Press Room: Tax Release

April 11, 2011

Limited Partners in Some Types of Partnerships May Be Subject to Self-Employment Taxes on Their Distributive Shares

In a recent case, the Tax Court held that income paid to limited partners who are active in the business of the partnership should be subject to self-employment tax.

This opinion is significant because it represents the first time that a court has addressed squarely the meaning of “limited partner” for purposes of Sec. 1402, focusing on the nature of the partner’s activity. Taxpayers generally have relied upon a state law determination of limited liability for purposes of Sec. 1402.

Under Sec. 1402(a)(13), the distributive share of a “limited partner” (other than guaranteed payments made to that partner under Sec. 707(c)) is exempted from the definition of “net earnings from self-employment”. However, the term “limited partner” is not defined. In Renkemeyer, Campbell & Weaver, LLP v. Comm’r, 136 T.C. No. 7 (2011), the Tax Court interpreted “limited partner” to mean a partner that “merely invests” and “does not actively participate in the partnership’s business operations.”

Renkemeyer involved a limited liability partnership consisting of three lawyers. For the tax years ending 2004 and 2005, none of the three partners reported any of their distributive shares of income as net earnings from self employment. The court explained that unlike a limited partnership, in which a limited partner cannot participate in the management of the partnership without losing liability protection, in a limited liability partnership, the nature of the entity is such that all partners have the ability to engage actively in the business of the partnership while enjoying liability protection.

The court focused on the level of activity in which the partner engaged, as opposed to whether the partner enjoyed liability protection. Since each of the three partners actively engaged in the law practice of the partnership, the court had little trouble concluding that each partner’s distributive share constituted net earnings from self employment. The case is most troublesome because the Tax Court, for the first time, defined the term “limited partner” for purposes of Sec. 1402 by focusing on the nature of the partner’s activity as opposed to whether the partner enjoyed limited liability.

The holding in Renkemeyer may apply only to limited liability partnerships. Such partnerships are unique and most involve professional services practices. In fact, a partner in a limited liability partnership arguably is more like a partner in a general partnership, since a partner in a limited liability partnership does face liability for his or her own actions. A limited liability company is different since, absent a piercing of the statutory veil, no member would ever face individual liability. Indeed, for this reason, some activities are statutorily prohibited from being undertaken in the limited liability company form (e.g., plumbing in California).

Renkemeyer is a regular Tax Court decision that is binding authority for the Tax Court and should be considered when determining whether the distributive share of a member in a limited liability entity will constitute net earnings from self-employment.