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IRS subjects LLC member’s distributive share of partnership income to self-employment tax

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Tax Hot Topics: IRS subjects LLC member’s income to self-employment taxIn a recently issued IRS memorandum (ILM 201640014) the IRS Office of Chief Counsel concluded that a restaurant franchisee was not a limited partner in a partnership within the meaning of Section 1402(a)(13) and thus, was subject to self-employment tax on his distributive share from the partnership.

In the memo, the owner of franchise restaurants (a franchisee) contributed the restaurants to a limited liability company that was treated as a partnership for federal tax purposes. The franchisee owned the majority of the partnership, and the remaining interests in the partnership were owned by his wife and her irrevocable trust. Neither the franchisee's wife nor her trust were involved with the partnership's business operations, and their status as limited partners for purposes of Section 1402(a)(13) was not in dispute.

The franchisee, on the other hand, handled numerous aspects of partnership management and operations, including directing operations, holding regular meetings and discussions with his management team and staff, making strategic and succession planning decisions, and making investment management and planning decisions. He was the partnership's operating manager, president and chief executive officer and had authority to manage the partnership, make all decisions, and do anything reasonably necessary in light of its business and objectives. He also had very broad authority to institute, prosecute and defend any proceedings in the partnership’s name; purchase, lease and sell property; enter into contracts; lend money and invest partnership funds; hire and fire partnership employees; establish pension plans; and hire accountants, investment advisors and legal counsel on behalf of the partnership. Additionally, the partnership made guaranteed payments to him.
 
The partnership treated the franchisee as a limited partner for purposes of Section 1402(a)(13) and included only the guaranteed payments in his net earnings from self-employment and not his full distributive share of partnership income. The partnership’s position was that the franchisee's income from the partnership should be bifurcated for self-employment tax purposes between his (1) income attributable to capital invested or the efforts of others, which is not subject to self-employment tax, and (2) compensation for services rendered, which is subject to self-employment tax. The partnership asserted that (1) the franchisee and the partnership made significant capital outlays to acquire and maintain the restaurants, and (2) that the partnership derived its income from the preparation and sale of food products and not from the personal services of the franchisee. The partnership also contended that the franchisee's guaranteed payments were reasonable compensation for his services and that his earnings beyond those payments were investment earnings.
 
The IRS concluded that the franchisee was not a limited partner for purposes of Section 1402(a)(13) and cited case law that found that the provision 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). One such case was Renkemeyer, Campbell and Weaver LLP v. Commissioner, 136 T.C. 137 (2011), in which the Tax Court held that practicing lawyers in a state limited liability partnership were not limited partners within the meaning of Section 1402(a)(13) and thus were subject to self-employment taxes. The Renkemeyer decision included a discussion of the ordinary meaning of limited partner and noted that the interest of a limited partner in a limited partnership is generally akin to that of a passive investor. The Renkemeyer court also explained 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 would not receive credits toward Social Security coverage.

In the memo, the IRS explained that the franchisee had sole authority over the partnership and was the majority owner, operating manager, president and chief executive officer with ultimate authority over every employee and each aspect of the business. Therefore, the income that the franchisee earned through the partnership was not income of a mere passive investor. The IRS added that Renkemeyer does not stand for the proposition that a capital-intensive partnership should be treated like a corporation for employment tax purposes. Instead, partners who are not limited partners are subject to self-employment tax, even in capital-intensive joint ventures where the work was performed by others.

The IRS also dismissed the argument by the partnership that the franchisee’s guaranteed payments were reasonable compensation, noting that Section 1402(a)(13) did not provide an exclusion for reasonable compensation to partners similar to authority in corporate shareholder-employee situations. The IRS ultimately concluded that under the Renkemeyer court’s interpretation of the legislative history, the franchisee was not a limited partner in the partnership within the meaning of Section 1402(a)(13) and was subject to self-employment tax on his full distributive shares of the partnership’s income.

In this ILM, the IRS suggests that if a partner has made capital contributions to a partnership where capital is material and is also active in the partnership’s business, a bifurcation analysis for partnerships (between investment and service income) is not available for self-employment taxes. This view is seemingly an all or nothing approach to the application of the limited partner exception in Section 1402(a)(13). The IRS appears to not focus on the capital investment made by the taxpayer, but instead on the management responsibilities of the taxpayer, interestingly in the context of a non-service partnership. The facts of Renkemeyer and other limited guidance in this area (see Riether v. United States, 919 F.Supp.2d 1140 (D. N.M. 2012), and CCA 201436049) involved service partnerships. If a partner were allowed to bifurcate the earnings from his/her partnership between investment and service-related income, the investment income piece would need to be analyzed for potential application of the net investment income rules under Section 1411.

Contact
Grace Kim
Principal, Washington National Tax Office
+1 202 521 1590

Josh Carrasco
Sr. Associate, Strategy & Performance Improvement
+1 832 476 3616


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