Claiming an Exemption from Self-Employment Tax as a Limited Partner? Think Twice
Limited partners claiming an exemption from Self-Employment Contributions Act (SECA) taxes may be putting themselves at risk – in certain circumstances. In fact, more recently, it has become even riskier. Why? Because the rules are unclear, and the IRS has prioritized this issue in examinations and successfully challenged exemption claims in court.
Unfortunately, neither the tax code nor regulations define the term ‘limited partner’. We share insights on the current state of the law and potential risks to limited partners who are considering claiming SECA tax exemptions.
Unsettled law and IRS scrutiny
Under the Internal Revenue Code, the distributive share of partnership income allocable to a “limited partner” is generally not subject to SECA tax, other than for certain guaranteed payments for services rendered.
Some taxpayers take the position that any taxpayer holding a limited partnership interest in a limited partnership formed under state law should be considered a limited partner for purposes of the SECA tax exception – regardless of the taxpayer’s level of activity in the partnership’s trade or business. However, the IRS has been challenging taxpayers taking such positions, and several recent court decisions that have considered this issue have found in favor of the government.
The IRS is giving the issue increased attention as one of its Large Business & International (LB&I) compliance campaigns. Through the SECA Tax compliance campaign, LB&I notes that individual partners – “including service partners in service partnerships organized as state-law limited liability partnerships, limited partnerships, and limited liability companies” – are making inappropriate claims of qualifying as limited partners that are not subject to SECA tax.
The Biden administration also sought to address the issue legislatively, proposing to eliminate the current exception from SECA tax for limited partners who provide services to and materially participate in the partnership’s trade or business.
How courts have ruled on the issue
The IRS has been successful in a series of cases challenging SECA tax exemption claims involving limited liability companies (LLCs) and limited liability partnerships (LLPs) – as well as, in one instance, potentially a state law limited partnership. However, that entity’s legal status was not considered by the court. We present several case law scenarios for consideration:
|
Case
|
Entity |
Outcome |
|
Renkemeyer, Campbell, & Weaver LLP v. Commissioner, 136 T.C. 137 (2011) |
Kansas limited liability partnership |
Members of the LLP law firm were not limited partners for SECA tax purposes and, therefore, income allocated to the partners was subject to SECA tax. |
|
Riether v. United States, 919 F.Supp.2d 1140 (D. N.M. 2012) |
LLC partnership |
Husband and wife were subject to SECA tax on their distributive shares from LLC. |
|
Vincent J. Castigliola, et ux., et al. v. Commissioner, TC Memo 2017-62 |
Mississippi Professional Limited Liability Company (PLLC) |
Members of PLLC in the practice of law were subject to SECA tax on their entire distributive share of the PLLC’s income, despite the fact that they received guaranteed payments commensurate with local legal salaries. |
|
George E. Joseph, T.C. Memo. 2020-65 |
Partnership for federal tax purposes, but status as state law limited partnership was not specifically considered by court |
Taxpayer was subject to SECA tax on his distributive share of partnership income, based on the taxpayer’s failure to demonstrate that he was a limited partner for purposes of SECA tax. |
Courts have not yet specifically addressed the availability of the exemption in the case of a state law limited partnership. However, the IRS is now beginning to tee up court cases to challenge limited partners in state law limited partnerships where the limited partners have not been allocated self-employment income with respect to their distributive share of partnership income.
One such case that may offer some clarity is the Soroban Capital Partners LP litigation, where two petitions were filed with the Tax Court by a New York hedge fund management company formed as a Delaware limited partnership. The petitions challenge the IRS’s characterization of partnership net income as net earnings from self-employment. According to the petitions, each of the three individual limited partners spent between 2,300–2,500 hours working for Soroban, its general partner, and various affiliates. This suggests that the taxpayer does not plan to dispute that the limited partners were “active participants” in the partnership business. Resolution of this case could finally compel the Tax Court to squarely address the question of whether a state law limited partner qualifies for the “limited partner” exception to SECA.
Mitigate risk until definitive guidance is delivered
While the IRS has been successful in arguing that active members of LLCs and LLPs are not limited partners for SECA tax purposes, the only case to date possibly involving a state law limited partnership failed to specifically address the issue. The pending litigation in Soroban Capital Partners LP could provide definitive direction.
Although there is currently no clear authority precluding “active” limited partners of a state law limited partnership from claiming exemption from SECA tax, such a position should be taken with caution and a clear understanding of the risks – including being subject to IRS challenge if audited. Moreover, the opportunity to take this position could close depending on the outcome of Soroban Capital Partners LP.
Written by Neal Weber and Justin Follis. Copyright © 2022 BDO USA, LLP. All rights reserved. www.bdo.com
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