Tax News
Tax Court: LLP Partners Did Not Qualify for Limited Partner Exception to Self-Employment Tax
March 15, 2011
A recent Tax Court opinion held that the "limited partner" exception to liability for self-employment tax ("SET") found in IRC Section 1402(a)(13) did not apply to the partners of a Kansas limited liability partnership, which was operated as a law firm specializing in, you guessed it, Federal income tax law.  The opinion--Renkenmeyer, Cambell & Weaver, LLP v. Commissioner, 136 T.C. No. 7 (February 9, 2011)-- is noteworthy both to interest holders in "newer" entities such as LLPs, LLLPs, and LLCs, and also to old-fashioned limited partners.

The prevailing view among practitioners has been that state law limited partners in an LP are exempt from SET without qualification per the express words of IRC Section 1402(a)(13).  With respect to interest holders in LLPs, LLLPs, and LLCs, the conservative approach has been to comply with the proposed regulations from the mid-90s (never finalized) which set forth tests, relating to the partner or other interest holder's participation in the business to determine whether an interest qualified for the limited partner exception.  The more aggressive approach, and the one taken by the taxpayer here, has been to analogize interests in these entities to limited partnership interests.

While not relying on the proposed regulations, the Tax Court used essentially a "participation" test to determine that the attorney partners were clearly more than "investors" in the partnership as substantially all of the LLP's income was attributable to their services.  While the court could have gone further and held that no such interests can qualify for the limited partner exception because they are not state law limited partner interests, it clearly signaled a rejection of the more aggressive approach that taxpayers have taken over the years.

In interpreting the term "limited partner" the court's reasoning relied almost solely on a passage from the legislative history to the limited partner exception, which provides that the purpose of the exception is to exempt certain earnings which are "basically of an investment nature".   Thus, instead of drawing a distinction on state law grounds between "limited partners" and everybody else, the court's reasoning indicates that it may analyze the participation of state law limited partners in determining whether they qualify for the limited partner exception.  As noted above, this reasoning is contrary to the prevailing view among practitioners that state law limited partnership interests were immune from the imposition of SET.

While it is an important tax case, Renkemeyer does not impact the SET treatment of most fund managers.  This is because most fund managers rely on the IRC Section 1402(a)(3)(A) exception from SET for capital gains, and to a lesser degree, the IRC Section 1402(a)(2) exception from SET for interest and dividends that they earn through their "carried interest" in partnership or LLC profits.  It should be noted that the proposed carried interest legislation that has been floating around both chambers of Congress during the past 2 years contains rules that explicitly subject carried interest income to SET.
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Tags: 1402(a)(13), 1402(a)(2), 1402(a)(3), self employment tax