IRS Rules That Members of LLC Are Not “Limited Partners” for Purposes of Avoiding Self-Employment Tax
In ILM 201436049 (9/5/2014), the IRS found that members of a management company LLC (“Management Company”) were not “limited partners” within the meaning of Section 1402(a)(13) and therefore were subject to the self-employment tax on their distributive shares of income of the Management Company.
Under the facts of the ruling, a limited liability company classified as a partnership for federal tax purposes served as the investment manager for “Managed Fund,” a family of investment partnership funds that carry on extensive trading and investing activity (the “Funds”).
The Management Company generally has full authority and responsibility to manage and control the affairs and business of the Funds. The Management Company is primarily responsible for carrying out the extensive market research and trading activity of each of the Funds, and carries on all investment activities, such as the purchasing, managing, restructuring and selling of the Funds’ investment assets. Members of the Management Company and its employees provide these extensive services to the Funds. The Management Company’s primary source of income is from fees for providing management services to the Funds. In consideration of the Management Company’s services, the limited partnership agreements of each of the Funds provide for payment of a quarterly “management fee” from the Funds to The Management Company. For the years in issue, the Management Company’s gross receipts were entirely attributable to management fees for providing services to the Funds, and the Management Company’s ordinary business income was comprised entirely of income from management fees.
Additionally, in the years in issue, each member of the Management Company worked full time for the Management Company, performing a wide-range of professional services. Each of the members receives a Form W-2 from the Management Company for specified wage amounts.
For the years in issue, the Management Company treated all of its members as “limited partners” not subject to the self-employment tax on their distributive share of the Management Company’s income. The only amounts reported as subject to self-employment tax were guaranteed payments representing health insurance premiums and parking benefits paid on behalf of the members by the Management Company.
The Management Company argued that the “wage” amounts represent “reasonable compensation” for each member of the Management Company, and that each member is a limited partner with respect to their distributive share of the income of the Management Company. The Management Company reasoned that because the Management Company has the same role in the business as the S corporation it succeeded, it can continue to apply the same “reasonable compensation” wage rules applicable to S corporations.
The ruling relies heavily on the legislative history behind Section 1402(a)(13) and the recent decisions by the courts in Renkemeyer, 136 TC 137 (2011) and Riether, 919 F. Supp. 2d (DC NM 2012).
Section 1402(a)(13) provides that there shall be excluded from self-employment income the distributive share of any item of income or loss of a limited partner, as such, other than guaranteed payments described in Section 707(c) to that member 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 legislative history for the exception in Section 1402(a)(13) clarifies that Congress did not intend to allow service partners in a service partnership acting in the manner of self-employed persons to avoid paying self-employment tax. The ruling goes on to cite the Renkemeyer case, in which the Tax Court found that the attorney-partners of an LLP engaged in the practice of law who were lawyers performing services for the LLP were not limited partners within the meaning of Section 1402(a)(13) for purposes of excluding their distributive share of the income of the LLP from the self-employment tax. The Tax Court in Renkemeyer went on to provide that the share of the law firm’s income did not arise as a return on the partners’ investment and were not “earnings which are basically of an investment nature.”
The ruling goes on to cite the Riether case discussed above, where the court granted the government’s motion for summary judgment on the issue of whether a husband and wife were subject to self-employment tax on their distributive share of income from an LLC. In the Riether case, the court concluded that Section 1402(a)(13) only applies to limited partners and not to taxpayers treated as a general partner, “irrespective of the nature of his membership.” The court went on to find that the taxpayers were not members of a limited partnership, nor did they resemble limited partners, which are those who “lack management powers but enjoy immunity from liability for debts of the partnership.” The Riether case concluded that whether the taxpayers were active or passive in the production of the LLC’s earnings, those earnings were self-employment income subject to the self-employment tax.
The ruling goes also provides that the Management Company’s members performed extensive investment and operational management services for the Management Company in their capacity as members (i.e., acting in the manner of self-employed persons) and that the Management Company derives its income from the investment management services performed by its members. The IRS concluded that the income earned by the members through the Management Company was not income which was “basically of an investment nature” of the sort that Congress sought to exclude from self-employment tax when it enacted the predecessor to Section 1402(a)(13). Additionally, the IRS stated that like the situation in Renkemeyer, the members’ earnings were not in the nature of a return on capital investment, even though the members paid more than a nominal amount for their membership interests. Rather, the IRS found that the earnings of each member from the Management Company were a direct result of the services rendered on behalf of the Management Company by such members. The IRS also stated that similar to Riether, the Management Company cannot change the character of its members’ distributive shares by paying a portion of each member’s distributive share as amounts mislabeled as so-called “wages,” citing Rev. Rul. 69-184, 1969-1, C.B. 256.
Finally, the IRS expressly stated that because The Management Company was not an S corporation, the “reasonable compensation” rules applicable to S corporations do not apply. This highlights the advantage of operating a business as an S corporation rather than as an LLC for self-employment and social security tax purposes.