January 29, 2018
Payments made by a law partnership to buy out a retiring partner’s entire ownership interest are generally subject to self-employment tax. Careful planning can change that.
We’ll explain how, but first, here is some background information.
Payments made by a law partnership to buy out a retiring partner’s entire ownership interest are covered by Section 736 of the Internal Revenue Code. These payments can be made in a single lump sum or they can be made in installments over a number of years. In any case, all Section 736 payments are classified as either:
Section 736(a) payments are treated as guaranteed payments to the retired partner. The partnership is allowed to deduct them, which means tax savings for the remaining partners. However, the retired partner must treat guaranteed payments as ordinary income, subject to a federal income tax rate of up to 37% (down from a maximum of 39.6% in 2017). In addition to income tax, guaranteed payments are generally subject to the federal self-employment (SE) tax too, even if the retired partner no longer works for the firm. (Sources: Internal Revenue Code Section 1402(a) and Treasury Regulation 1.1402(a)-1)
Section 736(b) payments are treated as liquidating distributions made by the partnership to pay for the retired partner’s share of partnership assets. As such, the retired partner treats the difference between the total Section 736(b) payments received and his or her tax basis in the partnership interest as capital gain or loss. No SE tax is due on Section 736(b) payments. This tax treatment is beneficial for the retired partner, but the partnership cannot deduct Section 736(b) payments. Amounts paid to buy out the entire interest of a retired partner that are not Section 736(b) payments are Section 736(a) payments.
As you can see, both Section 736(a) and Section 736(b) payments have their tax disadvantages. With proper planning, however, your partnership can set up a supplemental arrangement to funnel additional cash to retired partners and get better tax results for all concerned. This article briefly explains how this strategy works.
Set Up a Written Retirement Plan That Qualifies for Exemption
If your partnership makes payments to retired partners under a written partnership retirement plan that meets specified tax-law requirements, the payments are exempt from the SE tax. (Sources: Internal Revenue Code Section 1402(a)(10) and Treasury Regulation 1.1402(a)-17)
While the payments are still subject to income tax at regular rates on the retired partner’s personal return, the SE tax exemption is a big advantage. To be exempt, the plan must provide for bona fide retirement payments on a periodic basis to partners generally, or to a class or classes of partners, that continue at least until the retired partner’s death. Bona fide retirement payments mean payments that are made on account of the partner’s retirement. The amounts of such payments must be based on objective factors such as the partner’s years of service and compensation received from the partnership. Eligibility to begin receiving bona fide retirement payments generally must be based on the retired partner’s age, physical condition and years of service.
Three additional requirements must also be met for the SE tax exemption to apply:
- The retired partner cannot render services to the partnership during the year in which retirement payments are received.
- The partnership cannot have any obligations to the retired partner at the end of the year in which payments are received — except for the obligation to make additional payments under the written retirement plan or the obligation (if any) to make payments for sickness, accident, hospitalization, medical expenses or death.
- The retired partner’s share of partnership capital must be fully paid out to him or her before the end of the year in which retirement payments are received (therefore, any Section 736(b) payments due to the partner must be received by then).
If all three of these rules are met for the year, all payments received in that year under the written partnership retirement plan are exempt from SE tax. If all three of the rules are not met, all payments received in the year are subject to SE tax. Trickier timing rules apply if the partnership and/or the retired partner use a non-calendar tax year.
Note: The type of retirement program discussed here is not a tax-favored partnership retirement plan such as a 401(k) plan, Keogh plan or SEP plan. Instead, we are talking about a relatively simple written arrangement (generally unfunded) under which payments are made by the partnership directly to its retired partners. Such an arrangement is not subject to any of the complicated funding and nondiscrimination rules that can potentially apply to a tax-favored partnership retirement plan.
Payments Can Be Heavily Front-Loaded And Still Qualify
In one IRS Private Letter Ruling, the tax agency allowed a law firm’s partners to take advantage of the SE tax exemption even though the partnership’s written retirement plan called for heavily front-loaded payments. Under the plan, the firm’s partners could choose to retire at any time after reaching age 60. If a partner retired before age 60 with less than 25 years of service, payments under the plan did not begin until the year in which the partner attained age 60. If a partner retired before age 60 with at least 25 years of service, payments began no earlier than the year in which the partner attained age 55. To be entitled to any payments, a partner was required to have at least five years of service with the firm.
For purposes of operating the plan, the firm’s active partners were divided into two classes: general partners and special partners. Each retired general partner was entitled to receive a retirement payment equal to 150% of his or her highest annual compensation during the last four years of service. Each retired special partner was entitled to receive a retirement payment equal to 100% of his or her average annual compensation during the last five years of service. Under the plan, the initial five annual retirement payments were equal to these amounts. After that, retired partners were only entitled to receive $100 per month until death.
Key Point: After the initial five big annual payments, the maximum annual payment dropped to only $1,200. Nevertheless, the IRS agreed that payments under this plan met all the tax-law requirements to be exempt from the SE tax. Most importantly, the minimal amounts paid out after the first five years still met the requirement that payments must continue until the retired partner’s death. (IRS Private Letter Ruling 200403056)
Plan Ahead to Comply
With proper planning, your firm can set up a program that delivers payments to retired partners that are exempt from the SE tax. Even better, the payments can be heavily front-loaded without losing the exemption. This gives your firm the option of quickly funneling relatively large amounts of cash to retired partners in a tax-favored fashion.
While the tax-saving advantage of this strategy is clear, the written partnership retirement plan must also comply with the separate rules for non-qualified deferred compensation plans (under Section 409A of the Internal Revenue Code) to avoid other adverse tax consequences. (IRS Notice 2005-1) Contact your tax adviser if you want more information about structuring your plan to take advantage of the rules.