Limited Partner's Income Subject to Self-Employment Tax – We'll See
By Michael Purce, Tax Manager, Alternative Investment Practice Group
Within the financial services industry, the topic of self-employment tax has come up time and time again over the course of the last six years. The commentary behind this has led to numerous planning opportunities as well as potential exposure for taxpayers. In the IRS’s most recent correspondence on self-employment tax for limited liability company members, the agency has again confronted taxpayers with decisions that should be given attention, in the areas of structuring and compliance.
In Chief Counsel Memorandum CCA 201640014 (“the CCA”), the IRS has given what appears to be conclusive guidance regarding earnings as a limited partner being subject to self-employment tax within the meaning of Section 1402(a)(13).
For the case in question, the issue involved a franchisee who contributed franchise restaurants to a limited liability company (“LLC”). The LLC was considered a partnership for U.S. tax purposes and was majority-owned by the franchisee and his family. It is relevant in this case to understand that the franchisee materially participated in the management of the LLC by conducting nearly all operational aspects of the business. As compensation for managing the business, he received a guaranteed payment.
For purposes of the self-employment tax, the franchisee was treated as a limited partner and included in his earnings from self-employment only the guaranteed payment that he received as compensation for managing the LLC and not any of his distributive share of profit from the LLC. Much like the arguments made in Renkemeyer, Campbell and Weaver LLP v. Commissioner, 136 T.C. 137 (2011), the franchisee argued that for self-employment tax purposes, “(1) income attributable to capital invested or the efforts of others, which is not subject to self-employment tax, and (2) compensation for services rendered, which is subject to self-employment tax” could be broken out. The franchisee also argued that the guaranteed payment represents “reasonable compensation” for his services.
In the September 28, 2014, edition of AllAboutAlpha, Maury Cartine, CPA, a partner at Marcum LLP, wrote, “In 2011, the United States Tax Court took action to fill the gaping hole left by the legislative and administrative branches of our government. In Renkemeyer, the Court concluded that a service partner’s share of profits was never intended by Congress to be excluded from self-employment tax under Section 1402(a)(13). Citing House Report 95-702 for P.L. 95-216, the Court concluded that only a limited partner’s share of profits attributable to the partner’s investment in the partnership was intended to be excluded from the self-employment tax.”
Relying upon the ruling of the Renkemeyer court, the IRS issued Chief Counsel Memorandum CCA 201436049, on September 15, 2014, which concluded that a limited partner’s share of profits that are not attributable to a return on a capital investment should be subject to self-employment tax.
The IRS took a rather unique approach by issuing CCA 201640014 with a conclusion contrary to Renkemeyer, finding that Section 1402(a)(13) provides an exclusion for limited partners that is not based on the capital- intensive nature of the business, but rather on the partner’s status as a limited partner.
The issue of self-employment earnings as a member of an LLC in the financial services industry dates back to a previous discussion in the Winter 2013 edition of Private Investment Forum, where we state, “Fund managers have an opportunity to potentially escape both the 3.8% net investment income tax and the Medicare tax on management company income, provided that they receive their share of profits as a limited partner. To take advantage of this opportunity, fund managers may have to restructure their management companies by converting from a limited liability company to a limited partnership. Now that the 3.8% net investment income tax is effective, the Internal Revenue Service will have an ever-greater incentive to make sure limited liability company members do not escape the Medicare tax on their share of profits. Of course, guaranteed payments will continue to be subject to the full 3.8% Medicare tax. Fund managers who have structured their management companies as limited liability companies should consult their tax advisors as soon as possible.” This advice continues to hold true and fund managers would be served well to work with their attorneys and tax advisors to optimally structure their management companies as limited partnerships.
It seems that the IRS has staked its claim: a member’s share of profits through an LLC where the member performs services is subject to self-employment tax, while a limited partner’s share of profits through a limited partnership is spared…for the time being.