SE Tax, NIIT, Additional §1401 Tax - What's Up?

There has been more focus on self-employment tax in recent years than in many years prior. There is ongoing litigation on what "limited partner, as such" under Section 1402(a)(13), added in 1977, means. This special rule provides that net earnings from self-employment does not include the distributive share of any item of income or loss of a limited partner, as such, other than guaranteed payments for services actually rendered to or on behalf of the partnership.

Does limited partner mean that under state law you are a limited partner, or does it depend on what the partner does? After all, Congress did not just say "limited partner," it wrote "limited partner, as such." Most limited partners are not involved in partnership operations, but some (as hinted at in (a)(13) above) are providing services for which they receive a guaranteed payment. Some "limited partners" might be involved in some key activities of the partnership such as in a recent case - Denham Capital Management LP, TC Memo 2024-114 (12/23/24). As noted by the Tax Court: "The Partners treated their work for Denham as their full-time employment. Each of the Partners participated in the management of Denham in some way."

In this case, the court agreed with the IRS that these limited partners were not limited partners as such. They found these partners were operating the business in a way that Congress would view them as subject to SE tax. 

There are other cases in appeals, such as Soroban Capital Partners LP, 161 TC 310 (2023).

In January 2025, the IRS updated its training materials on SE tax and partners with lots of background on the relevant law and issues.

A few observations:

These limited partnership cases involved lots of dollars - well beyond the Social Security wage/SE base which is $176,100 for 2025, so the issue is whether the limited partners owe Medicare tax of 2.9% on their distributive share + the 0.9% additional Medicare tax under Section 1401 for a total of 3.8%.

What isn't addressed in the cases is the Section 1411 net investment income tax (NIIT) and application of Section 469, passive activity loss limitation. Because the limited partners worked over 500 hours in the partnership, assuming it was just one activity, they are material participants so the income is non-passive (active) and not subject to the NIIT (Reg. 1.469-5(f)). If on appeal, these partners win and are not subject to SE tax, they still won't owe the NIIT.

The FY2025 Treasury Greenbook under President Biden includes a proposal (also suggested by others), that basically would find that income above the Section 1411 and 1401 thresholds ($200K if Single, $250K if MFJ) will be subject to either the additional Medicare tax (total rate of 3.8%) or the NIIT (also at 3.8%). See page 73 of the Greenbook.

Will we see any clarification or change to Section 1402(a)(13) to perhaps not only address what "limited partner" means but also how Congress thinks this applies to LLC members (the IRS and Tax Court apply a functional analysis to LLC members as well as to limited partners as such). This can't happen in the upcoming tax bill which will be handled via the budget reconciliation process because one of several limitations on this approach which allows only 51 votes in the Senate rather than 60, it that it can't address Social Security.

I don't think we'll see separate legislation on this topic but we should see more rulings including from courts of appeals.

What do you think?

Minnesota Proposes Social Media Tax

Minnesota SF 3197 would impose a gross receipts tax on social media platforms that collect data from over 100,000 Minnesota consumers in a month. The rate depends on how many consumers data is collected from starting at 10 cents/customer/month if over 100,000 customers but not over 500,000, to 50 cents/month/customer if over 1 million customers. A consumer is only counted once per month. [also see bill summary from Senate Counsel]

Analysis from the MN Dept. of Revenue is that 14 social media platforms would be subject to this tax and it would generate $45.5 million for the General Fund for FY 2026 increasing to $99.9 million for FY 2029.

What is the rationale for this new tax? Likely it is revenue generation and to reflect the fact that the social media companies are making money from Minnesota consumers by getting their data and generating ad revenue from their use of the platforms. At a hearing on the bill on 4/9/25, the sponsor also noted concerns of some adverse effects of social media on children, "micro-targeting" (seemed to be a reference to cookies), great wealth of a few founders (Zuckerberg and Musk), efforts by some social media companies to reduce income taxes owed. Note that the hearing was available on YouTube.

The projection that this only applies to 14 social media platforms seems low until I looked up the definition of social media platform at MN 325M.31(j) and what is excluded such as an Internet search provider, Interview service provider, email service, broadband service, cloud computing service and others.  So I guess the tax would apply to Meta, TikTok, X, LinkedIn, YouTube, and others.

Observations:

It appears that the social media companies would not have to track down names or other identifying information of customers to count how many users but could just have some recordkeeping to show the number of unique users per month. If more data than this is needed, a privacy concern exists.

Does the MN income tax sourcing rules generate revenue from these companies? If not, can that be changed to generate tax under and existing tax rather than creating a new tax.

Is this fair to other companies that generate revenue from Minnesota consumers such as radio and television, email providers who run ads, any vendor who places "cookies" on user computers for continued advertising, "apps" that run ads, and more.

Would this tax violate the Internet Tax Freedom Act where there can't be a tax on an internet company if there isn't a similar tax on similar vendors (see my comment above).

One of the reasons offered for the bill is to address harms of social media implying that there are negative externalities. But are tax dollars from the social media companies (and others with negatives (such as advertising unhealthy products on all media for example)) sufficient to cover the costs of these negative externalities? Where is any data on this consideration?  Are there non-tax laws that might address some of these negative externalities (although it is difficult to regulate content online). The excise tax funds go to the General Fund, while I'm not a fan of earmarking tax dollars, seems that some of these funds should go to address some of the negative externalities such as providing alternative activities for children and helping parents with ideas on how to protect children.

What do you think?

Property Taxes Pay For Services; No Relation to Your Mortgage

In his State of the State address on March 4, 2025, Florida Governor DeSantis made this statement: 

"While Florida property values have surged in recent years, this has come at a cost to taxpayer squeezed by increasing local government property taxes. ... Taxpayers need relief. You buy a home, pay off a mortgage - and yet you still have to write a check to the government every year just to live in your own property?"

Perhaps he was more focused on increasing tax collections leading to more government spending rather than making an adjustment to reduce tax collections to match government spending needs.

But questioning why a homeowner should continue to pay taxes to the government after paying off their mortgage is odd and certainly doesn't help improve tax literacy.  Note that he didn't say that people who can afford to buy a home without a need for a mortgage should always be exempt from property taxes, which would seem to be the logical statement if property taxes are only paid by mortgagees.

Property taxes are paid, like other taxes, to fund government services and homeowners use a lot of them - streets, road maintenance, a judicial system, a school system, police and fire protection, sanitation services and likely even more. 

Florida does not impose an income tax so it needs to rely on its property tax to cover more government services than states that have more tax bases.

The Wall Street Journal (3/20/25) and other papers reported that Florida is considering eliminating the property tax because home prices have increased. I'm quoted in a Newsweek article (3/7/25 by Claire Dickey) on this topic (right next to a quote from Governor DeSantis). I was asked if local governments should have some control over their property taxes. I said yes! There may be situations where a homeowner has lost a job or can't work due to illness and risks losing their home because they can't temporarily pay their property taxes. A local government should be allowed to have a system to help these homeowners. 

And like many states did following the passage of Prop 13 in California in the 1970s, a state can modify the property tax base to have a cap on how much it can appreciate each year so if there is significant market increase, property taxes don't rise to the point where many homeowners can't afford to pay them (and along with that also could not afford to buy their home at today's value).

Given the close connection between the property tax which is usually a local tax and the numerous local government benefits taxpayers get, the property tax should stay. And it is one of the simpler taxes. But relief should be considered if property values are leading to tax increases (generally property tax is based on the current FMV) that many cannot afford. And, my suggestion for any Prop 13 relief measure is to modify it so that people with the highest value homes and most recent acquisitions get a higher annual revaluation because otherwise, Prop 13 provides a much larger tax break to the higher wealth/higher income homeowners.

What do you think?

Unusual Proposed Exclusion for Crypto Gains

HB 453 introduced in the Montana Legislature on February 11, 2025 calls for the Department of Revenue to create a program to allow state income taxes to be paid with cryptocurrency through arrangements with one ore more third party payment processors. That isn't unusual as at least one other state already does this - Colorado. 

What is unusual is that HB 453 would also make the payment of Montana income taxes with crypto tax free!  That is, if a taxpayer used bitcoin with a basis of $10 to pay state income taxes of $2,500, the realized gain of $2,490 ($2,500 liability satisfied with an asset with a basis of $10), would be tax free.

There is no tax policy justifying this treatment. The appreciation in the crypto used to pay state income taxes is a realized gain.  It is the same result if the holder sold the $10 basis bitcoin for $2,500 and used that money to pay their income taxes - a taxable gain. If someone had to sell stock to pay their taxes, any gain would be taxable.

Of course, if a state wants to exclude such a gain, it can certainly change its income tax to do so. The gain would still be taxable for federal purposes and likely a reason why few would take advantage of this state offer should HB 453 be enacted.

If enacted, I wonder if people would reduce their withholding, such as from paychecks and increase their estimated tax payments made with crypto to maximize their exclusion (but still taxable for federal purposes). Would others in Montana ask if they can pay their taxes with appreciated assets such as stock or gold, and also get an income exclusion? After all, what is so special about crypto, particularly if a third party is going to do the conversion of that asset to cash and get the cash to the Department of Revenue?

The revenue estimate for HB 453 is about $70,000 per year which minor. I suppose people with little gain in their crypto might take advantage as the federal tax consequences would be small. But individuals with large gains would most likely not be interested as they can also avoid the federal income tax gain if they die holding the appreciated crypto (which is a much greater tax policy flaw in our tax system - excluding gains at date of death).

What do you think about providing a special state rule for paying your taxes in crypto and avoiding state tax on that gain?

What's So Special About Tips to Make This Income Non-taxable?

Both presidential candidates offered a tax law change to make tips non-taxable. A few days after the inauguration, President Trump was in Las Vegas at a rally for "No Tax on Tips."  What is so special about tips to justify a law change to make then non-taxable?  I can't think of any, but offer these observations to remind us that tips are income just like wages and business income and there is little reason to provide a tax break to these workers - why not provide a tax break to all workers?

1. Tips are income: Income is defined by the US Supreme Court as "an undeniable accession to wealth, clearly realized, and over which the taxpayer has complete dominion" (Glenshaw Glass, 348 US 426 (1955)). Some people suggest tips are gifts so are not taxable. A gift is defined by the US Supreme Court as something given with "detached and disinterested generosity" where the donor expected or expects nothing in return (Duberstein, 363 US 278 (1960)). Someone who receives services at a restaurant, hotel, hair salon, or similar establishment, might offer a tip because they appreciated the service and the amount likely varies by how much they liked the service. It is not a gift. If the giver wants to make a gift to someone they should go up to a stranger and give them money with no expectation of anything in return - that is a gift.

2. More than tipped workers need tax relief: H.R. 8785, Tax Free Tips Act (118th Congress) would have changed the law to say that wages do not include tips and make them not subject to income or payroll taxes. The sponsors offered as a rationale that many people getting tips might be "working a second job to make ends meet" so should be able to keep their money. That sounds reasonable if we are talking about raising the standard deduction for ALL low-income workers, but why single out or assume that only tipped workers are in need of tax relief.

3. Challenges of defining tipped workers: It looks like the key proposal in the 119th Congress based on the number of sponsors is No Tax on Tips Act. It would exempt cash tips from income tax (not payroll tax) and has "guardrails to ensure only traditionally tipped employees will benefit from" the proposal (see 1/16/25 sponsor press release). Do note that it says employees. Thus, contractors, such as your Uber driver and owner of a business, would not benefit from the tip deduction. The deduction is limited to $25,000 for the year and would not apply if the worker's income exceeds $160,000 (this is the amount per the reference to §414(q) in the bill). "Qualified tips" for the deduction are defined as "any cash tip received by an individual in the course of such individual's employment in an occupation which traditionally and customarily received tips on or before December 31, 2023, as provided by the Secretary." Thus, the Treasury and IRS would have to define this employee group.  I think that means that there isn't already a list of traditionally tipped industries.

4. Tip versus Service Charges: Some restaurants including ones in DC, automatically add a charge to restaurant bills such as because it was for a group of 6 or more (in DC, even 1 customer gets a 20% fee added). Is that a tip or something else (the DC one appears to be a service charge)? For tax purposes today for rules relevant on tip reporting, a service charge is not a tip (Rev. Rul. 2012-18). The fee is wages if distributed to employees. Will any legislative proposal address whether "forced" tips or service charges are the traditional and customary tips to be non-taxable? Arguably, I think yes, but to me it just doesn't seem like a tip when the business adds the amount to your bill automatically. But this should be addressed in any legislative change (in defining "tip").

5. Challenge of excluding tips from Social Security/Medicare taxes and state income taxes: Any tax big tax bill this year will likely be accomplished via the Budget Reconciliation process so that only 51 votes are needed in the Senate. This process does not allow for changes to Social Security so any tip exclusion in the bill can only remove income taxes (as proposed with No Tax on Tips Act (see 3 above)). Also, I think most states will opt not to conform to a federal exclusion or deduction if enacted due to the loss of revenue and the inequity of providing a tax cut to only a small number of employees. The Budget Lab at Yale estimates that 2.5% of workers earn tip income. At the 1/25/25 rally in Las Vegas, President Trump said over 4 million workers receive tip income and that about 25% of a typical restaurant worker's pay is from tips. Will a state enact a tax change to let about 3% of employees exclude 25% of their pay from taxes with no break to other employees who are at the same pay levels? I don't think so.

6. Permanent or temporary: Will any exclusion or deduction for tip income be a permanent change or temporary? I think if the extension of TCJA expiring tax cuts is temporary, the change for tip income will also be temporary, but who knows.

So, there is a lot to consider on this topic that affects a relatively small number of employees. Given the tax cut for a small number, will other employees, particularly those making minimum wage or a bit more also ask for an equivalent tax cut?  I think they should to improve the equity of the proposal - that is, similarly situated taxpayers based on income should be treated similarly. If a tipped employee making $70,000 including tips gets a tax cut, a non-tipped employee also making $70,000 should also get the same tax cut.

What do you think?