Lawyers in Professional Limited Liability Company Subject to Self-Employment Tax

(Parker Tax Publishing April 2017)

The Tax Court held that Lawyers who were members of a professional limited liability company were functionally the equivalent of general partners and thus could not avail themselves of the exception in Code Sec. 1402(a)(13) and exclude certain partnership distributions from self-employment income. However, the court also concluded that the lawyers were not subject to income tax on unidentified amounts in a trust account and were not liable for accuracy-related penalties. Castigliola v. Comm'r, T.C. Memo. 2017-62.

Vincent Castigliola, John Banahan, and Harry Mullen are attorneys licensed to practice law in Mississippi. Originally, they practiced law through a general partnership, but in 2001, they reorganized their law firm as a professional limited liability company (PLLC).[ named Bryan, Nelson, Schroeder, Castigliola & Banahan, PLLC (PLLC). In 2005, the PLLC's office and many of its records were destroyed in Hurricane Katrina, but the members recovered and continued their practice.

For 2008-2010, Castigliola, Banahan, and Mullen were engaged in the practice of law solely through the PLLC. They were members of the PLLC during those years, and the PLLC is, and has always been, member-managed. The PLLC has never had a written operating agreement. The PLLC timely filed Forms 1065, U.S. Return of Partnership Income, for 2008, 2009, and 2010. During these years, the members' compensation agreement required guaranteed payments to each member; the guaranteed payments were commensurate with local legal salaries as determined by a survey of legal salaries in the area. Any net profits of the PLLC in excess of amounts paid out as guaranteed payments were distributed among the members in accordance with the members' agreement.

Castigliola, Banahan, and Mullen shared the same CPA. The CPA was an accountant for many years and served in several positions in the National Association of State Boards of Accountancy. He also served eight years with the Alabama State Bar of Accountancy. Around the time the PLLC was formed in 2001, the members met with the CPA to discuss the new PLLC entity. The CPA had prepared federal income tax returns for Castigliola, Banahan, and Mullen (and for the general partnership that preceded the PLLC) for many years and was familiar with the history of their law firm as a result. On the basis of the CPA's advice, they reported all guaranteed payments from the PLLC as self-employment income subject to self-employment tax, but they did not remit self-employment tax on the amounts in excess of their distributive shares over the guaranteed payments.

As part of its legal practice, the PLLC handled subrogation payments for State Farm Mutual Automobile Insurance Co. (State Farm). The PLLC negotiated payment plans with uninsured individuals involved in automobile accidents with State Farm policyholders. When these uninsured individuals made payments to the PLLC, it deposited the payments into the trust account. Approximately twice per year the PLLC disbursed subrogation payments from its trust account to State Farm. When it disbursed a subrogation payment to State Farm, the PLLC also transferred the compensation due to the PLLC from its trust account to its operating account. At the end of 2010, the trust account held $15,167 of undistributed funds; the members do not know to whom this amount belongs.

Self-Employment Tax Exception for Certain Partnership Distributions

Code Sec. 1401 imposes a tax on the self-employment income of every individual for a tax year (self-employment tax). Self-employment income is defined as the net earnings from self-employment derived by an individual during any tax years excluding (1) the portion in excess of the social security wage base limitation for the year as well as (2) all earnings from self-employment if the total amount of the individual's net earnings from self-employment for the tax year is less than $400.

Code Sec. 1402 defines net earnings from self-employment as the gross income derived by an individual from any trade or business carried on by such individual, less applicable deductions, plus his or her 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 or she is a member.

Code Sec. 1402(a)(13) provides that self-employment income does not include the distributive share of any item of income or loss of a limited partner, as such, other than guaranteed payments described in Code Sec. 707(c) 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.

In Renkemeyer, Campbell, & Weaver, LLP v. Comm'r, 136 T.C. 137 (2011), which involved a Kansas limited liabililty partnership engaged in the practice of law, the Tax Court noted that Code Sec. 1402(a)(13) was enacted before limited liability companies were widely used or generally treated as partnerships for federal tax purposes. The court said that the meaning of "limited partner" is not necessarily confined solely to the limited partnership context.

IRS Deficiency Notice

The IRS assessed self-employment tax deficiencies against Castigliola, Banahan, and Mullen because, it argued, the PLLC members were not limited partners for the purposes of Code Sec. 1402(a)(13) and therefore, the exclusion from self-employment tax did not apply. The members rejected this assessment, contending that the exclusion in Code Sec. 1402(a)(13) applied to the distributive shares of income in excess of their guaranteed payments.

Additionally, the IRS found that the PLLC members had additional income in 2010 in the form of undistributed funds held in the trust account and concluded they were liable for accuracy-related penalties under Code Sec. 6662(a) for 2008, 2009, and 2010 because they had underpayments due to substantial understatements of income tax or negligence.

Tax Court's Decision

With respect to whether the PLLC members were liable for the additional self-employment tax, the court said that the first inquiry to be made was whether the person claiming the Code Sec. 1402(a)(13) exemption held a position in an entity treated as a partnership that was functionally equivalent to that of a limited partner in a limited partnership. Because Castigliola, Banahan, and Mullen were all members of a member-managed PLLC, the court framed the issue as whether a member of such a PLLC is functionally equivalent to a limited partner in a limited partnership.

The exact meaning of "limited partner," the court observed, may vary slightly from state to state and so the court looked to documents drafted by The Uniform Law Commission: the Uniform Limited Partnership Act (ULPA (1916)) and the Revised Uniform Limited Partnership Act (RULPA (1976)). The court noted that amendments had been added to RULPA (1976) in 1985 (RULPA (1985)) and that versions of these uniform acts have been adopted in most states, sometimes with modifications. In particular, Mississippi adopted RULPA (1985) with some modifications in 1987. In terms almost identical to those of ULPA (1916) and RULPA (1976), the version of the limited partnership act that Mississippi adopted in 1987 and which was effective throughout the years at issue provided that a "limited partner" would lose limited liability protection if "in addition to the exercise of his rights and powers as a limited partner, he participates in the control of the business." Like RULPA (1976), Mississippi's version provides safe harbors for various activities a limited partner may perform without losing limited liability protection.

Common to each of the definitions of "limited partner," the court noted, were the primary characteristics of limited liability and lack of control of the business. In the instant case, the respective interests in the PLLC held by Castigliola, Banahan, and Mullen made each a member of the PLLC, which was member managed. Therefore, the court said, management power over the business of the PLLC was vested in each of them through the interest each held. The PLLC had no written operating agreement, nor was there any evidence to show that any member's management power was limited in any way. Furthermore, all members participated in control of the PLLC. For example, they all participated in collectively making decisions regarding their distributive shares, borrowing money, hiring, firing, and the rate of pay for employees. They each supervised associate attorneys and signed checks for the PLLC. On the basis of those facts, the court concluded that the respective interests held by Castigliola, Banahan, and Mullen could not have been limited partnership interests under any of the limited partnership acts. Therefore, the court held, they were not limited partners under Code Sec. 1402(a)(13) and their distributive shares in excess of the guaranteed payments were subject to self-employment tax.

Moreover, the court said, a limited partnership must have at least one general partner. The members had testified that all members participated equally in all decisions and had substantially identical relationships with the PLLC. Since by necessity at least one of the members must have occupied a role analogous to that of a general partner in a limited partnership, and because all of the members had the same rights and responsibilities, the court found that they all must all have had positions analogous to those of general partners in a limited partnership.

Trust Funds Aren't Taxable to PLLC Members

The Tax Court held that the funds remaining in the PLLC's trust account were not income to the PLLC members. The court noted that (1) the members testified credibly that the funds the IRS identified did not belong to the members; and (2) the IRS offered no evidence or arguments to support its contention that the members could withdraw these funds as fees.

Court Rejects Penalties Assessment

Finally, the Tax Court disagreed with the IRS that the PLLC members were liable for the penalties assessed by the IRS under Code Sec. 6662. The court noted that there is a substantial understatement of income tax for any tax year if the amount of the understatement for the tax year exceeds the greater of 10 percent of the tax required to be shown on the return for the tax year or $5,000. In looking at the calculations involving the various returns, the court found that the members' returns did not cross this threshold and thus the members did not substantially understate their income tax for any year at issue. Further, the court concluded that the members were not liable for the negligence penalty because they reasonably relied on the advice of their CPA and because there were no regulations or administrative or judicial guidance to assist the members at the time the returns were prepared.

For a discussion of partnership income and self-employment taxes, see Parker Tax ¶20,590.

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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