Rulings define tax treatment for partners in LLC

This column may seem to be a dry discussion of tax issues. But for the many New Mexico businesses organized as partnerships, including LLPs and LLCs, the issues are important and are likely to become more important as Congress seeks additional revenue sources.

Employees pay what we commonly call Social Security taxes. These taxes consist of two parts — the OADSI portion and Medicare. Together they are 7.65 percent of the employee’s compensation, and both the employee and the employer pay this rate.

The OADSI share, which is 6.2 percent, applies only to the first $127,200 of wages. This is the 2017 limit and it is adjusted each year.

Self-employed people pay both halves of the taxes, so they pay 15.3 percent of their net earnings from selfemployment (SE). The 12.4 percent OASDI share applies only to the first $127,200 of SE earnings.

Partners are selfemployed so they are subject to the higher 15.3 percent SE rate. However, limited partners are taxed only on “guaranteed payments” made for services.

A guaranteed payment is a payment determined apart from partnership income. Unlike payments subject to entrepreneurial risk that partners typically receive, a guaranteed payment is received whether there is income or not.

The guaranteed payment looks like a salary payment. This is why it is subject to SE tax even if paid to an otherwise-passive limited partner.

Members of limited liability companies (LLCs) are not partners, general or limited, under state law. But the tax law treats an LLC with two or more members as a partnership.

So a question has arisen as to the proper SE tax treatment when LLC members earn income from their business. Many LLC members have argued they are limited partners exempt from SE tax.

Others have taken a less aggressive position — they pay a guaranteed payment for the services provided, pay SE tax on these guaranteed payments, but do not pay SE tax on the rest of their income from the LLC.

Many competent tax advisers think use of a guaranteed payment to set SE income of LLC income is reasonable. There is nothing in the law that says otherwise, but also nothing that says the use of guaranteed payments to limit SE tax is correct.

The Tax Court seems to be lining up on the side of the IRS on this issue, at least with respect to LLCs that generate most of their income from professional services. In 2011, the IRS ruled against a law firm organized as a professional LLC. This case, Renkemeyer, has received a lot of attention among tax professionals, but it suffered from a bad fact pattern. The LLC tried to allocate most of the income to an S corporation member and paid no guaranteed payments for the services of the lawyer-owners.

I did not share the gloom-and-doom view of other advisers that followed the 2011 decision. I would never have suggested a structure like that firm did, and I think they set themselves up for failure.

But last month, the Tax Court weighed in on a much better fact pattern and again held for the IRS. This decision, Castigliola, is much more troubling. This LLC was also involved in performing legal services. Unlike the 2011 case, the lawyers were paid substantial guaranteed payments, $150,000 or $125,000 per year. SE tax was paid on these amounts. The issue was whether SE tax was due on all income earned by the attorneys.

The LLC used a CPA to prepare its return. This CPA was a good one who had served terms as an officer in several prominent CPA organizations. The CPA found the use of substantial guaranteed

payments to be reasonable.

The Tax Court disagreed. The court held that the LLC members were not limited partners, and since Congress did not make clear the intended meaning of the term “limited partner,” it must be given its ordinary meaning.

LLC members are not limited partners when the ordinary meaning of the word is used. So the IRS won the Castigliola case.

The Tax Court is not the end of the story here. But this recent case is a huge wet blanket for those members of a professional service firm trying to minimize SE tax for LLC income.