Guaranteed Payments Are the Only Amount Subject to Self-Employment Tax, Right?

Professional Services|Tax

By George Adams

On Wednesday, April 12, the Tax Court issued a memorandum decision Castigliola¹ that addressed the self-employment tax characterization of income earned.  This case involved a law firm located in Mississippi that was formed as a member-managed PLLC taxed as a partnership for income tax purposes, meaning all members participated in the management/control of the PLLC.  In addition, all members collectively participated in the management decisions of the firm.  There was no written operating agreement or other evidence that defined the members' responsibilities or in any way limited the members' management authority.

All of the members' guaranteed payments were commensurate with local legal salaries based on available legal salary surveys in the area.  All net profits in excess of guaranteed payments were distributed among the members in accordance with the members' agreement and reported as ordinary income not subject to self-employment tax.

The judge in this case indicated that the fundamental question to ask, relative to Internal Revenue Code §1402(a) (13) limited partner exemption for self-employment tax, was whether the members were "functionally equivalent to that of a limited partner in a limited partnership."  The judge indicated that given the fact that the PLLC was member-managed meant all that partners had control over the partnership.  He also referred to the Mississippi Limited Partnership Act, which 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."  There were safe harbor definitions in the law that provided examples of various activities that would not cause a limited partner to lose the limited liability protection.  The key component to these exemptions is the partner's lack of control of the business.

In the Castigliola case, each of the members of the PLLC had control based on the fact that the PLLC was member-managed and each of the members had management control over the business.  Therefore, the Court determined that all income in excess of the members' guaranteed payments was not eligible for the §1402 (a) (13) exemption,  and accordingly, would be subject to self-employment tax.

The key planning takeaway from this decision is to have a written operating agreement that clearly defines the members' management powers and related limitations.  In addition, at least one member should act in a general partner capacity to limit the possibility that all partners will be classified as general partners, thereby causing all partners' distributive shares of income to be subject to self-employment tax.  As detailed above, if the partner roles are clearly defined, the non-managing members should be able to treat their distributive share of income in excess of their guaranteed payments as eligible for the IRC §1402(a) (13) exemption from self-employment tax.  It is critical that all documentation and related roles and responsibilities of the partners be clearly defined to ensure that the self-employment tax exemption can be properly claimed and sustained.

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¹ T.C. Memo 2017-62

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