In general, self-employed individuals are subject to employment taxes on their net earnings.
The wages paid to individuals who are non-owner-employees of a business are also subject to employment taxes, regardless of how the business is organized.
The shareholders of a corporation are not subject to employment taxes in respect of any return on their investment in the corporation, though they are subject to employment taxes as to any wages paid to them by the corporation.
In the case of an S corporation, the IRS has sought to compel the corporation to pay its shareholder-employees a reasonable wage for services rendered to the corporation, and thus to prevent it from “converting” into a distribution of investment income that is not subject to employment taxes.
Finally, in the case of a partnership, a “limited partner” is generally not subject to employment taxes in respect of his distributive share of the partnership’s income, while the shares of a “general partner” are subject to such taxes, regardless of whether or not the general partner receives a distribution from the partnership.
Application to LLC Members
The U.S. Tax Court recently considered whether the members of an LLC may be treated as limited partners for purposes of applying the self-employment tax to their distributive share of the LLC’s net income.
Specifically, the issue for decision was whether the three member-managers of the LLC (the “Taxpayers”) were entitled to claim the exclusion from self-employment income for limited partners for a portion of their LLC distributions.
The Taxpayers were attorneys who initially practiced law through a general partnership before reorganizing their firm as a member-managed professional limited liability company (the “PLLC”). The PLLC never had a written operating agreement, and it filed federal income tax returns as a partnership.
For the years at issue, the Taxpayers’/members’ compensation agreement required guaranteed payments (i.e., payments to a partner for services, determined without regard to the income of the partnership) to each member that were commensurate with local area legal salaries. Any net profits of the PLLC in excess of the amounts paid out as guaranteed payments were distributed among the members in accordance with the Taxpayers’ agreement.
The Taxpayers reported all of their guaranteed payments from the PLLC as self-employment income subject to self-employment tax. However, they did not remit self-employment tax on the excess of their distributive shares over the guaranteed payments they received, on the grounds that such distributive shares were attributable to the efforts of the PLLC’s other employees (in other words, they represented a return on investment).
The IRS challenged the Taxpayers’ treatment of this excess.
The Code imposes a tax on the “self-employment income” of every individual for a taxable year (self-employment tax). In general, self-employment income is defined as “the net earnings from self-employment derived by an individual.”
“Net earnings from self-employment” is defined as the gross income derived by an individual from any trade or business carried on by such individual, less allowable deductions which are attributable to such trade or business, plus his distributive share (whether or not distributed) of income or loss from any trade or business carried on by a partnership of which he is a member . . . .”
Certain items are excluded from self-employment income, including “the distributive share of any item of income . . . of a limited partner, as such, other than guaranteed payments to that partner for services actually rendered to or on behalf of the partnership to the extent that those payments are established to be in the nature of remuneration for those services . . . .”
The Taxpayers contended that the above exclusion applied to their distributive shares in excess of the guaranteed payments. The IRS, however, argued that the members were not “limited partners” for purposes of this exclusion and, therefore, the distributive shares constituted self-employment income.
The Tax Court reviewed the history of the exclusion, explaining that it was enacted well before LLCs became widely used. The Court noted that no statutory or regulatory authority defines “limited partner” for purposes of the exclusion.
A “Historical” Digression
Prior to the enactment of the exclusion, the Code provided that a partner’s share of partnership income was includable in his net earnings from self-employment for tax purposes, regardless of the nature of his membership in the partnership.
In creating the exclusion for limited partners, Congress recognized that certain earnings were basically in the nature of a return on investment. Thus, the exclusion was not extended to guaranteed payments received for services actually rendered by the limited partner to the partnership.
In 1997, in response to the proliferation of LLCs, the IRS issued proposed regulations defining “limited partner” for self-employment tax purposes. These generally provided that an individual would be treated as a limited partner unless the individual: (1) had personal liability for the debts of or claims against the partnership by reason of being a partner; (2) had authority to contract on behalf of the partnership; or (3) participated in the partnership’s trade or business for more than 500 hours.
In response to criticism from the business community, Congress imposed a temporary moratorium on finalizing the proposed regulations, which has long since expired, yet the proposed regulations have neither been finalized nor withdrawn.
A number of courts, however, have addressed the attempts by taxpayers to distinguish between a partner’s wages and his share of partnership income. The courts have generally explained that a limited partnership has two fundamental classes of partners: general partners, who typically have management power and unlimited personal liability; and limited partners, who lack management powers but enjoy immunity from liability for debts of the partnership. A limited partner, these courts have pointed out, could lose his limited liability protection were he to engage in the business operations of the partnership. Consequently, the courts have observed that the interest of a limited partner is akin to that of a passive investor.
The Court’s Opinion
The Tax Court followed this line of this reasoning in its analysis of the Taxpayers’ position. The meaning of “limited partner,” it stated, was not confined to the limited partnership context. Therefore, the issue was whether a Taxpayer/member of the member-managed PLLC was functionally equivalent to a limited partner in a limited partnership.
In a limited partnership, the Court highlighted, a limited partner does not become liable as a general partner unless, in addition to the exercise of his rights and powers as a limited partner (e.g., the right to vote on the dissolution of the partnership or the sale of substantially all of its assets), he takes part in the control of the business.
In this case, the management power over the business of the PLLC was vested in each of the Taxpayer-members. The Taxpayers testified that each of them participated equally in all decisions and had substantially identical relationships with the PLLC, including the same rights and responsibilities: for example, they all participated in collectively making decisions regarding their distributive shares, borrowing money, hiring, firing, and rate of pay for employees, they each supervised associate attorneys, and they each signed checks for the PLLC.
There was no PLLC operating agreement or other evidence to suggest otherwise, nor was there any evidence to show that any member’s management power was limited in any way. Indeed, they had previously operated as a general partnership, and there was no evidence that organizing as a PLLC was accompanied by any change in the way they managed the business.
On the basis of the foregoing, the Court held that the respective membership interests held by the Taxpayers could not have been limited partnership interests, and the Taxpayers were not limited partners. Accordingly, the Taxpayers could not exclude any part of their distributive shares of PLLC net income from self-employment income.
Lessons & Planning
The Tax Court’s decision demonstrates that a business organization that is treated as a partnership for tax purposes cannot change the character of a partner/member’s distributive share for purposes of the self-employment tax simply by making guaranteed payments to the partner for his services. A partnership is not a corporation, and the “wage” and “reasonable compensation” rules that are applicable to corporations do not apply to partnerships.
The “limited partner exclusion” provided by the Code was intended to apply to those partners who “merely invest” rather than those who actively participate in and perform services for a partnership in their capacity as partners.
Therefore, a partner who is not a “limited partner” within the meaning of the exclusion is subject to self-employment tax on his full distributive share of the partnership’s income, even in cases involving a capital-intensive (as opposed to a service-intensive) business.
If a member of an LLC truly intends to be a passive investor, his status as such should be memorialized in an operating agreement, it should be reflected in his actions, and the LLC and other members should treat him accordingly.
As always, the taxpayers must be able to support their position, and the first steps in doing so are to adopt a form of operation (and, if relevant, organization) that conforms with the intended result, to contemporaneously memorialize that intention, including the “action plan” for attaining it, and to act consistently with the foregoing.