Partnerships

A general partner pays SE tax on his or her share of the trade or business income of the partnership, whether or not distributed (Treasury Regulations section 1.1402(a)-1(a)(2).) The partner’s allocated share of other income, such as interest and dividends, is not subject to SE tax (Treasury Regulations section 1.1402(a)-1(b).)

A limited partner does not pay SE tax (IRC section 1402(a)(13). But if the partner renders services to the partnership, his or her income attributable to the services is subject to SE tax no matter what type of partner he or she is (Treasury Regulations section 1.1402(a)-2(g).) Not only would the limited partner be subject to SE tax in that situation, but under state law, a limited partner who actively participates might lose the protection of limited liability. See, for example, N.Y. Partnership Law section 121-303.

The treatment of a general partner differs significantly from that of an S corporation shareholder. The S corporation shareholder has a payroll tax on his or her salary, but no payroll tax on allocated corporate profits. Some S corporations never report officer salaries, in fact, some S corporations with a single shareholder/officer never file payroll returns. This is a recipe for disaster—if the corporation never files payroll returns, the statute of limitations never starts, so it never ends.

Historically, the IRS has disputed salaries that are unreasonably low. For years beginning after Dec. 31, 2017, considering the QBI deduction, the IRS will likely dispute salaries that are unreasonably high—in other words, where taxpayers try to increase the W-2 wages used to calculate the maximum QBI deduction.

LLC and LLP members

Members of limited liability companies, limited liability partnerships, and professional service limited liability companies are shielded from the obligations of the entity: they have limited liability, like limited partners. Unlike limited partners in a limited partnership, they can actively participate without jeopardizing their limited liability.
For purposes of SE tax, they are treated like general partners or like limited partners, depending upon their participation in the operations of the business. The rest of this article examines cases where the taxpayers and IRS differed over whether SE tax applied.

Renkemeyer

This case involved a law firm that specialized in tax law. They structured their operations in an unsuccessful attempt to minimize SE tax, and it led to a decision in favor of the government. Renkemeyer, Campbell & Weaver, LLP v. Comm’r, 136 TC 137 (2011).

Facts

A law firm organized as an LLP had four partners: three attorneys (30% each P&L, 33.33% capital) and an S corporation (10% P&L, zero capital). The S corporation had one shareholder, a tax-exempt ESOP. Of course, the three lawyers were the beneficiaries of the ESOP.

In 2004, when the law firm did not have a written operating agreement, the law firm allocated 87.557% of its income to the S corporation. The IRS did not accept the special allocation.

In 2005, the law firm had an operating agreement that gave each lawyer a 1% general managing partner interest and a 32% investing partner interest. The parties did not divide income equally—the operating agreement specified that income would be allocated based on fees brought in by the partners. The IRS accepted the special allocation for 2005.

For both years, the law firm’s K-1 showed that none of the income was self-employment income. The IRS did not agree.

Issues

• Should special allocation of income be disallowed? Note: a special allocation is an allocation of income that differs from capital accounts.
• Is the income is subject to SE tax?

Analysis and court decision

The issue of special allocation was only in dispute for 2004. Because here was no written operating agreement presented in evidence, the court discounted taxpayer’s testimony regarding the terms of the purported agreement.

The court considered these factors: “(a) [t]he partners' relative capital contributions to the partnership; (b) the partners' respective interests in partnership profits and losses; (c) the partners' relative interests in cash flow and other nonliquidating distributions; and (d) the partners' rights to capital upon liquidation.” The court held that the IRS properly reallocated income according to P&L interests.

For 2005, the IRS accepted the special allocation.

For both years, taxpayers argued that they were limited partners and therefore their income wasn’t subject to SE tax. The court explored the history of the law.

The U.S. Department of the Treasury issued proposed regulations in 1997 that said that limited partners would be subject to SE tax. Congress responded by including a section in the Taxpayer Relief Act of 1997, Pub. L. 105-34, section 935: “No temporary or final regulation with respect to the definition of a limited partner under section 1402(a)(13) of the Internal Revenue Code of 1986 may be issued or made effective before July 1, 1998.” The court noted that the Treasury Department hadn’t issued regulations as of 2005 (the latest year in question) on this issue. In other words, the Treasury Department punted the question.

The court also looked to legislative history and decided that the intention of the SE tax was to exclude limited partners who don’t actively participate because they are merely investors. Because the partners in Renkemeyer actively rendered legal services, they were not mere investors. Note that this leads to a threshold argument: once a member actively participates, all his or her income is subject to SE. Thus, the attempt to recharacterize a portion of the 2005 income as “investment” failed.

There is a parallel to the New York limited partnership law, where a limited partner who actively participates loses the protection of limited liability. The same activities that would cause a limited partner to lose the protection of limited liability would subject that limited partner—or an LLC member—to the SE tax.

Riether

This case involved a medical practice where the husband and wife were sole members of an LLC. Riether v. U.S., 919 F. Supp. 2d 1140 (D.N.M. 2012).

Facts

This was a tax refund suit, litigated in district court rather than in the Tax Court.

The taxpayers had their LLC issue Forms W-2 to them as employees ($25,750 each) and issued Schedules K-1 as members ($38,493 each). Taxpayers claimed that payroll taxes applied to the “salaries” reported on Forms W-2 and that SE tax did not apply to the “unearned income” reported on Schedules K-1.

The case considered additional issues that are beyond the scope of this article, such as burden of proof, whether the IRS was permitted to raise new grounds for its assessment, whether the taxpayer proved the amount of a particular charitable deduction, and whether the recipient of that donation was a qualified charity.

Issues

• Can LLC members be treated as employees?
• Was the LLC income, or any part of it, exempt from SE tax?

Analysis and court decision

The IRS did not object to the issuance of Forms W-2. The court said that they were not employees, citing Revenue Ruling 69-184, 1969-1 C.B. 256, which holds that partners cannot be employees of the partnership. “The IRS made no bones about this, however, presumably because Plaintiffs had paid self-employment tax on that income through withholding.”

Limited partners (or LLC members who are analogous to limited partners) aren’t subject to SE tax. Because they received Forms W-2, they therefore were not inactive in the business: “[T]he LLC’s improper treatment of the ‘wage’ income further undermines Plaintiff’s simplistic argument [that they should be treated as mere passive investors].” Citing Renkemeyer, the court held that the entire income should have been subject to SE tax.

Castigliola

This case involved a law firm that made guaranteed payments to its members. Castigliola v. Comm’r, T.C. Memo 2017-62.

Facts

A law firm partnership became a PLLC in 2001. The PLLC never had a written operating agreement. The firm paid guaranteed payments to each member commensurate with local legal salaries. The law firm distributed net profits more than guaranteed payments according to the members’ agreement.

Based on advice of reputable CPA, they paid SE tax on guaranteed payments, but not on profits in excess of guaranteed payments.

The case also considered the additional issue of whether escrow funds were income to the law firm. Even though the law firm was unable to identify the proper owner of the funds, the funds did not belong to the lawyers due to ethical rules, and the court held that these funds didn’t represent additional income.

Issues

• Can LLC members be treated as employees?
• Was the LLC income, or any part of it, exempt from SE tax?
• Are the taxpayers subject to the accuracy related penalty for failing to pay SE tax on profits in excess of guaranteed payments?

Analysis and court decision

The court stated the general rule that a limited partner isn’t subject to SE tax, and a limited partner does not participate in management of the company. The three members who were plaintiffs in this case were all active in managing the law firm and were not limited partners. Therefore, the SE tax applied to all the income, not just the guaranteed payments.

Taxpayers relied on a CPA’s advice in their treatment of SE taxes. During the years in question, the SE tax issue had not been determined—it predated Renkemeyer. The Court held that taxpayers were not liable for the penalty.

Hardy

This case involved a doctor who had a medical practice and was a member in an LLC that operated a medical center. Hardy v. Comm’r, T.C. Memo 2017-16.

Facts

The taxpayer, a plastic surgeon, was the sole member of a PLLC (private medical practice) and a minority member in another LLC that owned and operated a medical center. The taxpayer had no day-to-day management responsibilities in the medical center.

When a patient required general anesthesia, the taxpayer had to operate at the medical center (or other hospital). The patient separately paid the taxpayer’s fee, the anesthesiologist’s fee, and the hospital facility fee. To ensure availability of hospital space, the taxpayer became a member of LLC that operated the medical center. The taxpayer’s distribution from the medical center LLC depended upon his percentage interest, not on the surgeries he performed there.

The taxpayer treated the income from the PLLC as active income and the medical center LLC as passive-activity income. The IRS wanted to re-group his activities into one to make them both active (and thus deny the taxpayer passive income to offset his PAL carryover from other activities). The taxpayer paid SE tax on the PLLC income but not on the medical center LLC income.

The IRS imposed an accuracy related penalty, to which the taxpayer objected. There was an additional issue regarding the amount of charitable deductions, which is not relevant here.

Issues

• Can the taxpayer treat his medical practice PLLC as active while treating his interest in the medical center LLC as passive?
• Does the taxpayer owe SE tax on his share of the medical center LLC income?
• Did the accuracy related penalty apply?

Analysis and court decision

The initial issue, regarding grouping activities for passive activity purposes, could be dispositive of the SE issue: if both activities were grouped as one, then the taxpayer’s active participation applies to both activities, and SE tax applies to income from both activities. The court held for the taxpayer on this issue.

The taxpayer can use any reasonable method to group, or not group, his activities for purposes of passive activity losses (PAL). It happened that the taxpayer had reported the medical center LLC income for a prior year as active, but this does not constitute an election to group activities—the question of active participation can vary from year to year. More importantly, the taxpayer consistently treated the PLLC and the medical center LLC as separate economic units.

The IRS applied Treasury Regulations section 469-4(f)(2) to regroup the two as one unit, claiming that they were essentially the same kinds of operations. In response, the taxpayer showed distinct differences: in the PLLC, he received fees for medical services, whereas in the medical center, his profits were unrelated to his medical services and only related to his investment. The court ruled for taxpayer.

There is an interesting aside to the arguments from both parties. Private letter rulings, including technical advice memoranda, may not be used or cited as precedent. Nevertheless, both sides argued the applicability of a Technical Advice Memorandum, and the court entertained it to reveal IRS reasoning. Thus, the IRS conceded that the Tax Court could consider a Technical Advice Memorandum. Nevertheless, a practitioner should not be the first one to raise a Technical Advice Memorandum; only raise it if the IRS raises it first.

Despite prevailing on the issue of grouping activities, the taxpayer was denied the PAL carryforward, because they had reported the medical center LLC as active income in the prior year. The taxpayer did not amend the prior year return to reflect proper classification, nor did the taxpayer timely raise the issue of equitable recoupment.

The taxpayer did not participate in management of the medical center LLC, and he could treat his income as limited partnership income, so it was not subject to SE tax.

The court struck down the accuracy related penalty relating to application of the SE tax and the PAL carryover. The taxpayer reasonably relied on a CPA with over 40 years of experience, so there was no penalty on tax due to disallowance of the PAL carryover. The penalty, however, did apply to a disallowed charitable contribution deduction.

Chief Counsel Advice

CCA 201640014

The taxpayer purchased a franchise for a restaurant and contributed the franchise rights to an LLC of which he was a member. The franchise agreement required him to personally devote full time and best efforts to operate the restaurants.

The taxpayer received guaranteed payments plus a share of the profits relating to his capital investment. The taxpayer argued SE tax should apply differently for income relating to services versus income relating to capital investment.

The IRS disagreed, citing Renkemeyer, Riether, and other cases, holding that the taxpayer owes SE tax on guaranteed payments plus share of profits.

CCA 201436049

An LLC received fees for providing investment management services. The LLC treated all its members as limited partners, and they paid SE tax only on their guaranteed payments.

As above, the IRS disagreed, citing Renkemeyer, Riether, and other cases, holding that the taxpayer owes SE tax on guaranteed payments plus share of profits.

Conclusion

A member who actively participates in an LLC must pay SE tax on all his or her ordinary income from the business, whether it is characterized as guaranteed payment or as a share of profits. A member who does not actively participate is not liable for SE tax.

If a taxpayer owns an interest in more than one entity, careful planning might distinguish the active income derived from one entity, which is subject to SE tax, from passive income derived form another empty, which is exempt from SE tax.

Dean L. Surkin, JD, LLM, is a tax director at Gettry Marcus CPA P.C. He is a tax attorney with broad-based experience in tax planning and research; has litigated major cases in the fields of taxation, probate and general commercial matters; and has been peer reviewed by Martindale-Hubbell. He holds the highest rating for legal ability and ethical standards, AV. Mr. Surkin received his BA from the University of Pennsylvania in 1973 (double major in mathematics and political science), his JD from New York University School of Law in 1976, and his LLM in taxation from New York University School of Law in 1985. He is admitted to the New York State Bar, the Federal District Courts of the Southern and Eastern Districts of New York, the Second Circuit Court of Appeals, and the U.S. Tax Court. Mr. Surkin also holds the faculty appointment of professor (adjunct) at Pace University Graduate School of Business, where he currently teaches tax procedure, research, writing, and ethics.