LLP Members in Law Firm Subject to Self-Employment Tax-Not “Like” Limited Partners

The Tax Court in Renkemeyer, Campbell & Weaver, LLP v. Commissioner (136 TC No. 7) was asked by the IRS to rule on the applicability of the self-employment tax in the case of a limited liability partnership, a ruling that should have similar implications for limited liability companies and similar entities that elect to be taxed as partnerships under the check the box regulations.  What the Tax Court ruled in a published case was not as severe as some may have worried might have been the case given prior rulings in cases like Norwood v. Commissioner (TC Memo 2000-84), but certainly does not give much comfort to anyone who was trying to take the position that an LLP or LLC member who is active in the entity was “like” a limited partner.

The case involved a law firm that was organized as an LLP.  The IRS had two problems with the entity.  The first was that the entity attempted to allocate a large portion of its income to an S corporation that was owned by an ESOP, an issue that proved even more problematical when the firm could not produce a partnership agreement for the year in question that had a special allocation to the ESOP nor any evidence of the economic reality of the allocation.  The IRS and the Tax Court rejected that allocation, and instead forced an allocation based on the profits and loss interests. That ruling wasn’t terribly unique nor, frankly, surprising.

However there was another issue that got brought into court to go with the first one.  The partnership had taken the position that none of its income was self-employment income, arguing that the members of the LLP were “like” limited partnership interests since a) they were called limited partnership interests in the entity’s documents (even though the entity was not a limited partnership under Kansas law) and b) they had limited liability.  However, the Tax Court pointed out that traditionally a limited partner was barred from participating in management, while LLP members could participate without risking their liability protection—so what we had certainly is not “just like” a limited partnership interest.

The Tax Court noted that §1402(a)(13) was enacted prior to the existence of entities such as LLPs and had no definition of what was a limited partnership interest in the statute.  The Court did not take the position outlined in the Norwood case that a limited partnership interest for §1402(a)(13) purposes had to be a limited partnership interest under state law (a position that would make all LLP members subject to self-employment tax on business income of an LLP), but rather attempted to determine what Congress’s intent was in enacting the bill.

The Court concluded, looking at the legislative history, that Congress was concerned with whether a partner merely was a passive investor, wanting to avoid giving the latter group credit towards Social Security coverage.  The Court concluded that since the income of law firm arose not from the attorneys’ investment in the law firm (which was minimal) but from the attorneys’ services performed on behalf of the law firm, they were subject to self-employment tax on the income of the partnership.

The case would suggest that a service partner in a service partnership is going to be subject to self-employment tax on all earnings passing out of an LLP or LLC.  The case didn’t deal with what would happen if there are services but capital is also a material factor in producing income, but to this author it would seem likely that the Court would look primarily at whether the person was “actively participating” in the entity and come up with an “all or nothing” treatment for self-employment taxes absent a true second class of ownership interests that were truly just investment interests.

While the opinion did not apply the 1997 proposed regulations, its reasoning seems largely in line with the holdings of those regulations as applied to LLCs and LLPs, which look largely to the factors that the opinion looked at, though in a more mechanical fashion.  What the case does make clear is that merely arguing an LLC or LLP member is “like” a limited partner for self-employment tax purposes based solely on limited liability is not going to pass muster at the Tax Court.

Advertisement