IRS Rejects LLC Member's Argument That Income Attributable to Capital Isn't Self-Employment Income

(Parker Tax Publishing October 2016)

The IRS Office of Chief Counsel (IRS) advised that the manager and president of a limited liability company (LLC) that operated franchise restaurants was not a limited partner and thus was subject to self-employment tax on his distributive share of the LLC's income as well as the guaranteed payments he received from the LLC. The IRS rejected the LLC's position that the individual's income should be bifurcated for self-employment tax purposes between income attributable to capital invested, and compensation for services rendered. CCA 201640014.

Background

An individual purchased franchise restaurants and contributed the restaurants to a limited liability company (LLC) taxed as a partnership for federal tax purposes. During the years at issue, the partnership's gross receipts and net ordinary business income were almost entirely attributable to food sales. The franchisee owns a majority interest in the partnership.

The franchise agreements require the franchisee to personally devote full time and best efforts to operating the restaurants. The partnership's operating agreement provides that the franchisee is the partnership's operating manager, president, and CEO and must conduct its day-to-day business affairs. In particular, the franchisee has authority to manage the partnership, make all decisions, and do anything reasonably necessary in light of its business and objectives. The franchisee has ultimate responsibility for hiring, firing, and overseeing all the partnership's employees, including members of the executive management team.

Self-Employment Tax Rules Applicable to Partnerships

Code Sec. 1402(b) generally provides that the term "self-employment income" means the net earnings from self-employment derived by an individual during any tax year. The term "net earnings from self-employment" is defined in Code Sec. 1402(a) as the gross income derived by an individual from any trade or business carried on by such individual, less certain deductions which are attributable to such trade or business, plus his distributive share (whether or not distributed) of income or loss described in Code Sec. 702(a)(8) from any trade or business carried on by a partnership of which he is a member, with certain enumerated exclusions. Code Sec. 702(a)(8) provides that in determining a partner's income tax, each partner must take into account separately his distributive share of the partnership's taxable income or loss, exclusive of items requiring separate computation.

Code Sec. 1402(a)(13) excludes from self-employment income the distributive share of any item of income or loss of a limited partner other than guaranteed payments described in Code Sec. 707(c) made to that partner for services actually rendered to or on behalf of the partnership to the extent that those payments are established to be in the nature of remuneration for those services.

Observation: Code Sec. 1402(a)(13) was originally enacted as Code Section 1402(a)(12) in 1977 before entities such as LLCs were widely used. The applicable statute did not, and still does not, define a "limited partner." At the time of the statute's enactment, the Revised Uniform Limited Partnership Act of 1976 provided that a "limited partner" would lose his limited liability protection if, in addition to the exercise of his rights and powers as a limited partner, he took part in the control of the business.

Partnership's Position

The partnership treated the franchisee as a limited partner for purposes of Code Sec. 1402(a)(13), and included only the guaranteed payments in the franchisee's net earnings from self-employment, not his full distributive share. The partnership argued that the franchisee's income from the partnership should be bifurcated for self-employment tax purposes between the franchisee's (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. According to the partnership, as a retail operation, the partnership requires capital investment for buildings, equipment, working capital and employees and, in fact, the partnership and the franchisee made significant capital outlays to acquire and maintain the restaurants. The partnership said that it derives its income from the preparation and sale of food products by its employees, not the personal services of the franchisee.

IRS Chief Counsel's Advice

The IRS Office of Chief Counsel (IRS) advised that the franchisee is not a limited partner within the meaning of Code Sec. 1402(a)(13) and thus is subject to self-employment tax on his distributive share from the partnership. In reaching its conclusion, the IRS looked at the Tax Court's decision in Renkemeyer, Campbell, and Weaver LLP v. Comm'r, 136 T.C. 137 (2011), where the Tax Court held that that practicing lawyers in a law firm organized as a Kansas limited liability partnership (LLP) were not limited partners within the meaning of Code Sec. 1402(a)(13) and thus were subject to self-employment taxes. In that decision, the Tax Court discussed Kansas state law under which an LLP is considered a general partnership and discussed the ordinary meaning of the term "limited partnership." The court opined that a limited partnership has two fundamental classes of partners: general and limited. General partners, the court said, typically have management power and unlimited personal liability. On the other hand, limited partners lack management powers but enjoy immunity from liability for debts of the partnership. According to the Tax Court, it is generally understood that a limited partner can lose his limited liability protection were he to engage in the business operations of the partnership. Consequently, the interest of a limited partner in a limited partnership is generally akin to that of a passive investor.

According to the IRS, the insight provided by the Tax Court reveals that the intent of Code Sec. 1402(a)(13) is to ensure that individuals who merely invest in a partnership and who are not actively participating in the partnership's business operations (which was the archetype of limited partners at the time) do not receive credits toward social security coverage. The legislative history of Code Sec. 1402(a)(13), the IRS said, 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.

For a discussion of the self-employment tax liability of LLC members, see Parker Tax ¶29,535.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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