A case that presented the reverse situation that the Tax Court decided in the 2011 case of Renkemeyer, Campbell & Weaver, LLP v. Commissioner on the issue of the self-employment tax liabilities of members of LLC was decided in the case of Hardy v. Commissioner, TC Memo 2017-16.
The case involved a surgeon that had purchased a 12.5% interest in an LLC that operated a surgery center. The surgeon did not actively participate in the management or operation of the center, but only performed a minority of his surgeries in the center, on similar terms as he worked in centers and hospitals in which he had no ownership interest.
In general IRC §1402 provides that a partner is subject to self-employment tax on the flow-through income from a trade or business conducted by the partnership—and, clearly, in this case the partnership was carrying on the business of operating the surgical center.
But a special exception exists at IRC §1402(a)(13). As the opinion notes:
Section 1402(a) provides several exclusions from the general rule. In particular, section 1402(a)(13) excludes "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 Commissioner argues that the section 1402(a)(13) exclusion does not apply in this case. He argues that because Dr. Hardy performs surgeries at MBJ, he is not acting as a limited partner.
The Tax Court turns to the application of IRC §1402(a)(13) to members of a limited liability company. The Court notes:
The Code does not define "limited partner" for purposes of section 1402(a)(13). However, we discussed the definition of limited partner in Renkemeyer, Campbell & Weaver, LLP v. Commissioner, 136 T.C. 137 (2011). In that case, the partners were lawyers operating out of a law firm, which was formed as a limited liability partnership. The law firm received revenue from the partners' legal fees, but the firm did not report those revenues on the firm's tax return as net earnings from self-employment. The Commissioner determined that the partners' distributive shares of the law firm's net business income were subject to self-employment tax. We agreed. Because section 1402(a)(13) was enacted before limited liability entities were contemplated and the term "limited partner" remained undefined, we interpreted the statute by looking at legislative history and explained that
[t]he intent of section 1402(a)(13) was to ensure that individuals who merely invested in a partnership and who were not actively participating in the partnership's business operations (which was the archetype of limited partners at the time) would not receive credits toward Social Security coverage. The legislative history of section 1402(a)(13) does not support a holding that Congress contemplated excluding partners who performed services for a partnership in their capacity as partners (i.e., acting in the manner of self-employed persons), from liability for self-employment taxes.
In the Renkemeyer case the Court found that the members were subject to self-employment tax on their income from the partnership, using the partner’s services to find that they could not qualify as limited partners for purposes of IRC §1402(a)(13).
But in this case the Court looked at the opposite possibility—that a member may be an investor who should qualify as a limited partner.
Dr. Hardy is an investor in MBJ, which is distinguishable from the limited liability partnership formed by the partners in the law firm in Renkemeyer, Campbell & Weaver, LLP v. Commissioner. MBJ owns and operates a surgical center. MBJ is equipped for doctors to perform surgeries that require local and general anesthesia. MBJ bills patients for the use of the facility. Although Dr. Hardy performs surgeries at MBJ, he is not involved in the operations of MBJ as a business. In contrast to the partners in Renkemeyer, Campbell & Weaver, LLP, who are lawyers practicing law and receiving distributive shares based on those fees from practicing law, Dr. Hardy is receiving a distribution based on the fees that patients pay to use the facility. The patients separately pay Dr. Hardy his fees as a surgeon, and they separately pay the surgical center for use of the facility in the same manner as with a hospital. Accordingly, Dr. Hardy's distributive shares are not subject to self-employment tax because he received the income in his capacity as an investor.
So now advisers know that if a member is a service member with no investment, the member is not treated as a limited partner for §1402(a)(13) purposes. As well, if a member is an investor who performs no services related to operating the business but has made a significant investment of capital we know the member is treated as a limited partner for §1402(a)(13) purposes.
What remains to be seen is the proper treatment of an LLC member who both performs significant services and has a significant amount of invested capital.