Tax Court has held in Castigliola v. Commissioner (T.C. Memo. 2017-62) that three lawyers who were member-managers of a professional limited liability company (PLLC) classified as a partnership for U.S. federal income tax purposes were not entitled to exclude a portion of their partnership income from self-employment taxes under the Section 1402(a)(13) limited partner exception.
In Castigliola, three lawyers worked together in a general partnership for several years and eventually organized their law practice as a PLLC under Mississippi law. Although the PLLC did not have a written operating agreement, the lawyers had a compensation agreement that required that each of them to receive a guaranteed payment for the services rendered to the PLLC. The guaranteed payments were commensurate with local legal salaries as determined by a survey of legal salaries in the area. Each partner also received a distributive share of the PLLC's net profits in excess of the amounts paid out as guaranteed payments. The lawyers reported the guaranteed payments as income from self-employment and subject to self-employment tax. However, they did not report their distributive shares in excess of the guaranteed payments as self-employment income.
The IRS issued a notice of deficiency for the 2008-10 tax years. The IRS argued that the lawyers were not limited partners within the meaning of Section 1402(a)(13) and therefore, their distributive shares in the PLLC were also subject to self-employment tax. Section 1402(a)(13) provides an exclusion from self-employment income for the distributive share of income or loss of a partner, other than guaranteed payments described in Section 707(c) 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.
The taxpayers petitioned the Tax Court, which agreed with the IRS and held that the exclusion in Section 1402(a)(13) did not apply to the lawyers. The Tax Court looked to Renkemeyer, Campbell, & Weaver, LLP v. Commissioner, 136 T.C. 137, 148 (2011), where the court recognized that the meaning of "limited partner" is not necessarily confined to the limited partnership context. Applying Renkemeyer, the Tax Court focused on whether they held positions that were the functional equivalent of a limited partner in a limited partnership. The Tax Court examined state law definitions of a limited partner and noted that that the primary characteristics of a limited partner are: (1) limited liability, and (2) a lack of control over the business.
The Tax Court found that the lawyers had control over their business. All three participated in decisions to hire and fire workers, wrote checks and assumed liabilities for the firm, and participated in decisions regarding their distributive shares. Given the level of control over the business that each partner exercised, the Tax Court held that the lawyers were not limited partners under section 1402(a)(13). The Court declined, however, to impose an accuracy-related penalty based on their reliance on the advice of their CPA and the lack of administrative or judicial guidance defining "limited partner" at the time they prepared their returns.
Castigliola illustrates the difficulties faced by partners in service partnerships or LLCs who seek to bifurcate their partnership income to avoid self-employment taxes. Though not clear, a footnote in the opinion might suggest that a partner's full partnership interest could be bifurcated into different interests for purposes of the limited partner exception, such that a portion of the entire interest might qualify as a limited partner interest. The footnote states "[t]here is no evidence to suggest that any member held a different type of interest in the PLLC or held more than one type of interest in the PLLC." This perhaps suggests that if the facts of the case were different, a part of a member's entire PLLC interest might qualify as a limited partner interest under section 1402(a)(13). Ultimately, where the facts are similar to those of Castigliola, even if partners receive a guaranteed payment that is commensurate in amount with local salaries and have limited liability, such partners may be subject to self-employment tax on their entire distributive share of partnership income.
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