June 28, 2017
The Internal Revenue Code’s self-employment (SE) tax provisions were enacted long before the existence of limited liability partnerships (LLPs). So there are questions about how to apply the SE tax rules to LLP partners.
One Tax Court decision delivers some much-needed clarity, although it does not deliver news that is friendly to law firm partners. According to the Tax Court, the active partners in a Kansas law firm LLP were subject to SE tax on their shares of the LLP’s net income. (Renkemeyer, Campbell & Weaver, LLP, 136 TC No.7,2011)
Self-Employment Tax Considerations
To understand the SE tax issue for LLP partners, we must start with the longstanding special SE tax rule for limited partners. Under that special rule, a limited partner includes in his or her SE income only guaranteed payments from the partnership for services rendered to the partnership. Such guaranteed payments are determined without regard to the partnership’s income. They are often called “partner salaries.” The special SE tax rule is beneficial to limited partners because they typically do not receive any partner salaries and therefore typically do not owe any SE tax on their shares of partnership income. (Internal Revenue Code Section 1402(a)(13))
In contrast, a general partner must include his or her share of the partnership’s net income from business activities in SE income. Therefore, general partners usually owe SE tax on their shares of net partnership income. (Internal Revenue Code Section 1402(a))
The favorable special SE tax rule for limited partners was enacted long before LLPs existed. So how do LLP partners deal with the SE tax issue? Can they claim they are limited partners for SE tax purposes because they are not personally liable for the LLP’s debts? If the answer is yes, they could avoid the SE tax by simply not taking any partner salaries. Instead, they could take random SE-tax-free distributions to collect their shares of the LLP’s cash flow. Basically, that was the argument made by the Kansas law firm partners in the Renkemeyer, Campbell & Weaver, LLP case. Unfortunately, the Tax Court did not buy it.
Tax Court: Active LLP Partners Are Not Limited Partners for SE Tax Purposes
The Tax Court ruled that LLP members who were active in the entity’s business should not be treated as limited partners for SE tax purposes —- because the “active factor” is more important than the “limited liability factor.”
In reaching this conclusion, the Tax Court looked at the legislative history of the special SE tax rule for limited partners, which was enacted as part of the Social Security Amendments of 1977(Public Law 95-216). The legislative history says the intent of Congress was to exclude for Social Security benefits eligibility purposes income received by a limited partner that is “of an investment nature.” Consistent with that intent, the special limited partner rule made such income exempt from the SE tax.
The shares of income received by the partners in Renkemeyer, Campbell & Weaver, LLP were clearly not earnings “of an investment nature.” Instead, they were earnings from actively participating in the law firm’s business. Therefore, the Tax Court said the special SE tax rule for limited partners was inapplicable, and the LLP partners owed the SE tax.
In addition, the Tax Court observed that a limited partner is, by definition, a member of a limited partnership. In contrast, an LLP partner is basically a member of a special category of general partnership established under the applicable state LLP statute. This consideration gave further weight to the conclusion that an active LLP partner’s earnings cannot be sheltered from the SE tax by the special limited partner rule.
Partnership Tax Basics
- A partnership is not subject to Federal income tax. Rather, the partners are liable for tax in their separate or individual capacities.
- Each partner is required to take into account his distributive share of the partnership’s income, gain, loss, deductions and credits.
- A partner’s distributive share of income, gain, loss, deductions or credits generally is determined by the governing partnership agreement. A partnership agreement may be either written or oral.
- If the partnership agreement doesn’t provide how a partner’s distributive share is to be determined, or if the allocation in the partnership agreement doesn’t have substantial economic effect, the partner’s distributive share is determined in accordance with his or her interest in the partnership.