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By David I. Kempler, Esq. and Elizabeth Carrott Minnigh, Esq.
Buchanan Ingersoll & Rooney PC, Washington, DC
In Renkemeyer v. Comr., 136 T.C. No. 7 (2011), the Tax Court struck down limited liability partnership's special allocation of 87.557% of its net business income to its S corporation partner, which was owned by an ESOP whose beneficiaries were the firm's individual partners, and upheld the IRS's determination to reallocate that amount to individual partners according to their respective profits and loss interests. Additionally, the Tax Court found that the individual partners' distributive shares of firm's net business income from legal services were subject to self-employment tax because the individual partners performed legal services for the firm in their capacity as partners and, therefore, their distributive shares were attributable to these services rather than merely to return on investment. This case brings into question whether any partner of a limited liability partnership or member of a limited liability company who is active in the business will ever be treated as limited partner for federal tax purposes.
Under §701, a partnership is not subject to federal income tax; rather, the partners are liable for tax in their individual capacities. Under §704, each partner must take into account his distributive share of the partnership's income, gain, loss, deductions, and credits, which share generally is determined by the governing partnership agreement (whether written or oral). If the partnership agreement fails to set forth how a partner's distributive share is to be determined, or if the allocation provided in the partnership agreement does not have substantial economic effect, then the partner's distributive share is determined in accordance with the partner's interest in the partnership pursuant to §704(b). Moreover, a partner's distributive share is included in the determination of self employment taxes unless an exception applies.
In 2004, P, a Kansas limited liability partnership engaged in the practice of law, had three individual partners who were attorneys performing legal services and a fourth partner RCGW, which was an S corporation owned by a tax-exempt ESOP whose beneficiaries were the law firm's three attorney partners. The three attorney partners each had a one-third capital interest and a 30% profits and loss interest in the law firm and RCGW had a 10% profits and loss interest in the law firm. In 2005, the partnership agreement was restated to remove the interest of RCGW. During the year at issue, approximately 99% of the law firm's net business income was derived from legal services rendered by the three individual attorney partners and only 1% was generated as a result of the recognition of passthrough income from RCGW but the law firm allocated 87.557% of its net business income to the S corporation. The IRS determined that the special allocation did not reflect economic reality and found that the partnership agreement did not support the special allocation. Accordingly, the IRS reallocated the law firm's net business income to its partners on the basis of each partner's profits and loss interest. The IRS further determined that the three attorney partners' distributive shares of the law firm's net business income were net earnings from self-employment subject to tax on self-employment income.
The tax matters partner asserted that the special allocation of the net business income of the law firm for its 2004 tax year was proper because the allocation was made pursuant to the provisions of the partnership agreement. However, the partnership agreement effective for the 2004 tax year was not available and the 2005 partnership agreement provided that the allocation of the partners' distributive shares was to be made according to (1) the ownership interests of the partners, except that (2) the allocation to each partner is to be limited to the average monthly collection of fees from the partner's clients, with the further exception that the allocation is not to be less than $5,000 per calendar month. Assuming that this provision was part of the partnership agreement effective for the 2004 tax year, the Tax Court concluded that the 2004 special allocation in which RCGW received 87.557% of the law firm's net income was not consistent with the partnership agreement.
Therefore, because the partnership agreement did not control, under §704(b), the Tax Court determined that it must look to the partners' respective interests in the partnership (determined by taking into account all facts and circumstances) to determine the proper allocation of the law firm's net business income. In determining the partners' respective interests in a partnership, the Tax Court stated that the following factors are relevant: (a) the partners' relative capital contributions; (b) the partners' respective interests in profits and losses; (c) the partners' relative interests in cashflow and other nonliquidating distributions; and (d) the partners' relative rights to capital upon a liquidation.1
In applying the first factor, the Tax Court noted that according to the partnership's Form 1065 and the partners' respective Schedules K-1 for the 2004 tax year, RCGW made no capital contributions in the 2004 tax year to the partnership, whereas the individual partners each contributed capital to the partnership during the 2004 tax year. Consequently, the Tax Court concluded that the first factor did not support the law firm's special allocation for the 2004 tax year.
In applying the second factor, the Tax Court noted that according to the Schedules K-1, the individual partners each held a 33.3333% capital interest and a 30% profits and loss interest, whereas RCGW held a 10% profits and loss interest. Consequently, the Tax Court concluded that the second factor did not support the law firm's special allocation for the 2004 tax year.
In applying the third factor, the Tax Court noted that according to statement 10 on the partnership's Form 1065 and the partners' respective Schedules K-1 report RCGW received no distributions from the partnership, whereas the individual partners received distributions. Consequently, the Tax Court concluded that the third factor did not support the law firm's special allocation for the 2004 tax year. Finally, with respect to the fourth factor, the Tax Court noted that the record did not include any information with respect to this factor for the 2004 tax year or earlier. Consequently, the Tax Court concluded that the fourth factor did not support the law firm's special allocation for the 2004 tax year. Accordingly, the Tax Court concluded that the facts and circumstances supported the reallocation of the partnership's net business income for its 2004 tax year consistent with the partners' profits and loss interests as determined by the IRS.
The Tax Court then turned its attention to whether the attorney partners' distributive shares of the law firm's business income for the 2004 and 2005 tax years were subject to self-employment tax. Under §1401(a), a tax is imposed on the self-employment income of every individual for a taxable year. Self-employment income is defined in §1401(b) as the net earnings from self-employment excluding (a) the portion in excess of the Social Security wage base limitation for the year and (b) all earnings from self-employment if the total amount of the individual's net earnings from self-employment for the taxable year is less than $400. Net earnings from self-employment is defined under §1402(a) as the gross income derived by an individual from any trade or business carried, less the deductions allowed which are attributable to such trade or business, plus his distributive share (whether or not distributed) of certain income or loss from any trade or business carried on by a partnership of which he is a member. In general, under §702(a)(8), a partner must include his distributive share of partnership income in calculating his net earnings from self-employment. Fees for services, like those generated by a law partnership, are part of the partners' distributive shares, and consequently, are generally included in calculating net earnings from self-employment, unless an exclusion applies.
Section 1402(a)(13) excludes from the distributive share of a limited partner any item of income or loss other than guaranteed payments to that partner for services actually rendered to or on behalf of the partnership in the nature of remuneration for those services. The tax matters partner posited that the individual partner's interests in the law firm, organized as a Kansas limited liability partnership, each should be considered a limited partner's interest in a limited partnership for purposes of §1402(a)(13). The tax matters partner maintained that the individual partner's respective interests in the law firm share characteristics of those of a limited partner in a limited partnership because (a) their interests are designated as limited partnership interests in the organizational documents, and (b) their interests in the law firm enjoy limited liability pursuant to Kansas law.
A limited partnership has two fundamental classes of partners: (a) general partners, who typically have management power and unlimited personal liability and (b) limited partners, who lack management powers but enjoy immunity from liability for debts of the partnership. In contrast, all partners of a limited liability partnership enjoy limited liability protection and may have management powers. The Tax Court noted that §1402(a)(13), originally enacted as §1402(a)(12) under the Social Security Amendments of 1977,2 was enacted before entities such as limited liability partnerships were contemplated. Additionally, the Tax Court noted that §1402(a)(13) does not define "limited partner." Proposed regulations defining "limited partner" for purposes of this section were introduced in 1997 but never adopted after controversy over whether the Treasury department had exceeded its authority in adopting them.3 Since that time, considerable ambiguity about the term "limited partner" has existed. Accordingly, the Tax Court stated that it must look both to the ordinary meaning of the term and, if ambiguous, the legislative history to ascertain Congress' intent. The Tax Court concluded that the term "limited partner" had become obscured over time because of the increasing complexity of partnerships and other flowthrough entities; therefore, the Tax Court turned to the legislative history for guidance.
Upon review of the legislative history,4 the Tax Court determined that §1402(a)(13) was enacted 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 and that Congress did not contemplate excluding partners who performed services for a partnership in their capacity as partners from liability for self-employment taxes.
The Tax Court noted that aside from a nominal amount of income arising from recognition of certain pass-through income from the S corporation partner, all of the law firm's revenues were derived from legal services performed by the individual partners in their capacities as partners, and that each partner contributed only $110 for their respective partnership units. Consequentially, the Tax Court determined that the partners' distributive shares of the law firm's income did not arise as a return on the partners' investment and were not "earnings which are basically of an investment nature." Rather, the Tax Court concluded that the individual partners' distributive shares arose from legal services they performed on behalf of the law firm. Therefore, the Tax Court held that the respective distributive shares of individual partners arising from the legal services they performed in their capacity as partners in the law firm are subject to self-employment taxes for the 2004 and 2005 tax years.
The Tax Court's decision in this case suggests that a partner in a service limited liability partnership or a member in a limited liability company who performs services for that entity is going to be subject to self-employment tax on all earnings passing out of the limited liability partnership or limited liability company. The decision did not address the tax treatment where the income generated was due not almost entirely just to services but also income from capital and it is possible that the Tax Court would treat any income as subject to self-employment taxes absent a true second class of ownership interests that were purely investment interests. Accordingly, until regulations are adopted defining "limited partner," considerable ambiguity may continue to exist for many service partners.
For more information, in BNA's Tax Management Portfolios, see Sloan and Sullivan, 712 T.M., Partnerships — Taxable Income; Allocation of Distributive Shares; Capital Accounts, and in Tax Practice Series, see ¶4090, Distributive Shares & Special Allocations, and ¶4100, Limited Liability Companies.
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