Self-employment tax is always a big tax hit for sole proprietors and partners: 15.3% on 92.35% of the taxpayer’s net earnings from self-employment. For $100,000 of income subject to self-employment tax, that’s an additional $14,130 in tax above-and-beyond regular income tax.
A partner, however, can avoid self-employment tax on his or her distributive share of the partnership’s business income if a limited partner. Guaranteed payments to limited partners for services actually rendered to the partnership remain subject to self-employment tax.
With the advent of the limited liability company (LLC) and limited liability partnership (LLP), there is a lot of confusion about who can avail themselves of the limited partner exception and avoid self-employment tax.
A taxpayer could be considered a limited partner vis-a-vis his or her ownership of a LLC or LLP; however, that does not mean he or she is a limited partner for all federal tax purposes. §1402, which governs self-employment tax, does not provide a definition for the term limited partner.
In Renkemeyer, Campbell & Weaver, LLP v. Comm., 136 T.C. 137 (2011), the Tax Court had to determine whether three law firm partners, whose services generated 99% of the law firm income, were subject to self-employment tax on their distributive share of the partnership’s income as members of a state limited liability partnership.
By looking at legislative history, the Tax Court came to the following conclusion:
Section 1402(a)(13) was enacted by the Social Security Amendments of 1977, Pub. L. 95-216, sec. 313(b), 91 Stat. 1536. The relevant legislative history provides insight with respect to Congress' intent:
Under present law each partner's share of partnership income is includable in his net earnings from self-employment for social security purposes, irrespective of the nature of his membership in the partnership. The bill would exclude from social security coverage, the distributive share of income or loss received by a limited partner from the trade or business of a limited partnership. This is to exclude for coverage purposes certain earnings which are basically of an investment nature. However, the exclusion from coverage would not extend to guaranteed payments (as described in 707(c) of the Internal Revenue Code), such as salary and professional fees, received for services actually performed by the limited partner for the partnership.
H. Rept. 95-702 (Part 1), at 11 (1977) (emphasis added).
The insight provided reveals that the 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.
The Tax Court applied a similar line of reasoning in Castigliola v. Comm., T.C. Memo 2017-62 in holding that members of a professional LLC were not limited partners for purposes of the self-employment tax exclusion.
The IRS issued Prop. Reg. §1.1402(a)-2(h) in 1997 to define a limited partner for self-employment tax purposes. While the regulations were not finalized, they are instructive. The IRS Concept Unit on Self-Employment Tax and Partners, which is not authority, states that “Taxpayers, however, may rely on the 1997 proposed regulations. In other words, the IRS will respect a partner’s status as a limited partner if the partner qualifies as a limited partner under the 1997 proposed regulations.”
Under the proposed regulations, an individual is treated as limited partner unless the individual:
Has personal liability for the debts or claims against the partnership due to being a partner, or
Has authority (under the law of the jurisdiction in which the partnership is formed) to contract on behalf of the partnership, or
Participates in the partnership’s trades or businesses for more than 500 hours during the partnership’s taxable year.
Therefore, if a partner meets any one of the three above situations, he or she is not a limited partner.
The proposed regulations have three important other provisions:
If substantially all of the partnership’s activities involve the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, or consulting, any individual who provides services as part of that trade or business is not considered a limited partner, regardless of what the other rules in the proposed regulation may provide.
A partner can potentially bifurcate interests in the case of an individual holding more than one class of interest in a partnership, allowing a partner to be treated as both a general partner and a limited partner in the same partnership. The amounts should be “demonstrably returns on capital invested in the partnership,” according to the proposed regulations preamble.
There is also an exception for partners who cannot be limited partners only due to the participation hours test; they may be able to be treated as a limited partner if (1) limited partners own a substantial, continuing interest in that specific class of partnership interest, and (2) the individual’s rights and obligations with respect to the specific class of interest are identical to the rights and obligations of the specific class of interest held by the limited partners.
The straightforward way for a partner to be treated as a limited partner for self-employment tax purposes is to meet the above three-prong test; the less involvement in the partnership activities, the clearer the treatment is. Ideally, a limited partner is a mere investor and only has de minimis involvement with the partnership.
A common question is whether a spousal partnership can have one spouse be a limited partner and escape self-employment tax on his or her distributive share. There is nothing in the law that precludes this opportunity. In Howell v. Comm., T.C. Memo. 2012-303, the Tax Court found both spouses subject to self-employment tax in a spousal partnership; however, the Tax Court implied that clearer documentation may have led to a different outcome.
It is important to note that one spouse’s involvement would port to the other spouse for §469 passive loss purposes under §469(h)(5); therefore, the limited partner interest would be non-passive under Treas. Reg. §1.469-5T(e)(2) if the general partner spouse participates for more than 500 hours.
In the case of a spousal partnership, I believe it should be crystal clear that the one spouse is a true limited partner for self-employment tax purposes, meaning that he or she:
Invests cash or property for a limited partnership interest pursuant to a formal written agreement,
Has no involvement in the partnership activities (or de minimis involvement, if there must be some),
Has no liability for partnership debts, and
Has no authority to contract on behalf of the partnership.
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