A recent Tax Court case, Renkemeyer, Campbell & Weaver, LLP v. Commissioner, disallowed a special allocation of a law firm limited liability partnership's net business income and held that income generated from the firm's legal practice that was allocated to the attorney partners was subject to self-employment tax.

The partnership originally consisted of three attorneys and an S corporation that was owned by an Employee Stock Ownership Plan of which the three attorneys were the beneficiaries. The partners shared profits and losses as follows: 30% each to the three attorneys and 10% to the S corporation. The law firm specially allocated 87.5% of its net business income to the S corporation. The law firm did not report any of its business revenues from its law practice on its partnership return as net earnings from self-employment.

The IRS reallocated the partner's distributive shares of the firm's net business income in accordance with the profit and loss sharing percentages. The law firm argued that the special allocation was proper because it was made pursuant to the partnership agreement; however, the firm could not produce a partnership agreement to support such an allocation. As a result, the Tax Court looked at the partners' capital contributions, interests in profits and losses, cash flow and other non-liquidating distributions, and the partners' rights to capital on liquidation to determine the partners' interests in the partnership. In making such determination, the Court found that there was no indication that the S corporation ever made any capital contributions to the partnership, the S corporation only held a 10% profit and loss interest, there was no indication that the S corporation received any distributions from the partnership and there was no indication regarding the partners' rights to distributions of capital upon liquidation of the partnership.

The IRS determined that the attorneys' shares of such income were subject to self-employment tax. The law firm argued that the partners did not have to include their distributive share of partnership income in calculating net earnings from self-employment because they were limited partners in a limited partnership and the distributive share of an item of income or loss of a limited partner (other than certain guaranteed payments) is excluded from such calculation. The exception does not define the term limited partner so the Court looked to the legislative history for guidance. The legislative history indicates that the intent of the exception was to ensure that individuals who simply invested in a partnership and were not actively participating in the partnership's business operations would not receive credits toward Social Security coverage.

The legislative history does not support a finding that Congress contemplated excluding partners who performed services for a partnership in their capacity as partners from liability for self-employment taxes. The Tax Court determined that the partners' distributive shares of the law firm's income did not arise as a return on their investment and were not earnings of an investment nature. Thus, the distributive shares of the law firm partners arising from the legal services performed in their capacity as partners in the law firm were subject to self-employment taxes.

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