Law Firm Members Not Allowed to Treat Income in Excess of Reasonable Compensation Guaranteed Payments as Not Self-Employment Income

Some additional guidance has emerged on the self-employment tax status of member-managers of an PLLC in the case of Castigliola, et al v. Commissioner, TC Memo 2017‑62. 

Like the members in the case of Renkemeyer, Campbell, & Weaver, LLP v. Commissioner, 136 TC 137 (2011) the individual members in this case were attorneys who practiced in a law firm.  However, unlike the attorneys in Renkemeyer, these attorneys did not claim that all income from the law firm was not subject to self-employment tax.

Rather, the attorneys had consulted with an experienced CPA well versed in tax matters and agreed to pay out guaranteed payments to each member that was equivalent to a reasonable salary for an attorney of that individual’s experience level in their locality.  The guaranteed payments were reported as self-employment income and self-employment tax was paid on those amounts.  To the extent the law firm had income in excess of the guaranteed payments, those amounts flowing out on the K-1s weretreated as income not subject to self-employment tax.

The question of whether the members can escape self-employment tax depends on whether they should be treated as limited partners under IRC §1402(a)(13).  IRC §1402(a) begins with a broad statement that partners are subject to self-employment tax on income flowing to them from a business carried on by the partnership.  However, that is subject several exclusions, the key one being at IRC §1402(a)(13) which exempts from treatment as self-employment income tax most income allocated to a limited partner, excluding only guaranteed payments received by the limited partner for services actually rendered.

As the Tax Court noted in its opinion, during the years in question (all of which are before 2011, the year the Renkemeyer decision was released) there was little guidance on how to handle the self-employment tax status of LLC members, especially if or to what extent and in what cases such members would qualify to be treated as “limited partners” under IRC §1402(a)(130.  The Tax Court in Renekemeyer, while concluding the attorneys in that case did not qualify as limited partners, also made clear that federal tax limited partners would not just be limited to “state law” limited partners—and, presumably, that an LLC member could be a limited partner in circumstances other than those before the Tax Court in the Renkemeyer case.

So now the issue becomes—is this fact pattern, which is clearly different from that of Renkemeyer, one where the members would be treated as limited partners with respect to the income other than the “reasonable compensation” guaranteed payments.

The Court looked to the rationale in Renkemeyer, noting:

Therefore, following the approach taken in Renkemeyer, our first inquiry is whether the person claiming the section 1402(a)(13) exemption held a position in an entity treated as a partnership for Federal tax purposes that is functionally equivalent to that of a limited partner in a limited partnership. Mr. Castigliola, Mr. Banahan, and Mr. Mullen were all members of a member- managed PLLC. Consequently, the issue is whether a member of such a PLLC is functionally equivalent to a limited partner in a limited partnership.

The Court then looked at the Uniform Limited Partnership Act drafted in 1916 and the Revised Uniform Limited Partnership Act issued in 1976, as well as the law adopted by the state of Mississippi, the state in which the PLLC operated.  The Court found that all the sources defined a limited partner as having two key characteristics:

  • Limited liability and
  • Lack of control of the business.

As you might guess, the second test would prove problematical for the attorneys in the PLLC in question.  As the opinion notes:

In this case, the respective interests in the PLLC held by Mr. Castigliola, Mr. Banahan, and Mr. Mullen made each a member of the PLLC, which was member- managed.   Therefore management power over the business of the PLLC was vested in each of them through the interest each held. See id. sec. 79-29-302 (effective after July 1, 1994). The PLLC had no written operating agreement, nor is there any evidence to show that any member’s management power was limited in any way. Furthermore, all members participated in control of the PLLC:  For example, they all participated in collectively making decisions regarding their distributive shares, borrowing money, hiring, firing, and rate of pay for employees. They each supervised associate attorneys and signed checks for the PLLC. On the basis of the foregoing facts, the respective interests held by Mr. Castigliola, Mr. Banahan, and Mr. Mullen could not have been limited partnership interests under any of the limited partnership acts. Therefore, they were not limited partners under section 1402(a)(13).

As well, the Court concluded that a limited partnership demands at least one general partner—but in this case all the attorneys had the same responsibilities and rights. 

The Court noted:

Because there must be at least one partner who is in control of the business, there must be at least one general partner. The members testified that all members participated equally in all decisions and had substantially identical relationships with the PLLC. There was no PLLC operating agreement or other evidence to suggest otherwise. But since by necessity at least one of the members must have occupied a role analogous to that of a general partner in a limited partnership, and because all of the members had the same rights and responsibilities, they must all have had positions analogous to those of general partners in a limited partnership.

The Court also cited the history of the firm—prior to becoming a PLLC, they had operated as a general partnership and the Court noted that they had not changed the way they managed the business when they formed the PLLC.

So, what does this case mean?  Certainly, by the logic of the case it appears that while it might not be impossible for a member-manager to be treated as a limited partner for some of his/her income, it certainly will be easier for someone who is not a manager.  In fact, given the Court’s specific focus on the two-pronged definition it seems that, in fact, a “mere member” may have a very strong argument that he/she must be treated as a limited partner.  This view of limited management activity is consistent with Court’s ruling in the Hardy v. Commissioner case (TC Memo 2017-16).

The Court applied a “could this person have been a state law limited partner” test to the situation.  Thus, it would be useful to consult with legal counsel regarding how provisions could be drafted to meet that test under the applicable state statute—what powers have been deemed under the state’s law as “permissible” for a limited partner to have without losing his/her limited partner status.

Finally, it’s important to note the Court spent no time dealing with the fact that the guaranteed payments were truly a reasonable amount of compensation for the services provided by the member.  While it’s possible that this could be an issue with somewhat different facts, the Court in this case admitted that the position taken was not an abusive position, refusing to impose penalties for these pre-Renkemeyer years.  So one key takeaway is that a member needs more than just a “reasonable compensation guaranteed payment” argument to sustain the position some income is not subject to self-employment tax under this case’s reasoning.