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IRS: Partners' Share Of LLC Income Is Subject to Self-Employment Tax

This article is more than 9 years old.

Every Friday afternoon, while you're seeking solace in the bottom of a pint glass from another week of hellish reality, the IRS publishes its written determinations for the week. Last week's release was noteworthy in its volume: the Service released a whopping 57 Private Letter Rulings, Determination Letters, and Chief Counsel Memorandums.

Buried within the typical scores of late S corporation election relief rulings and Section 501(c)(3) determinations was a very important Chief Counsel Advice that could potentially impact the tax treatment of many limited partners, as well as partners in other limited liability partnership vehicles, such as LLCs and LLPs.   And just in time for next weeks extended partnership return due date!

In CCA 201436049, the IRS concluded that the distributive share of partnership income allocated to members of an LLC was subject to self-employment tax. This is a rather big deal, because the treatment of an LLC member's distributive share of income for purposes of self-employment income has long been clouded--largely due to the Service's inability or unwillingness to finalize regulations governing the issue over the past three decades. With the release of last week's Memorandum ("the ILM"), it should serve as notice that the IRS may be ready to approach the issue more aggressively.

So what does the ILM really mean to limited partners and LLC members? Let's take a look with a little Q&A.

Q: Sorry, but your introduction did little to nothing to make me care about the issue. Why don't you try again, but more slowly this time. First things first: what is this self-employment tax you speak of?

A: Fair enough. Under IRC Section 1401, "self-employment income" is taxed at 15.3%-- 12.4% goes to the Old-Age, Survivors, and Disability Insurance tax, with the remaining 2.9% earmarked for the Hospital Insurance tax. In addition, beginning January 1, 2013, an extra 0.9% tax is tacked on to a taxpayer's self-employment income in excess of $250,000 (if married filing jointly, $200,000 if single). Thus, the total self-employment tax burden under current law can reach as high as 16.2%, before considering the deduction for one-half of the self-employment tax (not including the new 0.9% surtax) as permitted by IRC Section 164(f).

Q: Got it. But that begs the question: What is self-employment income?

A: Well, that speaks to the very crux of the issue addressed in the ILM. It gets complicated, so lets take it one step at a time. Under IRC Section 1402, self-employment income is generally defined as the gross income derived by an individual from any trade or business carried on by the individual, less deductions allocated to the business.

Q: So how does that apply to a partner in a partnership?

A: Great question. Because of the pass-through nature of partnerships, partners are generally considered to be conducting the business of the partnership. As a result, explicitly included within the definition of self-employment income is a partner's distributive share of income or loss from any trade or business carried on by a partnership.

Q: Got it. But what exactly is a partner's "distributive share" of partnership income?

A: There are three ways a partner can receive income from a partnership. If the partner renders services to the partnership, he can be paid wages and receive a W-2, just like any other employee. While this treatment is popular, it's also very wrong, as Revenue Ruling 69-184 states that "members of a partnership are not employees of the partnership."

The right way to compensate an employee for services rendered is to pay them a "guaranteed payment." This amount is governed by IRC Section 707 and is subject to self-employment tax (more on this later). Lastly, any net income of the partnership that isn't paid out to the partners as guaranteed payments is divided among the partners, with each partner including his allocable share of the partnership's net income (or loss) in his taxable income, whether or not the partnership actually distributes this income to the partner. This is known as the partner's "distributive share" under IRC Section 702.

Q: How 'bout an example?

A: Sure. Partnership AB has two equal partners, A and B. AB generates $100,000 of net income in 2013 before considering guaranteed payments. A performs services for AB, and is paid $20,000 in guaranteed payments. This guaranteed payment is included in the taxable income of A, but is also deductible by AB, reducing AB's net income to $80,000. This $80,000 is then divided equally between A and B, with each including $40,000 attributable to the partnership in their taxable income. This $40,000 represents each partner's "distributive share" of the partnership income, and is included in the income of A and B regardless of whether they ever see a penny in cash distributions. From a self-employment income  perspective, A would include in his self-employment income both the $20,000 of guaranteed payment and his $40,000 distributive share. B would include in his self-employment income only his $40,000 distributive share.

Q: OK, so what's the big deal? You said that guaranteed payments are included in self-employment income, and IRC Section 1402 provides that a partner's distributive share of partnership income is included in self-employment income, so where's the controversy?

A: IRC Section 1402, like many provisions of the Code, starts off by setting the general rule-- i.e., all trade or business income, including a partner's distributive share of partnership income, is included in self-employment income--before listing a host of excpetions to that general rule. Specific to this discussion, IRC Section 1402(a)(13) provides that the distributive share of partnership income of a limited partner-- other than guaranteed payments--is NOT included in self-employment income.

Q: Great. On to our next definition. What is a limited partner?

A: That, good sir, is exactly what the IRS is struggling to figure out, because there is no definition to be found anywhere in the Code. . Understand this, however: when IRC Section 1402(a)(13) was added to the statute in 1977, LLCs--the most popular form of doing business as a partnership today--did not yet exist. So when the statute was written, it was intended for conventional partnership forms like limited partnerships.

In a limited partnership, there are two types of partners under state law: general partners and limited partners. General partners are free to manage and control the business; the price they pay for that control, however, is that they have unlimited legal liability. If a creditor cannot be repaid from the partnership, they can pursue the assets of the general partner. A limited partner, to the contrary, has, you guessed it...limited legal liability. A creditor can only take from the limited partner that partner's investment in the limited partnership, it cannot pursue the limited partner's personal assets. The cost of that limited liability to the limited partner, at least at the time the exception from self-employment income for limited partners was written into the law-- is that under the Revised Uniform Limited Partnership Act of 1976, the limited partner could not take part in control of the partnership.

Q: So if a limited partner was barred from participating in the control of the partnership, what did the limited partners really add to the business?

A: Great question, and it speaks to the intent of Congress in excluding the distributive share of limited partners from self-employment income. Because a limited partner couldn't participate in any management of the partnership, the limited partner's involvement was essentially limited to his cash investment in the partnership. It would follow, then, that the limited partner's distributive share of partnership income was akin to earnings on a passive investment, rather than income from the active conduct of a trade or business. As a result, Congress decided, it shouldn't be included in self-employment income. If the limited partner performed any services for the partnership and was paid a guaranteed payment, that guaranteed payment would be included in his self-employment income, however.

Q: OK. So, a general partner's distributive share of partnership income is self-employment income. A limited partner's distributive share of partnership income is not self-employment income. Seems simple enough. What's the issue?

A: The issue, smart guy, is that after IRC Section 1402(a)(13) was added to the Code,  "Limited Liability Companies" became a thing. In an LLC, unlike a general or limited partnership, ALL of the members of the partnership have limited legal liability. That would seem to indicate that ALL of the members are limited partners. As opposed to limited partners, however, LLC members are permitted to some degree to participate in the management of the LLC, with that permissible degree varying from state to state. As a result, LLC members are a hybrid of general partnership and limited partnership interests that didn't exist back in 1977, and this poses a huge problem for a tax law that doesn't yet specifically address the issues created by these hybrid partnership interests.

Q: I just checked Wikipedia, and it says LLCs started in Wyoming in 1977. Last time I checked, it's now 2014. Are you telling me that in 37 years, the IRS couldn't address how to treat a distributive share of LLC income for self-employment income purposes?

A: That's exactly what I'm telling you. Though, if it makes you feel better, the IRS also hasn't found the time to address how to treat an LLC interest for purposes of the passive activity rules of IRC Section 469, either, but that's an entirely different conversation. Here's the problem: In 1997, the IRS issued proposed regulations that would govern whether the distributive share of partnership income of LLC members was included in self-employment income. It basically provided that an LLC member would be treated as a limited partner -- and thus the distributive share would NOT be self-employment income-- unless the LLC member either 1) had personal liability for the debts of the LLC under state law (this would be pretty rare), 2) has authority under state law to contract on behalf of the LLC, or 3) participated in the trade or business of the LLC for more than 500 hours during the year.

Q: Let me guess...the proposed regulations were never finalized?

A: That's right, largely through no fault of the IRS, but rather because powerful people in Congress and media went ballistic at the idea of this "hidden tax increase," and that's why were in the mess we're in. Without any concrete guidance, the IRS and the courts are left to determine whether an LLC interest is akin to a limited partnership interest on a case-by-case basis.

Q: So what did this new Chief Counsel Memorandum have to say?

A: In the ILM, the LLC was a large investment management company which acted as an investment manager of a family of funds. The management company managed and controlled the affairs and business of each fund, and performed activities such as purchasing, managing, restructuring, and selling all of the funds' investment assets. Of course, partnerships don't provide services, people do, so the actual services were provided by the members of the management company LLC. Each partner worked full-time and performed a wide range of services to the LLC.

In exchange for the services provided to the funds, the management company received management fees. These fees were the LLC's primary source of income.

Q: OK, so the LLC generates income. Services that generated the income were provided by the LLC members. How did the LLC and its members treat the LLC income for self-employment purposes?

A: The LLC took advantage of all three options--right and wrong--available to get income to its members. First, it paid the members a salary on a W-2, which as we've already discussed, is contrary to the guidance provided in administrative rulings. Obviously, the LLC and its partners paid payroll taxes on these amounts.

In addition, small amounts for health insurance premiums and parking benefits that were paid on the behalf  of the LLC members by the LLC were treated as guaranteed payments and appropriately included in each partner's self-employment income.

Lastly, and as you might have guessed, the LLC treated all of its partners as limited partners for self-employment purposes. As a result, the remaining distributive share after reduction for wages and guaranteed payments that was allocated to each member was excluded from self-employment income under IRC Section 1402(a)(13).

Q: And what did the IRS have to say about this?

A: Because the IRS had no regulations on which to rely, it began its analysis by looking to the legislative history to IRC Section 1402(a)(13). In doing so, the IRS reiterated that the exclusion from self-employment income for limited partners was intended to protect partners whose interest in the partnership represented merely a passive investment. In the facts of the ILM, however, the IRS argued that by virtue of their considerable management services, the members of the LLC represented service partners in a service partnership acting in the manner of self-employed persons. It was not the intention of Congress, the Service noted, to exempt partners who performed services for a partnership in their capacity as partners from self-employment income on their distributive share.

Next, the IRS looked to two recent cases, Renkmeyer and Riether, in which the IRS rules that LLP and LLC members, respectively, were not limited partners. In Renkmeyer, the Tax Court ruled that practicing lawyers in a law firm were subject to self-employment income on their distributive shares. In doing so, the court noted that all of the LLP's income was generated by the services provided by its members, and thus it was clear that the partners' distributive shares of the law firm's income did not arise as a return on the partner's nominal investment and were not "earnings which are basically of an investment nature."

In Riether, a New Mexico district court granted the government's motion for summary judgment on the issue of whether LLC members were subject to self-employment income on their distributive share of the LLC's income. In that case, the LLC members, like the members of the LLC in the ILM, paid themselves a salary and received a W-2 from the LLC. This salary, they argued, made the LLC members employees rather than self-employed, and thus their distributive share of the LLC's income, they reasoned, should escape self-employment tax. The district court was unconvinced, holding that the members' treatment of some of the LLC's income as wages did not change the character of the distributive share as self-employment income.

Furthermore, the court ruled that the exception found in IRC Section 1402(a)(13) did not apply to the LLC members because they "are not members of a limited partnership, nor do they resemble limited partners, which are those who lack management powers but enjoy immunity from liability for debts of the partnership." Thus, the district court concluded, whether the LLC members were active or passive in the production of the LLC's income, those earnings were self-employment income. As you can see, this approach was more expansive than the one taken by the Tax Court in Renkmeyer, where the court placed great weight on the amount of services provided to the LLP by its members. To the contrary, in Riether, it appears the district court was setting the tone that all LLC income should be subject to self-employment tax, regardless of the extent of the services provided by the LLC's members.

Relying on  the legislative history and the decisions in Renkmeyer and Riether, the IRS concluded in the ILM that the services provided by the management company LLC's members were extensive, and that those services directly correlated to the income earned by the LLC from the funds. As a result, each member's distributive share did not represent income which is basically of an investment nature that Congress intended to exclude from self-employment income when it enacted IRC Section 1402(a)(13). Thus, each LLC member was not a limited partners, and each member's share of the distributive income was self-employment income.

Q: Did the taxpayer in the ILM have any argument in its defense?

A: Yes, and it's an interesting one. The management company LLC had previously been an S corporation. Strangely enough, while both partnerships and S corporation are "flow-through entities" for tax purposes -- i.e., the income of the entity is generally not taxed at the entity level, but rather at the partner/shareholder level on each investor's distributive share-- S corporations are treated differently for purposes of self-employment income. Under Revenue Ruling 59-221, each shareholder's distributive share of the S corporation's income is not subject to self-employment income, regardless of the shareholder's level of participation or services rendered.

To combat abuses of this exception, S corporation shareholder-employees are required to pay themselves "reasonable compensation." Any amounts above this reasonable compensation amount, however, may pass through to the shareholder as his distributive share free from self-employment tax.

The taxpayer in the ILM argued, quite logically, mind you, that if the pass-through income of the predecessor S corporation management company had not been subject to self-employment tax, then why should the pass-through income of the LLC -- which had the same role and business as the previous S corporation-- be subject to self-employment tax?

Alas, the mysteries of the tax law are many, and the IRS basically shrugged its shoulders and said, "it is what it is." S corporation shareholder-employees have enjoyed an exclusion from self employment income for fifty years. The exception for LLC members has been much less clear. The taxpayer should have known that going into the structure they chose.

Q: So what does this mean? Is the distributive share of all LLC members now subject to self-employment tax?

A: I wouldn't go that far. This ILM was specific to the taxpayer, but there are certainly lessons to be learned. If the LLC's members provide significant services to the LLC, and it is those services that give rise to the majority of the LLC's income, it is clear that the IRS is going to be prepared to argue that the LLC members are not limited partners for purposes of the exception from self-employment income found at IRC Section 1402(a)(13). You may want to have a strong defense ready to go, or else be prepared to have a hard conversation with your LLC member clients in the next few days explaining why income that has not been subject to self-employment income in the past is subject to self-employment tax on their most recent tax return.

Q: This was very informative. Now if you'll excuse me, I've got 17 partnership tax returns to go redo.

A: That's not a question, but thanks. And good luck.

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