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In ILM 201640014 (the ILM), the Office of the Associate Chief Counsel (Associate Chief Counsel) determined that the exclusion from "self-employment income" (SEI) available to allocations by a partnership to a "limited partner" under Section 1402(a)(13) was intended to apply only to those who "merely invested" in a partnership and not to those that "actively participated" and "performed services." Accordingly, a person who was the Operating Manager, President, and Chief Executive Officer, as well as a member, of a limited liability company treated as a partnership for US federal income tax purposes was not a "limited partner" under Section 1402(a)(13) and thus was subject to self-employment tax on his full distributive share of the limited liability company's income from restaurant operations.

Facts

Taxpayer purchased several franchise restaurants. He contributed the restaurants (but not the franchises) to LLC, a limited liability company treated as a partnership for US federal income tax purposes, which owned and operated them. LLC's gross receipts and net ordinary business income were almost entirely attributable to the preparation and sale of food products. The members of LLC were Taxpayer, his wife, and his wife's irrevocable trust. The franchise agreements required Taxpayer to personally devote full-time and best efforts work to the operation of the restaurants. Taxpayer served as LLC's Operating Manager, President and Chief Executive Officer. Taxpayer directed the operations of LLC and conducted day-to-day business affairs in managing LLC in his capacity as a member of LLC. Taxpayer held regular meetings and discussions with LLC's management and staff. He made strategic and succession decisions. He also made LLC's investment and planning decisions, such as acquisitions, sales transactions and real estate activities. He was involved in regional and national meetings and conferences affecting LLC. His daily activities included handling emails and phone calls for LLC, visiting LLC restaurants when he was in town, and management/staff meetings. Taxpayer was authorized on behalf of LLC to: (i) institute, prosecute and defend LLC's legal proceedings; (ii) purchase, lease and sell LLC's property; (iii) enter into contracts; (iv) lend money and invest LLC funds; (v) establish pension plans; and (vi) hire accountants, investment advisors and attorneys for LLC. Taxpayer had ultimate authority over hiring and firing decisions, as well as oversight of all employees of the business. The details of the number of hours he spent working on the LLC's restaurant business are redacted from the ILM, but there is no implication that Taxpayer had in any way defaulted on his obligation under the franchise agreements to render his full time and attention to the restaurant business.

For each of the years the ILM addressed, LLC had paid Taxpayer a guaranteed payment and the Taxpayer had received a distributive share. LLC argued that the guaranteed payments represented "reasonable compensation" for the services it received from Taxpayer, so these guaranteed payments may have served as Taxpayer's "salary" from LLC. These guaranteed payments were treated as SEI. LLC otherwise treated Taxpayer as a "limited partner" for purposes of Section 1402(a)(13), so that his distributive share from LLC was not SEI. LLC argued that Taxpayer had contributed the restaurants to it in exchange for membership interests, and that Taxpayer's distributive share of LLC net income and net loss represented a reasonable return on the Taxpayer's capital investment that was not SEI and not subject to self-employment tax. In this regard, LLC argued that it made significant capital outlays to acquire and maintain restaurants, and that it derived its income from the preparation and sale of food products by its employees, not the personal services of Taxpayer. LLC asserted that Taxpayer had a reasonable expectation for a return on his investment beyond his compensation from LLC.

Law and analysis

Section 1401 generally imposes a tax on the SEI of every individual for a tax year. Section 1402(b) generally defines SEI as an individual's net earnings from self-employment.

Section 1402(a) generally defines net earnings from self-employment, including some items and excluding others. Section 1402(a)(13) excludes from SEI the distributive share of partnership income of a "limited partner," other than payments to the limited partner for services to the partnership, including guaranteed payments. Section 1402(a)(13) does not define the term "limited partner." The legislative history to P.L. 95-216, the 1977 statute that enacted Section 1402(a)(13), describes Congress' thinking in enacting it. In most relevant part, that thinking was that, "[t]he bill would exclude from social security coverage, the distributive share of income or loss received by a limited partner from the trade or business of a limited partnership. This is to exclude for coverage purposes certain earnings which are basically of an investment nature."

Associate Chief Counsel noted that all of the distributive share of partnership income allocated to an individual who is not a "limited partner" within the meaning of Section 1402(a)(13) is SEI, regardless of the extent of the individual's participation in the partnership's business or the capital-intensive nature of the partnership's business. See, Cokes v. Commissioner, 91 T.C. 222 (1988), Methvin v. Commissioner, T.C. Memo. 2015-81, and Perry v. Commissioner, T.C. Memo. 1994-215, each of which involved individuals who owned working interests in oil and gas joint ventures, but who did not participate in the business operations of the relevant partnerships.

In Renkemeyer, Campbell, and Weaver LLP v. Commissioner, 136 T.C. 137 (2011) the Tax Court held that the partners of a law firm organized as a Kansas limited liability partnership were not limited partners within the meaning of Section 1402(a)(13) and thus were subject to self-employment taxes on their distributive shares of partnership income. Associate Chief Counsel quoted the following language from Renkemeyer: "A limited partnership has two fundamental classes of partners, general and limited. General partners 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. 1 Bromberg & Ribstein, Partnership, sec. 1.01(b)(3) (2002-2 Supp.). Indeed, it is generally understood that a limited partner could 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. See 3 Bromberg & Ribstein, supra sec. 12.01(a) (1988)."

Similarly, the taxpayers in Riether v. United States, 919 F.Supp.2d 1140 (D. N.M., 2012) argued unsuccessfully that that their distributive shares of limited liability company income were "unearned income not subject to the self-employment tax." Riether involved a limited liability company that was in the business of rendering X-ray services. It was owned by a husband and wife through their S corporations. The facts of Riether are similar to those of the ILM in that the limited liability company in Riether paid compensation to its owners that was treated as SEI, with the affected partners being treated as "limited partners" with respect to their distributive shares of LLC income for purposes of Section 1402(a)(13). The Tax Court granted summary judgment in favor of the government in Riether that the taxpayers were subject to self-employment tax on their distributive shares of limited liability company income, as well as their compensation payments.

In the ILM, Associate Chief Counsel's review of the authority under Section 1402(a)(13) was generally very thorough. It gave little weight to the fact that LLC had many employees of which Taxpayer was only one. It instead found Taxpayer was the only partner of LLC who was involved with LLC's business. It found that Taxpayer was not a "mere investor" in LLC's business but instead rather actively participated in LLC's operations in his capacity as a partner, which it compared to "acting in the manner of a self-employed person." Accordingly, Associate Chief Counsel concluded that Taxpayer's distributive share of LLC income was not received by him as a "limited partner" of LLC within the meaning of Section 1402(a)(13), but was SEI in its entirety.

Conclusion

The ILM concludes that Section 1402(a)(13) is intended to exclude the distributive shares of partners from SEI only for those partners who are "merely invested" in the partnership rather than those who "actively participate" in the partnership's activities. Accordingly, it concludes that Taxpayer was not a "limited partner" within the meaning of Section 1402(a)(13) and, therefore, was subject to self-employment tax on his full distributive share of his LLC income.

Implications

The analysis in the ILM generally aligns with that of the District Court in Riether in which a limited liability company had paid compensation to its members that it (and they) asserted was reasonable, so that any return to the members above that compensation had to be a return on invested capital that was not SEI under Section 1402(a)(13), stating that partners who are not limited partners are subject to self-employment tax even in instances involving a limited liability company involved in capital-intensive activities. The ILM stands as evidence of the government's on-going concern regarding the application of Section 1402(a)(13) to members of limited liability companies who substantively participate in the activities of their companies.

The ILM may be read to stand for three propositions. First, the ILM may be read to be consistent with the proposition that the Service views Section 1402(a)(13) as a binary decision. That is, a person is entirely a "limited partner" under Section 1402(a)(13), so that no part of his distributive share is SEI, or the person is entirely a "general partner" under Section 1402(a)(13), so that all of his distributive share is SEI. There is no bifurcation into amounts attributable to the member's personal services and amounts attributable to property, workforce or other assets of the LLC. The reasonableness of any compensation paid by a tax partnership to a partner does not appear to be relevant to this view. In this regard, it is notable that the ILM includes text from the Reither decision citing Revenue Ruling 69-184, 1969-1 C.B. 256, which the Service has maintained as its position that a partner cannot be employed by his or her partnership.

Second, the ILM simply does not address whether the Taxpayer's status as a general partner under Section 1402(a)(13) had any effect on his wife's status as a general or limited partner under Section 1402(a)(13). Its only reference to Taxpayer's wife was that she had no involvement in the business. This omission might support an argument that there is no attribution or extension of status as a general or limited partner under Section 1402(a)(13) between spouses. If so, presumably a smaller portion of the LLC's income would have been treated as SEI if the facts were reversed such that that Taxpayer's wife owned a larger percentage of the LLC and was treated as a "limited partner" under Section 1402(a)(13). Because the ILM simply rendered no decision on the status of Taxpayer's wife as a general or limited partner under Section 1402(a)(13), there is no decision supporting or opposing this observation. For passive activity loss and net investment income tax purposes, however, the work performed by one spouse is attributed to the other, so both spouses would be treated as nonpassive and exempt from the net investment income tax.

Third, although not within the four corners of the ILM, the position taken by the government might be taxpayer-favorable in some instances. For purposes of calculating net earnings from self-employment, distributable losses from an LLC can be used to offset net earnings from self-employment from other sources, such as guaranteed payments and other Schedule C-type income. Therefore, the position taken by the Service would have been a favorable one to the taxpayer if his distributive of net income from the LLC was a loss because it would have offset the guaranteed payment reported on the same Schedule K-1.

The ILM does not involve a state law partnership and thus does not raise the fact pattern that is perhaps most important to many taxpayers who are concerned with Section 1402(a)(13). Suppose that LLC had instead been a state law limited partnership and Taxpayer had been a state law limited partner? The laws of many states now permit limited partners to be just as active in the conduct of a partnership's business as the general partners, and they do so without any risk to such limited partners' limitations to exposure for partnership obligations. Section 1402(a)(13) does not define what it means when it uses the term "limited partner." Many taxpayers have interpreted that term as meaning that a state law limited partner in a state law limited partnership is a "limited partner" under Section 1402(a)(13), without regard to the nature or extent of that limited partner's involvement in the business activities of the pertinent limited partnership. Due to its facts, the ILM does not address whether the Service believes state law status is determinative under existing law. In that regard, however, it is worthy of note that the arguments made by the Associate Chief Counsel in the ILM might apply to an active state law limited partner with very little change, except for the argument that state law concepts and definitions control SEI tax consequences.

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