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In Vincent J. Castigliola, et ux., et al. v. Commissioner, the Tax Court held that three attorneys who are member-managers of their law firm, organized as a professional limited liability company (PLLC) classified as a partnership, were not limited partners for purposes of Section 1402(a)(13) and therefore were liable for self-employment income tax on their distributive shares.

Facts

The law office, located in Mississippi, was originally organized as a general partnership. In 2001, the attorneys reorganized the practice from a general partnership to a PLLC. The PLLC timely filed partnership tax returns on Form 1065 for the years at issue (2008-2010). The members' compensation agreement for the years at issue required guaranteed payments be made to each member, commensurate with local salaries for lawyers. Net profits that exceeded the guaranteed payment amounts were distributed to the members in accordance with their members' agreement. The members reported all of the guaranteed payments as self-employment income subject to self-employment tax, but they did not pay self-employment tax on the portions of their distributive shares that exceeded their guaranteed payments.

Law and analysis

Self-employment income is taxed under Section 1402(a), but Section 1402(a)(13) provides an exclusion for "the distributive share of any item of income or loss of a limited partner, as such, other than guaranteed payments described in Section 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."

Based on the advice of their CPA, the members asserted that they qualified for the Section 1402(a)(13) exclusion because they should be considered limited partners for purposes of the statute. The IRS contended that the members were not limited partners and therefore were not entitled to claim the exclusion.

The Tax Court noted that, when the Section 1402(a)(13) exclusion was originally enacted, limited liability companies were not "widely used or generally treated as partnerships for [federal] tax purposes," and that "no statutory or regulatory authority defines 'limited partner' for purposes of [Section] 1402(a)(13)." Citing Renkemeyer, Campbell & Weaver, LLP v. Commissioner, 136 T.C. 137 (2011) (see Tax Alert 2011-279), the Court noted that "the meaning of 'limited partner' is not necessarily confined solely to the limited partnership context" and that the first question to ask is whether the person claiming the limited-partner exemption "held a position in an entity treated as a partnership for [federal] tax purposes that is functionally equivalent to that of a limited partner in a limited partnership," and therefore whether the members of the PLLC were the functional equivalent of limited partners in a limited partnership.

To determine what it means to be functionally equivalent to a limited partner, the Tax Court considered both the Uniform Limited Partnership Act of 1916 and the Revised Uniform Limited Partnership Act of 1976 (with amendments added in 1985). From this, the Tax Court concluded that, "common to each of the definitions of 'limited partner' … are the primary characteristics of limited liability and lack of control of the business."

In this case, the PLLC did not have a written operating agreement or any other document showing the members' management power was limited. Additionally, the Tax Court found that the law practice continued to be operated in the same manner before and after the conversion from a general partnership to a PLLC. Therefore, although the members had limited liability, the Tax Court concluded the members were more akin to general partners who had control of the PLLC, and did not qualify for the Section 1402(a)(13) exclusion from self-employment income tax.

Implications

This decision follows a trend in which courts have agreed with the IRS that service providers who hold interests in a tax partnership are not limited partners under Section 1402(a)(13) when the service providers are not limited partners in a state law limited partnership. For example, courts and the IRS have recently decided that an interest in a limited liability partnership (LLP) and a limited liability company (LLC) were not limited partnership interests under Section 1402(a)(13). See e.g., Renkemeyer, Campbell & Weaver, LLP v. Commissioner (cited previously). Taxpayers should be aware of these decisions, and should discuss with their tax advisors how these decisions may affect them.

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