LLC Members Could Soon Be Subject to Self-Employment Tax
Internal Revenue Code Section 1402(a) defines “net earnings from self-employment” as:
- Gross income an individual receives from any trade or business, plus
- An individual’s distributive share of income or loss from a partnership in which he or she is a partner, unless a specific exclusion applies.
Such an exclusion is located in IRC Section 1402(a)(13) which generally provides that the distributive share of partnership income or loss is excluded from the net earnings from self-employment if the partner receiving the distribution of income is a Limited Partner.
An issue has arisen due to the legal differences between the activities a Limited Liability Company member can perform versus those of a traditional Limited Partner. The issue is further complicated because the Internal Revenue Code (“IRC”) and applicable Regulations did not, and still have not, defined the term Limited Partner. In addition, the Revised Uniform Limited Partnership Act of 1976 provides that a Limited Partner would lose his limited liability protection if, in addition to the exercise of his rights and powers as a limited partner, he takes part in the control of the business which clearly differentiates an LLC member from a Limited Partner.
In recent action, the Internal Revenue Service issued a Chief Counsel Advice Memorandum (CCA 201436049) which determined that partners in a financial management company were not Limited Partners for purposes of self-employment tax because extensive services are being performed for the management company.
In the Memorandum, the management company, formed as a limited liability company, serves as the investment manager for two investment funds. Following are the facts of the case:
- The funds are comprised of a family of investment partnerships that operate independently and pay quarterly management fees up to the investment manager.
- The management company has full authority and responsibility to manage and control the affairs and business of each investment fund
- The partners of the management company and its employees provide these services to the investment funds.
- The primary source of revenue to the management company was the quarterly management fees charged to the funds.
- Each of the partners in the management company receives a W-2 for yearly compensation, a guaranteed payment for health benefits and a pro-rata piece of the ordinary income generated from the receipt of management fees.
Based on these facts, the management company treated all of its partners as Limited Partners not subject to self-employment tax aside from the guaranteed payments for health benefits.
In the IRS’s view, the partners in the management company were taking control of the business as the partners. That is, they:
“perform extensive investment and operational management services for the partnership in their capacity as partners (i.e., acting in the manner of self-employed persons) and the management company derives its income from the investment management services performed by its partners.”
Based on this, the IRS concluded the partners are not limited partners for purposes of the exclusion under Section 1402(a)(13).
This Chief Counsel Advice further demonstrates the IRS’s desire to restrict the scope of the limited partner exemption in Section 1402(a)(13).