In the ongoing debate over whether self-employment taxes apply to distributions from limited liability entities such as limited partnerships and limited liability companies, the United States Tax Court reviewed the issue earlier this year in Renkemeyer v. Commissioner, 136 T.C. No. 7 (2011). In that case, the court held that the attorney partners’ distributive shares of a law firm organized as a limited liability partnership (LLP) were subject to self-employment taxes and not subject to the exclusion for distributive shares of limited partners.

Internal Revenue Code (“Code”) Section 1401(a) imposes a tax on the self-employment income of every individual for a taxable year. For partnerships, Code Section 1402(a) defines “net earnings from self-employment” as including an individual’s “distributive share (whether or not distributed) of income or loss described in section 702(a)(8) from any trade or business carried on by a partnership” of which such individual is a member. Under Code Section 1402(a)(13), however, a limited partner’s distributive share of income or loss from the limited partnership is excluded from self-employment tax, but guaranteed payments for services actually rendered to or on behalf of the partnership are not.

The crux of the problem is that the term “limited partner” is not defined in the Code or the Treasury Regulations. Until Renkemeyer, cases have determined the status of a limited partner by reference to applicable state law regardless of how the limited partner functioned in the partnership. Thus, if a limited partner was such under state law, then his or her distributive share of partnership income was exempt under Code Section 1402(a)(13), regardless of how active such partner was in the partnership. The converse was also true, such that if a partner was not a limited partner under state law, then his or her distributive share of partnership income was not excluded under Code Section 1402(a)(13), regardless of the passive nature of his or her activities.

The IRS in 1997 proposed regulations to functionally define a “limited partner” and expand that definition to limited liability companies and other entities. See 62 Fed.Reg. 1702-01 (Jan. 13, 1997). These rules provide a partner in a partnership (or a member of an LLC taxed as a partnership) with limited partner treatment unless such person had unlimited personal liability for debts of or claims against the partnership, had authority to contract for the partnership, or participated in the partnership’s trade or business activities for more than 500 hours in a taxable year. Prop. Treas. Reg. §1.1402(a)-2(h)(2). However, if the person is a partner providing services in a “service partnership,” which is defined to include partnerships substantially all of the activities of which involve the performance of professional services such as law and accounting, the limited partner’s distributive share of partnership income would not be excluded from self-employment tax. Prop. Treas. Reg. §1.1402(a)-2(h)(5). These proposed regulations were met with substantial political opposition, including a Congressional one-year moratorium on their finalization. No further action on this matter has been taken, so we are left with much uncertainty regarding the application of self-employment tax to the income of limited partners.

Renkemeyer involved a law firm that was organized as a Kansas LLP consisting of three partners practicing law and an employee stock ownership plan (ESOP) as a fourth partner. In 2004, most of the partnership income was allocated to the ESOP and no self-employment tax was paid on that income. In 2005, the ESOP withdrew and the partnership was recapitalized with the individual partners receiving general managing partner interests and investing partner interests. The 2005 income was allocated among the partners according to the amended partnership agreement, with no partner paying any self-employment tax. Upon audit, the IRS reallocated the 2004 income in accordance with the partners’ profits and loss interests and determined that the three attorney partners’ 2004 and 2005 distributive shares of partnership income were net earnings from self-employment subject to the tax on self-employment income. In the Tax Court, the partners argued that their interests were limited partner interests because they were designated as such in the law firm’s organizational documents and the interests enjoyed limited liability under Kansas law, and so their distributive shares of partnership income qualified for the Code Section 1402(a)(13) limited partner exclusion from self-employment tax.

The court held that since the attorney partners’ distributive shares arose from legal services they performed on behalf of the law firm, they were subject to self-employment tax. While noting the obscurity of the term ‘limited partner” as a result of the increasing complexity of partnerships and other flow through entities, the court did not rely upon the definition of a limited partner as one who is a limited partner under state law. Rather, it reviewed the legislative history of Code Section 1402(a)(13) and determined that a limited partner means someone with earnings of an investment nature, and that Congress did not wish to exclude service-performing partners from self-employment tax liability. In doing so, the Tax Court apparently discounted any limited liability of the underlying partnership interests under state law and aligned itself with the functional analysis of the Proposed Regulations. Instead of merely holding that partners of an LLP are not limited partners under Code Section 1402(a)(13), the court used a functional test to make that determination. Under that test, partners in a partnership or, similarly, members in a limited liability company taxed as a partnership, who actively perform services for the partnership would not be treated as limited partners because their distributive shares of partnership income would not be of an investment nature but would be for services performed on behalf of the partnership.

The Renkemeyer decision is not surprising for its result but for the Tax Court’s particular analysis in achieving it. Rather than simply holding that a partner in a LLP is not a limited partner for purposes of the self-employment tax, the court seemingly ignored any state law limited liability and adopted a functional test based on active participation similar to that used in the Proposed Regulations, even though the Proposed Regulations have neither been finalized nor withdrawn by the IRS for over a decade. Readers who are members or partners in limited liability entities are cautioned to continue to look to the Proposed Regulations for guidance in this area.