The IRS has expanded its view of what doesn’t work for treating an LLC member’s income as not subject to self-employment tax in Chief Counsel Advice 201640014.
Self-employment income is defined broadly at IRC §1402(a) as:
(a) Net earnings from self-employment
The term “net earnings from self-employment” means the gross income derived by an individual from any trade or business carried on by such individual, less the deductions allowed by this subtitle which are attributable to such trade or business, plus his distributive share (whether or not distributed) of income or loss described in section 702(a)(8) from any trade or business carried on by a partnership of which he is a member;
While partnership business income is generally defined as self-employment income, a special exception for limited partners exists at IRC §1402(a)(13) which reads:
(13) 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;
Limited liability companies (LLCs) with more than one owner may elect to be treated as partnership for tax purposes. Once that election is made, the question arises about whether, and under what circumstances, an LLC member may be treated as a limited partner with income passing out not being treated as self-employment income.
The memorandum in question deals with the case of a partner in a partnership that operates restaurants under a franchise is able to treat his share of flow through income, other than that paid to him by the partnership as a guaranteed payment for his services, as income not subject to self-employment tax. The partner in this case served as the operating manager, president, and chief executive officer of the partnership.
The taxpayer argued that the passthrough income should be excluded from self-employment income because he had taken out an amount of guaranteed payments that represented reasonable compensation for the services he had rendered, and the remaining passthrough income represented a return on his significant invested capital.
As the memorandum notes:
Partnership cites to Brinks Gilson & Lione a Professional Corporation v. Commissioner, T.C. Memo 2016-20, a case involving a corporation’s deduction for compensation paid to employees who were also shareholders, for the propositions that Partnership’s guaranteed payments to Franchisee are reasonable compensation for Franchisee’s services, and that Franchisee’s distributive share represents a reasonable return on the capital investments. Therefore, Partnership concludes that Franchisee is a limited partner for purposes of § 1402(a)(13) with respect to his distributive share.
The memorandum concludes the partnership is in error in this case. It notes that the partner in question is not a mere passive investor, noting:
As discussed above, the Renkemeyer Court reviewed the legislative history of § 1402(a)(13) and concluded that § 1402(a)(13) was intended to apply to those who “merely invested” rather than those who “actively participated” and “performed services for a partnership in their capacity as partners (i.e., acting in the manner of self-employed persons).” Renkemeyer, 136 TC at 150. The Renkemeyer Court explained that “the interest of a limited partner in a limited partnership is generally akin to that of a passive investor.” Id. at 147, 148. And as the Riether Court stated, limited partners are those who “lack management powers but enjoy immunity from liability for debts of the partnership.” Riether, 919 F.Supp.2d 1140, at 1159, 1160. Here, Franchisee has sole authority over Partnership, and is the majority owner, Operating Manager, President, and Chief Executive Officer with ultimate authority over every employee and each aspect of the business. Even though Partnership has many employees, including several executive-level employees, Franchisee is the only partner of Partnership involved with the business and is not a mere investor, but rather actively participates in the partnership’s operations and performs extensive executive and operational management services for Partnership in his capacity as a partner (i.e., acting in the manner of a self-employed person). Therefore, the income Franchisee earns through Partnership is not income of a mere passive investor that Congress sought to exclude from self-employment tax when it enacted the predecessor to § 1402(a)(13).
The memo notes that the partnership argues that this should not dispose of the matter and gives the following reasons:
Partnership concedes that under the legislative history quoted above and the Renkemeyer opinion, “service partners in a service partnership acting in the manner of self-employer persons” are not limited partners. However, Partnership argues that a different analysis should apply to limited liability members which: (1) derive their income from the sale of products, (2) have made substantial capital investments, and (3) have delegated significant management responsibilities to executive-level employees. Partnership asserts that in these cases the IRS should apply “substance over form” principles to exclude from self-employment tax a reasonable return on capital invested.
The memorandum concludes that the law for self-employment tax does not allow for a “reasonable compensation” limitation on self-employment income. As the memo notes:
Partnership’s arguments inappropriately conflate the separate statutory self-employment tax rules for partners and the statutory employment tax rules for corporate shareholder employees. Section 1402(a)(13) provides an exclusion for limited partners, not for a reasonable return on capital, and does not indicate that a partner’s status as a limited partner depends on the presence of a guaranteed payment or the capital-intensive nature of the partnership’s business.
Following the Court’s analysis in Riether, Partnership cannot change the character of Franchisee’s distributive shares by paying Franchisee guaranteed payments. Partnership is not a corporation and the “wage” and “reasonable compensation” rules which are applicable to corporations and were at issue in the Brinks case do not apply.
The memorandum specifically rejects reading the commentary in Renkemeyer as creating an exclusion from self-employment treatment for income that would represent a return on invested capital, noting:
Although the Renkemeyer Court noted the partners’ small capital contributions and service-generated income as factors influencing its decision that the partners in that case were not limited partners, Renkemeyer does not stand for the proposition that a capital-intensive partnership should be treated like a corporation for employment tax purposes. Instead, as the Tax Court has repeatedly held, partners who are not limited partners are subject to self-employment tax, even in cases involving capital-intensive oil and gas joint ventures where all of the work was performed by other parties. See Cokes, Methvin, and Perry. Under the Renkemeyer Court’s interpretation of the legislative history, and consistent with the Court’s holding in Riether, Franchisee is not a limited partner in Partnership within the meaning of § 1402(a)(13) and is subject to self-employment tax on his full distributive shares of Partnership’s income described in § 702(a)(8).