This Journal of Taxation column, edited by Sheldon I. Banoff and Richard M. Lipton, comments on the IRS's and courts' positions on characterizing members of limited liability entities as "limited partners" and "general partners," for purposes of potential self-employment tax avoidance under Section 1402(a)(13).
Drucker & Scaccetti Special Consultant Ronald M. Wiener was extensively quoted in this article. Important tax consequences can turn on whether or not a member of a partnership or LLC is treated as a “limited partner.” He points out an important issue that the IRS failed to raise and the Tax Court did not address. Here is the article:
Who's a 'Limited Partner'? More Confusion Courtesy of Renkemeyer and Howell
In our February column we explored whether one is a "limited partner" or "general partner" for purposes of Section 1402(a)(13). We focused on two Tax Court decisions—Renkemeyer, Campbell & Weaver, LLP, 136 TC 137 (2011) and Howell, TC Memo 2012-303, RIA TC Memo ¶2012-303 —that have added to the decades-long confusion as to the proper characterization of members of state law limited partnerships, LLCs, LLPs, LLLPs, and other unincorporated limited liability entities as "limited partners" or "general partners" for purposes of each operative provision of the Code and Regulations where either or both terms appear. See Shop Talk, "Does Renkemeyer’s Legacy of Confusion Live On?," 118 JTAX 99 (February 2013).
As discussed herein, a reader has raised further exasperating questions as to the scope of Renkemeyer and Howell, and the Service's and courts' positions on characterizing members of limited liability entities as "limited partners" and "general partners," for purposes of potential self-employment (SE) tax avoidance under Section 1402(a)(13). But let's first reset the table for our readers before we knock some dishes off it.
In Renkemeyer, the Tax Court determined that the taxpayers' partnership interests in a law firm organized as an LLP should be considered "limited partner" interests for purposes of Section 1402(a)(13). Under that section, individuals owning "limited partner" interests may avoid SE taxes on their allocable shares of partnership income; "general partners" do not so qualify. The court in Renkemeyer reached the right result, i.e., that the attorney-partners' distributive shares of the law firm's business income for the relevant tax years were subject to SE tax.
Nevertheless, the Tax Court's decision adds to the confusion as to what approach is applied to determine the characterization of members of limited liability entities as "limited partners" or "general partners" for purposes of Section 1402(a)(13) (and other Code provisions, conceivably). The Service's brief (not cited or discussed in the opinion) makes it clear that the IRS would apply the state law characterization approach to subject all of the LLP's members to SE tax. Under this approach, the state law characterization of each member of the unincorporated limited liability entity as a general or limited partner would control for federal tax purposes. As an LLP is a general partnership under state law, the attorneys would not be "limited partners" for tax purposes under the state law characterization approach.
The taxpayers in Renkemeyer contended that they were "limited partners" for purposes for Section 1402(a)(13) because, among other things, their interests in the law firm enjoyed limited liability pursuant to state law. Hence, they argued, their distributive shares of the law firm's business income qualified for the Section 1402(a)(13) exception.
The Tax Court rejected the partners' position, but did not adopt the state law characterization approach raised in the Service's brief. Rather, the court created its own method of analysis, which was summarized in Howell as follows:
"In Renkemeyer, ... we applied accepted principles of statutory construction to decide whether the taxpayer's partnership interests in a law firm should be considered limited partner interests for purposes of section 1402(a)(13), stating as follows:
"‘The insight provided reveals 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 towards Social Security coverage. The legislative history of section 1402(a)(13) 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), for liability for self-employment taxes.'
"This Court held that the taxpayers were not limited partners for purposes of section 1402(a)(13) because the distributive shares received ‘arose from legal services ... [the taxpayers] performed on behalf of the law firm’ and ‘did not arise as a return on the partners' investment.’"
One of your editors has previously analyzed in some detail the uncertain (and potentially troubling) scope of Renkemeyer, both with respect to interests of members of pass-through entities for purposes of Section 1402(a)(13) and (if its approach were extended) for other provisions of the Code and Regulations. See Banoff, "Renkemeyer Compounds the Confusion in Characterizing Limited and General Partners—Parts 1 and 2," 115 JTAX 306 (December 2011) and 116 JTAX 300 (June 2012).
In Howell, the Tax Court again was asked to address whether a member of a limited liability entity (this time, an LLC) should be characterized as a "limited partner" or "general partner" for purposes of Section 1402(a)(13). The Tax Court cited Renkemeyer in its introduction, but apparently failed to apply Renkemeyer in its analysis and holding. As a result, the scope of Renkemeyer remains confusing, as discussed in our February Shop Talk column.
Like Renkemeyer, Howell involved the contention by a member of an unincorporated limited liability entity that she was a "limited partner" whose share of earnings was not subject to SE tax pursuant to Section 1402(a)(13). At issue was whether taxpayers Lauren and Michael Howell were liable for SE tax under Section 1401 in 2000 and 2001 on payments made to Lauren by Intelemed, LLC.
Intelemed was a medical technology company that provided software and hardware to hospitals. It was a partnership for federal income tax purposes. Intelemed deducted its payments to Lauren as guaranteed payments under Section 707(c) on its Form 1065 tax returns for 2000 and 2001, and reported the guaranteed payments on her Schedules K-1 for such years. The Howells did not report the payments as subject to SE tax on their (joint) Form 1040 tax returns for those years, but rather as partnership distributions.
Of the numerous alternative arguments raised by the IRS, the one most relevant to this column was the contention that Lauren "was an active participant in Intelemed and consequently she may not exclude the payments from her net earnings from self-employment under section 1402(a)(13)." The Service's brief discusses Renkemeyer and quotes the court's determination therein that the intent of Section 1402(a)(13), based on the statute and legislative history, was to "ensure that individuals who merely invested in a partnership and who were not actively participating in the partnership's business (which was the archetype of limited partners at the time)" would not have net earnings from self-employment (NEFSE); and conversely, that the legislative history "does not support the holding that Congress contemplated excluding partners who performed services for a partnership in their capacity as partners" from SE taxes.
The IRS contended that Lauren was active in Intelemed, and not simply a passive investor. Lauren's rendering of services (so as to distinguish her from being a "passive investor") was an issue in Howell. "In contrast, in Renkemeyer, virtually all of the LLP's income was attributable to legal services provided by the taxpayer-partners and employees."
Although Lauren had no background in engineering or computer technology (unlike her husband, an employee of Intelemed), the IRS claimed that there was evidence that, among other things, she signed contracts on behalf of Intelemed, made significant purchases for Intelemed, executed tax returns on behalf of Intelemed, and received a stream of payments consistent with compensation. Finally, the Service contended that Lauren's purported capital contributions to the LLC (all non-cash) "are not the type of contributions typically made by a passive investor." Lauren's capital contributions, as described in the LLC's operating agreement, were intellectual property, a business plan, and organizational design at Intelemed's formation.
The taxpayers, appearing pro se, contended that Lauren was a "limited partner of Intelemed" and that therefore her distributive share of income from Intelemed was excluded from her NEFSE. The court stated that the taxpayers appeared to contend that Lauren was not actively engaged in the business and implied that she did not receive the payments as remuneration for services she rendered to Intelemed.
The Tax Court held that Lauren was subject to SE tax, but it did not strictly follow Renkemeyer. Had it done so, the court would have held Lauren not to be a "limited partner," which it did not do. Although the opinion in Howell, as described above, quotes essentially the same portion of Renkemeyer as appears in the Service's brief, the Howell opinion, in its analysis of the arguments, does not apply or even cite Renkemeyer. Rather, the Howell court determined, among other things, that a "limited partner" must include "guaranteed payments from self-employment" under Section 1402(a)(13) in computing SE tax if those payments were received "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." The taxpayers bore the burden of proving that Lauren did not receive the payments at issue in exchange for services she rendered to or on behalf of Intelemed.
The Tax Court concluded that the record established that Lauren "performed services for Intelemed and that she was not merely a passive investor in Intelemed." The court found that "the payments to Mrs. Howell were, to some extent, payments for services she rendered to Intelemed." Moreover, the taxpayers did not carry their burden of proving the extent to which the payments did not constitute payments for services rendered. Accordingly, the court sustained the Service's determination of Lauren's liability for SE tax.
The Howell court did not make a determination that Lauren's interest in the LLC was "not that of a limited partner," which was at the heart of Renkemeyer’s analysis with respect to the nature of the law partners' LLP interests. Rather, the Howell opinion seems to circumvent the battle of "limited partner" vs. "general partner" characterization, and instead focuses on Lauren's share of the payments or distributive share of income being guaranteed payments for services, so as to be subject to SE taxes (even if she were a "limited partner" for tax purposes).
Further evidence that the Howell court had no interest in defining Lauren's status as a "general partner" (i.e., not a "limited partner") under Section 1402 is the court's failure, in its discussion of alternative grounds for upholding SE tax treatment, to raise the potential characterization of Lauren as a "general partner." The opposite is true: in a footnote the court implicitly views Lauren's LLC interest as that of a "limited partner" for purposes of Section 1402(a)(13).
Our reading of Howell (and the Howell court's above-described method of analysis) is that Howell studiously avoided Renkemeyer’s controversial definitional battle of "limited partner" vs. "general partner." While the Howell opinion gives lip service to Renkemeyer in its "Introduction," Howell clearly did not want to (and in fact did not) address the taxpayers' contention that "Mrs. Howell is a limited partner of Intelemed."
In retrospect, we viewed Howell as making Renkemeyer superfluous, because it did not matter whether or not Lauren was a "limited partner" or a "general partner"—the fixed payments she received (effectively found to be, and referred to by the court as, "guaranteed payments for services") that were at issue in the case were subject to SE tax in either event.
Ronald M. Wiener, of the Philadelphia tax and CPA firm of Drucker & Scaccetti, P.C., and a prior contributor to this column, writes to us about a nuance of Howell that we failed to cover in our February column. Although the case focused on the fixed payments for services paid to Lauren, she was allocated additional income for the years in question that presumably constituted her distributive share of partnership income. It is only the distributive share that is subject to SE taxes if Lauren is characterized as a "general partner" under Section 1402(a)(13), but is not subject to SE tax if she is characterized as a "limited partner." (In contrast, as noted above, guaranteed payments to a partner for services are subject to SE tax regardless of one's status as a "limited partner" or "general partner.") Mr. Wiener writes:
"I read the February Shop Talk column and reviewed the court's opinion. The question I was most interested in was how the IRS and the Tax Court treated Mrs. Howell's share of ordinary income from the LLC, over and above the income that was characterized on the returns as guaranteed payments. It turns out the answer to my question is pretty clear: the Service didn't assert that the residual income was net income from self-employment, and the court's opinion doesn't address the issue. It seems to me that this might have been the only potential issue in the case to which the court's Renkemeyer discussion might have been relevant. Under the circumstances, I'm disappointed that the court found it necessary to talk about Renkemeyer, let alone seem to add credibility to that opinion by endorsing its conclusions.
"As you and others have pointed out, the Renkemeyer opinion is a bit of a mess, failing as it did to recognize that there were no ‘limited partners’ in the LLP at issue in Renkemeyer and that all of the partners were general partners as a matter of state law. (As a former partner in a law firm that converted itself from a general partnership into an LLP under a state law that provided similar attributes to partners in an LLP, I was very cognizant of the limited protection provided to me by LLP status. I've been told that some states have LLP laws that provide liability protection to the partners that's comparable to the protection given to traditional limited partners, but I have no personal experience with that kind of statute.)
"The doctrine of judicial restraint easily could have permitted the Tax Court to decide Renkemeyer entirely on the ground that all the partners were ‘general partners’ and that the limited protection provided by LLP status did not provide attributes equivalent to those of a limited partner in a state law limited partnership. It seems to me that, absent clear legislative action by Congress, the confusion will continue.
"Thanks again to Shop Talk's editors for your thoughtful analysis."
We re-checked the Howell opinion and the Service's Opening Brief, and we agree with Mr. Wiener's observation: the IRS and the Tax Court may have missed the boat by not treating Lauren's share of Intelemed's ordinary income as subject to SE tax. The Howell opinion states that on its 2000 Form 1065 Intelemed allocated to Lauren $4,757 of ordinary income and $63,850 of guaranteed payments. On its 2001 Form 1065 Intelemed reported $10,713 of ordinary income and $149,500 of guaranteed payments to Lauren.
In its notice of deficiency for years 2000-2001, the IRS determined that Lauren received from Intelemed guaranteed payments of $63,850 and $149,500, respectively, and ordinary income of $4,757 and $10,713 for 2000 and 2001, respectively. The IRS determined that Lauren received SE income of $63,850 for 2000 and $149,500 for 2001.
On their Form 1040 joint tax returns for 2000-2001, the Howells attached a Schedule SE ("Self-Employment Tax") only for Michael, and thus did not report any of Lauren's ordinary income or guaranteed payments as subject to SE tax. That reporting position would be consistent with characterizing Lauren as a "limited partner" for tax purposes, as a partner's allocable share of ordinary income is exempted from SE tax under Section 1402(a)(13), unlike the partner's guaranteed payments for services.
Page 2 of the Service's Opening Brief states that the notices of deficiency (for 2000 and 2001) "are consistent with the items on the returns provided by [Michael and Lauren Howell], except for the application of self-employment tax on guaranteed payments received by Ms. Howell. Accordingly, this is the only adjustment at issue in this case."
This failure to characterize Lauren as subject to SE tax on her ordinary income (i.e., treat her as a "general partner" with respect to her LLC interest in Intelemed) for 2000 and 2001 is all the more confusing, in light of the Service's requested findings of fact from the Tax Court. Request No. 71 states: "During the examinations of Intelemed and petitioners, respondent's examiners determined that Ms. Howell was active in Intelemed, and could not be considered a limited partner for self-employment tax purposes under section 1402(a)(13)." As is evident from the opinion, the Tax Court made no such finding of fact that Lauren was other than a limited partner for purposes of Section 1402(a)(13).
We thank Mr. Wiener for his observations. As we observed in our February column, Howell leaves us with more questions than answers about who is a "general partner" and who is a "limited partner" for tax purposes. The case does not (explicitly) undercut Renkemeyer, but it certainly does nothing to dispel the confusion Renkemeyer has wrought. Mr. Wiener's observations add to the mystery—and Howell!
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