Is that K-1 Income Subject to Self Employment Tax?

It is late spring and you receive a K-1 from a Limited Liability Company (LLC) in which you are a member. On line 14 of the K-1, there is a number being reported to you: self-employment earnings.

Is it correct? Should you be reporting your share of LLC income as self-employment earnings? If you do, you now have an additional tax to pay, called the self-employment tax. This self-employment tax is imposed in addition to the regular income tax you already pay, and is imposed on your self-employment earnings. The self-employment tax rate for self-employment earnings is generally 15.3%. However, for 2011, the rate is reduced to 13.3%.

Generally, a taxpayer’s share of ordinary income reported on a Schedule K-1 from a partnership engaged in a trade or business is subject to the self-employment tax. However, like any general rule, there are a myriad of exceptions, including one excepting a limited partner's share of ordinary income from a partnership. Should the term “limited partner” be interpreted to include members of a LLC? How about partners in a Limited Liability Partnership (LLP)?

When Congress added the exception some 30 years ago, it did not define “limited partner.” Arguably, no definition was needed. Limited partner essentially meant one thing under most states’ laws – a partner enjoying limited liability who did not participate in the management or control of the partnership. However, the legal landscape has changed since Congress added the exception and some would argue the tax landscape needs to catch up.

What legal changes have taken place? First, revised partnership statutes in most states have redefined the term limited partner to expand significantly the extent to which such a partner may participate in the control or activities of the partnership without jeopardizing the partner's limited liability. Second, all states have added at least two new types of legal entities since the exception found its way into the Internal Revenue Code: LLCs and LLPs. While there are similarities between LLCs, LLPs, and traditional limited partnerships, the comparison is far from exact.

In a LLC, each member enjoys limited liability. Depending on the type of LLC (i.e., member-managed versus manager-managed), as well as provisions of the operating agreement, members are free to participate in the control and activities of the LLC to any extent.

LLPs arose as a means of protecting professionals from the liability of their partners engaging in negligent acts. Unlike a limited partnership, there is no need in a LLP for a general partner that remains wholly liable for the liabilities of the partnership; rather, each partner remains liable only for his or her own acts. In some states, the privilege of operating within the LLP form is reserved to certain professions (e.g., lawyers, doctors, architects, etc.) but in all cases, the partners of a LLP are free to participate in the control and activities of the entity without jeopardizing their liability protection.

Applying the term “limited partner” in the changing legal landscape has proven to be a vexing issue for Internal Revenue Service (IRS). Despite two sets of proposed regulations, still no definitive meaning exists. Following its last regulatory effort, numerous taxpayers complained that the Department of Treasury (Treasury) had overstepped its regulatory authority in defining “limited partner.” Congress agreed and imposed a one-year moratorium on the finalization of any regulations. The Senate went so far as to pass a resolution urging Treasury to withdraw its proposed regulations. And while the moratorium has long since passed, neither Treasury nor IRS have offered a revised proposal.

Informally, attorneys within IRS have suggested that taxpayers following the latest proposed regulations will not be challenged upon audit. In practice, some taxpayers and practitioners do rely on the proposed regulations while others rely on an acceptable interpretation of the term “limited partner” found in the statute.

In a recent Tax Court case involving a LLP, the taxpayers relied on such an interpretation. They argued that since they enjoyed limited liability as partners within a LLP, they fell within the intended definition of limited partner. Using its own statutory interpretation, the Tax Court found that the intent of the limited partner exception was to ensure that taxpayers who merely invested in a partnership did not receive credits towards Social Security coverage. In other words, Congressional intent did not support the argument that Congress meant to exclude partners who performed services for a partnership in their capacity as partners (i.e., acting in the manner of self-employed persons). Accordingly, the Court held that the taxpayers’ income from the LLP constituted self-employment earnings and should be reported on line 14 of their K-1s.

So what is the right answer to the question of whether ordinary income on a K-1 constitutes self-employment earnings? Perhaps the reason why Congress, Treasury, IRS and Courts have found this to be such a vexing issue is that finding the right answer is so highly dependent on the facts and circumstances of each case. The recent Tax Court case seems to have focused on the nature of the taxpayer’s activities, and not on the title “limited,” or the liability protection enjoyed. In determining self-employment earnings, it would seem that, such a tack is appropriate. Unfortunately, it means that absent Congress coming forth with some bright-line definition, each situation will need to be analyzed carefully to determine whether the income constitutes self-employment earnings.