When it comes to tax law, there are quite a few known-unknowns.
These are tax questions that have been raised tangentially in court cases and rulings, but have not been fully answered.
These situations confuse taxpayers. Tax practitioners are often asked to provide answers. The answers from tax practitioners often differ, as practitioners have different views on what the correct answer is.
The ongoing question of whether a limited partner (or LLC member) is subject to self-employment tax for their partnership (or LLC) profits is an example. The court seems to think this issue has been fully resolved, but yet, many tax practitioners do not agree. Other tax practitioners sidestep the debate by suggesting changes to distinguish their client’s case to avoid the issue. And other tax practitioners actively use the IRS’ and court’s position in ways that help their clients.
The recent Joesph v. Commissioner, T.C. Memo. 2020-65, case provides an opportunity to consider this issue. It involves a doctor who operated a medical practice as a limited partnership. The IRS asserted that the partnership distribution was subject to self-employment tax.
Facts & Procedural History
The doctor is an ophthalmologist. He owns several different business entities. The entities used for medical practices were taxed as S corporations. They were likely set up this way to avoid paying employment taxes on a part of the business profits.
The doctor also owned a limited partnership. The limited partnership was intended to operate a surgical center. The doctor owned 99% of the limited partnership. Another entity owned by the doctor owned the other 1%.
It appears that the plans for the surgical center fell through and the doctor started using his partnership entity for his medical practice. It is not clear why he did this, but it caused the business income and expense to be reported on a partnership return rather than the S corporation return for the prior entity.
The doctor failed to timely file his income tax returns. On audit, the IRS prepared substitute for returns for the doctor. The doctor then prepared his own tax returns. Tax court litigation ensued over the differences.
One of the issues was whether the doctor was subject to self-employment tax on the distributable share of the net income earned by the limited partnership.
About Self-Employment Tax
Self-employment tax includes Social Security and Medicare taxes. The self-employment tax rate is 15.3%. The rate consists of two parts: 12.4% for social security (old-age, survivors, and disability insurance) and 2.9% for Medicare (hospital insurance).
The tax is computed on the Schedule SE, Self-Employment Tax, attached to a Form 1040, Individual Income Tax Return. One half of the self-employment tax is deductible on the Form 1040.
Self-employment tax is charged on “net earnings from self-employment.” This term means gross income from a business less the corresponding tax deductions. For partnerships, it includes the partner’s distributive share of income or loss earned by a partnership.
There are several items that are not counted as gross income or the partners distributive share. This includes rental income, dividends, community property income (for taxpayers located in community property states, such as Texas), etc.
Exclusion for Limited Partners
The list of exclusions from self-employment tax also includes this language:
there shall be excluded 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 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 tax court has previously considered this language in other disputes. The Renkemeyer v. Commissioner, 136 T.C. 137 (2011) case is the leading case on point.
The Renkemeyer case involved a law firm that was structured as a limited liability partnership (LLP). The limited partners argued that they were limited partners under the exclusion cited above. The court noted that LLPs are a type of business entity that did not exist at the time the above-cited exclusion was drafted.
The court construed the term “limited partner” to mean an investor. To the court, it included an investor who is “not actively participating in the partnership’s business operations.” The court concluded that the limited partners in Renkemeyer were not “limited partners” for the above-cited exception, as they were lawyers whose earnings came from providing legal services to clients via the LLP.
The decision seems contrary to a plain reading of the statute.
This brings us back to the Joseph case. The doctor in Joseph operated his medical practice in an entity taxed as a limited partnership. The doctor owned a 99% interest in the limited partnership and the other interest was held by another entity the doctor owned.
The doctor testified that the limited partnership received income from surgeries the doctor performed. Based on this testimony, the court concludes that the distributive share of the partnership income was subject to self-employment tax. The court applied Renkemeyer in support of its position.
Lingering Questions About Self-Employment Tax
While the court in Joseph seems to suggest that this issue is fully settled and the law clear, it is not. There are a number of questions that still have not been answered.
For example, the court in Renkemeyer did not consider a limited partner who served in a manager role, rather than in the business operations. Does Renkemeyer apply if the limited partner is merely a manager? What if the management function does not drive revenue for the partnership?
The court did not consider a limited partnership with partners owning a bifurcated interest. What if the limited partner has two interests under the partnership agreement, with one representing the profits from his services and one representing the profits not from his services? Can the bifurcated interest escape self-employment taxes?
Or what if the limited partnership interest is held by another entity, such as an S corporation, and the limited partnership makes distributions to the S corporation? If the owner works for the S corporation and not the limited partnership, is the S corporation a limited partner and the amounts it receives not subject to self-employment tax?
Planning for Self-Employment Tax
It is important to note that not all taxpayers want to avoid paying self-employment taxes. With a little tax planning, the rule that “limited partners” are not subject to self-employment tax may actually help some taxpayers.
While avoiding self-employment tax is important to some taxpayers, others prefer that their income is subject to self-employment tax. This is true for those who are trying to increase or qualify for Social Security benefits. Self-employment income is reported to the Social Security Administration and it factors into the calculations of how much Social Security one is entitled to.
It may also be true for those who have business expense deductions or credits that are contingent on the activity rising to the level of a trade or business. A limited partner who wants to take a research tax credit for activities performed by the limited partnership (or LLC) is an example. The research tax credit is generally calculated using the limited partner’s income that is subject to self-employment tax (the amounts reported to the partner that are subject to self-employment tax count as qualified research expenses or QREs for the credit). The research tax credit is also limited to this income. The tax benefit from the tax deductions and credits may exceed the self-employment tax. The Renkemeyer line of cases is actually helpful for these taxpayers.
Given that the court continues to find that limited partners are subject to self-employment tax even though the code says that they are not subject to self-employment tax, limited partners should consider how they report their partnership income.