts and claims of the partnership; 2. the individual has contract authority for the partnership; or 3. the individual participates in the partnership trade or business more than 500 hours per taxable year except that individual partners providing services in health, law, engineering, architecture, accounting, actuarial science, or consulting will never be considered limited partners. (*10) Without regard to whether the Service's proposed approach is right or wrong, the Service has established tests not even hinted at in (1402 and which create a potential tax obligation for millions of partners in hundreds of thousands of partnerships. The tacit authority delegated by Congress to establish a standard and the amount of discretion and expertise required to set that standard provides strong evidence that the proposed rule is legislative, not interpretative. As such, the Service is obliged to comply with the Administrative Procedures Act and the Regulatory Flexibility Act.
Significant Economic Impact on a Substantial Number of Small Entities Once it is determined that the proposed rule is legislative, if, upon analysis, the agency finds that the proposed rule will not have a significant economic impact on a substantial number of small entities, it may so certify in the proposal. (*11) In the proposed rule under consideration, the Service did not prepare such a certification because it assumed the rule was interpretative and, therefore, requiring no further examination of its impact on small entities. Clearly the rule would have widespread impact, particularly on the so-called professional limited partnerships and professional limited liability corporations because the rule states that distributions to the professionals in these partnerships will always be considered net earnings from self-employment and, therefore, subject to employment taxes. In cases where these professionals have a substantial investment in capital assets, the income stream that was formerly treated as return on investment will now be subject to self-employment taxation. The amount of assets controlled by such groups is significant; for example, partnerships related to healthcare, legal, accounting, consulting, architecture and engineering services control about $48 billion in capital assets. The most recent data on partnerships (*12) shows that there were 1.49 million partnerships in 1994. Of those, 283,000 were limited partnerships and an additional 48,000 were limited liability corporations, or about one fifth of all partnerships. Trends seen in most recent reports indicate a dramatic increase in the number of limited liability corporations since 1994. As far as the number of individuals affected in 1994, there were over 10 million limited partners and 293,000 limited liability corporation investors ('partners'). The total amount of net income distributed to individual limited partnerships (therefore the total amount that could be subject to self-employment tax under the proposed rule) in 1994 was $13.4 billion. The total amount of net income distributed to service industry limited partnerships, (which would include the medical, legal, actuarial, engineering, and architectural i.e. "professional partnerships"), all of which would be categorized as net income from employment under the proposed rule and therefore subject to self- employment tax, was $2.9 billion. Even if one assumes that limited partnerships and limited liability corporations will restructure or find ways to characterize distributions as returns on investment and, thus, avoid self-employment taxes, such restructuring would have a significant impact on thousands of partnerships and millions of partners, and therefore, the restructuring should be analyzed as a possibility and taken into account by the Service before rules are promulgated. The analysis should let the service and the business community know what the impact of the proposed rule will be. For example, how much tax revenue will this change generate? What percentage of limited partners and limited liability corporation investors who are not now paying self-employment tax would be required to do so by the proposed rule? How many partners in the professional fields the proposed rule enumerates do not include their entire partnership distribution as net income from self-employment? What is the current percentage of limited partners who declare any portion of a distribution to be net income from self-employment? Could we expect partnerships to restructure to avoid the new tax obligation?
Information Collection Requirement Even if the Service decides that the proposed rule is interpretative, a classification we feel is wrong, the RFA as amended by SBREFA provides that an analysis still should be done "to the extent that such interpretative rules provide a collection of information requirement." (*13) "Collection of information" is defined within the title to include "recordkeeping requirements," which are defined as a "requirements imposed by an agency on persons to maintain specified records." (*14) Section 1.1402(a)-2 (h)(iii) of the proposed rule would treat a partnership distribution to a partner as net earnings from self-employment if that individual "participates in the partnership's trade or business for more than 500 hours during the partnership's taxable year." At the very least that will require the prudent partner to maintain or cause to be maintained the records reflecting the amount of hours spent participating in the partnership's business each taxable year. The fact that this recordkeeping requirement is not spelled out in detail in the proposed rule does not make it any less real to the partner. The Office of Advocacy believes the proposed regulation, which will establish a national definition for "limited partner," will require all prudent partners and partnerships to keep records to satisfy the new burden of proof that this regulation would impose on those who do not want partnership distributions taxed as self-employment income. The Office of Advocacy anticipates that the IRS might contend that nothing in the regulations compels recordkeeping but the Office of Advocacy believes the new stricter standard imposes a de facto recordkeeping requirement. As such, SBREFA requires the burden on small business to be analyzed with an opportunity for the public to comment on the analysis.
RECOMMENDATIONS
Because it is the Office of Advocacy's opinion that this proposed rule is clearly subject to the Regulatory Flexibility Act and has a demonstrable significant economic and recordkeeping impact on a substantial number of small entities, we recommend that the Service withdraw its proposed rule and, at the very least, prepare an initial regulatory flexibility analysis so that the impact on small partnerships can be taken into account by the regulators and so that small businesses can better understand what the impact will be on them. In the alternative, if the Service does not withdraw the proposed rule, the deadline for comments should be extended to give the small business community time to read more deeply into the proposed rule to understand its impact and comment intelligently. For this purpose, it would be helpful to have an initial regulatory flexibility analysis as soon as possible so that businesses can be more fully informed about how the rule will affect them. If, upon analysis, the IRS believes that the proposed rule is legislative and therefore subject to the RFA but will not have a significant economic impact on a substantial number of small businesses, the Commissioner is required to so certify in a new notice of proposed rule-making and support the finding with factual information. (*15) We surmise that such certification would not be supportable since the proposed rule will have an impact on hundreds of thousands of limited partnerships and limited liability corporations and millions of partners receiving billions of dollars. In view of the newly created tax obligation that may apply, this is a substantial economic impact warranting analysis. Thank you for this opportunity to comment.
ENDNOTES
1 26 U.S.C 7805(f)
2 5 U.S.C. Chapter 6
3 P.L.104-121
4 15 U.S.C. (634( c )
5 5 U.S.C. (601 2(b)
6 Administrative Law Treatise, Kenneth Culp
Davis, KC Davis Publishing, 1979, p. 36.
7 See Testimony of Commissioner Roscoe Egger,
Internal Revenue Service , Implementation of the Regulatory
Flexibility Act: Hearings before the Subcom. On Special Small
Business Problems of the House Committee on Small Business, 99th
Cong., 2nd Sess.(1986) p. 70 The difference between legislative
and interpretative is: "primarily the degree of discretion
that we have in applying the rules. In other words, if the
statute is not specific but says 'this is the objective we want
to achieve and you (IRS) write the rules to achieve it' we regard
those as legislative; but when they say 'these are the rules,'
obviously then they are interpretative."
8 26 U.S.C. (1402 (a)(13)
9 62 FR 1703, 1704 section on Background
10 62 FR 1703, 1704 'Explanation of Provisions'
11 5 U.S.C 605(b)
12 "Partnership Statistics Of Income,
Internal Revenue Service, Fall 1996
13 5 U.S.C. (603(a)
14 5 U.S.C. (601(7)(A)(I) and (8)
15 PL 104-121, sec. 243 amending 5 U.S.C. 605(b)
* Last Modified: 6/14/01