Self-Employment Tax – Limited Partners Beware!

Partner accounting 28 Sep 2014

02-21-12 © f9photosBy Maury Cartine, CPA, JD, Partner in Charge of Alternative Investment Group Tax, Marcum, LLP

The IRS released Chief Counsel Memorandum CCA 201436049 on September 5, 2014 which provides guidance on the treatment of the exemption from self-employment tax under Section 1402(a)(13) of the Internal Revenue Code for a limited partner’s share of profits.

Section 1402(a)(13) exempts from self-employment tax a limited partner’s share of profits other than guaranteed payments for services described in Section 707(c) of the Internal Revenue Code. Since the date of enactment of then Section 1402(a)(12) [now Section 1402(a)(13)]on December 20, 1977 as part of P.L. 95-216, Social Security Amendments of 1977, tax professionals have generally treated a limited partner’s share of profits other than guaranteed payments as exempt from self-employment tax even when the limited partner had no significant capital at risk.   Consequently, limited partners in service businesses paid self-employment tax only on guaranteed payments. Tax professionals were somewhat less aggressive with members of limited liability companies since it was never clear that a member of a limited liability company was a “limited partner” for purposes of Section 1402(a)(13).

In 1997, the Treasury Department and the IRS promulgated proposed regulations defining limited partner for purposes of Section 1402(a)(13). Under these proposed regulations, a partner in a service partnership would not be treated as a limited partner under Section 1402(a)(13) and thus, a limited partner under state law would not be permitted to exclude his or her share of profits of a service partnership from self-employment tax. These proposed regulations ignited controversy and as a result Congress precluded the Treasury Department from issuing any proposed regulations with respect to the definition of limited partner until July 1, 1998 under the Taxpayer Relief Act of 1997.   The date of July 1, 1998 passed, but neither Congress nor the IRS took any further action.

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, Campbell & Weaver, LLP et. al. v. Commissioner, 136 T.C. 137 (2011), the Court concluded that a service partner’s share of profits was never intended to be excluded from self-employment tax under Section 1402(a)(13) by Congress. Citing the 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.

The Chief Counsel Memorandum concludes, similar to the Court in Renkemeyer v. Commissioner, supra, 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. It is interesting to note that both the United States Tax Court and the Chief Counsel were careful to distinguish limited partners of a limited partnership from partners in a limited liability partnership or members of a limited liability company.   Notwithstanding the apparent reliance by both the Court and the IRS on the intent of Congress, both the Court and the IRS seem to take additional comfort in distinguishing limited partners from members in other types of entities treated as partnerships for federal income tax purposes.

It is now clear that the exclusion of a limited partner’s share of profits in a service partnership from self-employment tax is under a formidable attack. Partners of limited liability partnerships and members of limited liability companies face even more dire straits since they apparently will not be regarded as “limited partners.” Many tax professionals warned their clients of the impact of the decision in Renkemeyer v. Commissioner, supra back in 2011. At that time, our firm suggested that limited liability companies convert to limited partnerships if the members wanted to avail themselves of the exclusion from self-employment tax under Section 1402(a)(13).   This still seems to be good advice.   However, the risks remain great even for limited partners. The issue may ultimately be settled by a simple legal analysis.   Should the Committee Reports control when a statute is clear and unambiguous on its face?   Why did Congress object to an IRS proposed regulation that would ostensibly validate the alleged Congressional intent? This matter is far from over, but members in service partnerships should give themselves the best chance for successful exclusion of profits from self-employment tax by making sure they qualify as “limited partners.”

Be Sociable, Share!

Leave A Reply

← Key Alpha-Oriented Law Firms Merging Looking at the Next Generation of Institutional Investing →