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Editor: Paul L. Caron, Dean
Pepperdine University School of Law

Monday, July 3, 2017

Schwidetzky:  Castigliola, Hardy, And Tax Planning For Self-Employment Taxes

SchwidetzkyTaxProf Blog op-ed:  Castigliola, Hardy, and Tax Planning for Self-Employment Taxes, by Walter Schwidetzky (Baltimore):

Recently, the Tax Court stuck to its Renkemeyer guns in the unpronounceable, but fairly important, case of Castigliola.[1]  (Admittedly, I am ill-positioned to complain about names that are difficult to pronounce).  Contemporaneously, the Tax Court arguably held in Hardy,[2] to my knowledge for the first time, that the interest of an owner in an entity other than a state-law limited partnership should be treated as a limited partnership interest. Some context:

Generally, the IRS takes the view that a partner cannot be an employee of a partnership, and recently Treasury issued Temporary Regulations that repeat this view (though Treasury did ask for comments).[3]  I am aware of no cases to the contrary. Indeed, a recent 10th Circuit decision supports the government view.[4]  Thus, currently one has to assume that the entirety of a general partner's share of partnership business income is self-employment income, which is subject to self-employment taxes (e.g. Social Security and Medicare taxes). Traditional investment income, such as dividends, is not treated as self-employment income.[5] Partnership income of a limited partner is generally not self-employment income, except for I.R.C. § 707(c) guaranteed payments paid to the limited partner for services rendered to the partnership.[6]

Taxpayers have attempted, to date without success, to extend this limited partner treatment to interests in non-state law limited partnerships.  Renkemeyer[7] involved a law firm of tax lawyers organized as an LLP (i.e. a limited liability partnership, which is a state law general partnership with a liability shield—permitted in all states).  To oversimplify the facts a bit, in 2004 the partners recapitalized the LLP into “general managing partner partnership units” and “investing partnership units”, with the general managing partner partnership units having full authority to act on behalf of the partnership.  The vast majority of the LLP income was allocated to the investing partnership units.  The partners claimed that these latter interests should be treated as limited partnership interests and be free from self-employment taxes.  The court rejected this approach and held that all of the partnership income was subject to self-employment taxes.  In concluding that the partners did not constitute limited partners, the court noted that the  term “limited partner” was not defined in I.R.C. § 1402(a)(13) (the relevant tax statute), and that it would apply statutory construction principles and look at the history of the regulatory interpretation of the exception as well as the legislative history I.R.C. § 1402(a)(13).  The court did not insist that the state law definition of a limited partner was controlling.  But, in the court’s view, limited partners are akin to passive investors who receive a return on their investment. In contrast, the three law partners had management powers and performed services that generated the LLP’s income. The court opined:

The legislative history of section 1402(a)(13)  does not support a holding that Congress contemplated excluding partners who performed services in their capacity as partners (i.e. acting in the manner of self-employed persons), from liability for self-employment taxes.[8]

The Tax Court reached the same conclusion in the LLC context in Castigliola.  There, three lawyers practiced law through a member-managed LLC taxed as a partnership.  They paid themselves I.R.C. § 707(c) guaranteed payments and essentially claimed that the excess of the net income of the LLC over the guaranteed payments was exempt from self-employment taxes.  The lawyers argued that as to this excess, they received their payments as limited partners within the meaning of I.R.C. § 1402(a)(13).  Citing Renkemeyer, the Tax Court held that because members of a member-managed LLC participate in the control of the LLC, they cannot be limited partners.  The court further said that all of the members “had positions analogous to those of general partners in a limited partnership.”   Accordingly, no part of the income of the LLC could be excluded from self-employment income.

The taxpayer was more successful in Hardy.  There a surgeon held a passive interest in an LLC that operated a surgery center.  (The LLC was apparently member-managed.) While the surgeon used the surgery center for his surgeries, he was not involved in the surgery center’s management and treated the interest in the surgery center as a separate activity from his surgery practice.  As a consequence, the income from the LLC interest was passive income to the surgeon under I.R.C. § 469.  At one point the court seems to say that the surgeon’s interest in the LLC is a limited partnership interest:  “The Commissioner argues that the section 1402(a)(13) exclusion does not apply in this case. He argues that because Dr. Hardy performs surgeries at [the surgery center], he is not acting as a limited partner. We disagree.”  So far, so good, though I would have preferred an express statement that the taxpayer qualified as a limited partner. But later the court states:  “Accordingly, Dr. Hardy's distributive shares [from the surgery center] are not subject to self-employment tax because he received the income in his capacity as an investor.”  This may be sloppy drafting, or perhaps I am being too picky, but I would have preferred the second statement of the court to state that there is no self-employment tax because the taxpayer received the income in his capacity as a limited partner.  As noted earlier, investment income, independently from the limited partner rule, is not self-employment income under I.R.C. § 1402(a)(2).  That said, the income from the surgery center was presumably from operations and thus would not constitute investment income.  Thus, calling the taxpayer an investor did not necessarily undermine the court’s (less than direct) conclusion that the taxpayer counted as a limited partner.

There are important issues that, to my knowledge, the courts have not addressed.  If, in fact, a state-law limited partnership is created, under state law the same person may hold general and limited partnership interests.  In such a circumstance, is the income allocated to the limited partnership interests free of self-employment taxes (assuming no guaranteed payments are involved)?  The answer would seem to be yes, at least if the taxpayers are not gaming the system, but I am aware of no case directly on point.  If the answer is indeed yes, a manager-managed LLC should get the same treatment. Under state law, the same person can hold a managerial interest and a non-managerial interest.  Income allocated to the non-managerial interest should be able to be free from self-employment taxes as well. 

Also, and very importantly, we need clear guidance from the Service on when income is from services and when from capital.  Many businesses with significant income from services also have significant investments in capital.  Only income from services should be subject to self-employment taxes.  We have been asking for guidance on this issue for many years, and we are still waiting.  To be sure, it is not always an easy line to draw.  As I have argued in other places, to simplify matters, it might be wise to provide that all income from traditional service businesses (law, accounting, etc.) be automatically subject to self-employment taxes.

Particularly in light of the Medicare funding shortfall, we need to have clear rules.  Currently, there is an incentive to engage in aggressive strategies to avoid self-employment taxes. The lack of clear guidance means the strategies, typically, are not literally prohibited, and the low audit risk means there is little chance of getting caught.

[1]   Castigliola v. Commissioner, T.C. Memo 2017-62.

[2]   Hardy v. Commissioner, T.C. Memo 2017-16.

[3]   See Temp. Treas. Reg. Section 301.7701-2T (TD 9766); Rev. Rul. 69-184, 1969-1 C.B. 256; I.R.S. Gen. Couns. Mem. 34001 (Dec. 23, 1969); I.R.S. Gen. Couns. Mem. 34173 (July 25, 1969); also see Riether v. United States, 919 F.Supp.2d 1140 (NM 2012).  See § 3.7.

[4]   See Methvin v. Commissioner, 2016 WL 3457623 (10th Cir. 2016) in which the taxpayer entered into a contractual arrangement that the court concluded was a partnership. The taxpayer held a 2-3% interest in the deemed partnership.  The partnership owned working interests in oil and gas ventures.  The taxpayer’s income from the partnership was subject to self-employment taxes notwithstanding his passive role.

[5]   I.R.C. §1402(a)(2).

[6]   I.R.C. § 1402(a)(13).

[7]  Renkemeyer, Campbell, and Weaver v. Commissioner, 136 T.C. 137 (2011).

[8]   Id. At 150; see Susan Megaard and Michael Megaard, Reducing Self-Employment Taxes on Owners of LLCs and LLPs, Business Entities, March/April 2012; also see Lauren A. Howell v. Commissioner, TC Memo 2012-303.

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Comments

Very informative update. Thanks!

Posted by: Tuphat | Jul 3, 2017 9:58:47 AM

Yes, thank you. It's nice to have a real article for a change.

Posted by: Dale Spradling | Jul 4, 2017 8:33:32 AM