LLC Partnership with one general and one limited partner

[origun]

I just met a new client with a business partnership where he is the only one to do any work for the business. However, it was set up as an LLC with client as general partner, wife as limited partner (50% each). The reason it was set up that way, he tells me, is to avoid paying SE tax on the entire net gain of the business. They pay tax on the entire net proceeds but only pay SE on his half. I usually only do individual returns so am wondering about this arrangement. Is it common practice and an acceptable way to set up an LLC/partnership? It seems a bit like tax avoidance to me!

[JoshinNC]

It's wrong

I just met a new client with a business partnership where he is the only one to do any work for the business. However, it was set up as an LLC with client as general partner, wife as limited partner (50% each). The reason it was set up that way, he tells me, is to avoid paying SE tax on the entire net gain of the business. They pay tax on the entire net proceeds but only pay SE on his half. I usually only do individual returns so am wondering about this arrangement. Is it common practice and an acceptable way to set up an LLC/partnership? It seems a bit like tax avoidance to me!

But not for the reason you think. Every partner (Member) in an LLC is a limited partner, there is no general partner. So, all of the distributive profit is exempt from SE tax, unless there are guaranteed payments to a partner, which are subject to SE tax.

[AJsTax]

Not entirely true either

But not for the reason you think. Every partner (Member) in an LLC is a limited partner, there is no general partner. So, all of the distributive profit is exempt from SE tax, unless there are guaranteed payments to a partner, which are subject to SE tax.

There was a ruling in the near past that said that the fact alone that partner was a member of a LLC does not make them a limited partner. If they are active in the business they are general partners. Can not find it right now, no time, but just happened last fall.
And I might add, finally something that makes sense in the realm of LLC/partnerships. I never agreed that a person could be limited partner in an active role in a business.

[origun]

Guaranteed payments et al

Thanks for the input. My potential client has not shown any guaranteed payments on his return (1065 or individual K-1). However, he has paid SE on his half of the net profits...so I guess he is treating them as guaranteed payments It seems that previous preparers (not professionals) were kind of sloppy with the returns.

The business existed for taxpayer (before he was married) as a sole proprietorship Schedule C. Then a few years ago a lawyer/accountant (client is not sure what!) suggested he was "paying too many taxes" and drew up documents for an LLC partnership. By then he was married so it is possible some joint funds were contributed but basically it is a business with fairly low capital investment so I am `fairly sure her name on the partnership is an investment in name only. But his SE tax was cut in half! And he will receive less in SS payments when he retires! Meanwhile he is happy.

I thinking that I should send him on his way; I'm not experienced with p-ships and don't have time at this time of the season to teach myself and clean up someone else's return. And I don't like to deal with schemers who are trying to beat the system.

[Bees Knees]

I think the days of claiming LLC members are exempt from SE tax are over.

From TTB, page 26-2:

Court Case: A limited liability partnership was engaged in the practice
of law. Three of the law firm’s partners were attorneys performing legal
services. The fourth partner was an S corporation owned by a tax-exempt
ESOP whose beneficiaries were the law firm’s three attorney-partners.
The three attorney-partners each had a one-third capital interest
and a 30% profits and loss interest in the law firm. The S corporation
had a 10% profits and loss interest in the law firm. Approximately 99% of
the law firm’s net business income was derived from legal services rendered
by these three attorney-partners. For the year in question, the law
firm allocated 87.557% of its net business income to the S corporation.
The IRS determined that the special allocation did not reflect economic
reality and consequently reallocated the law firm’s net business income
to its partners on the basis of each partner’s profits and loss interest.
The IRS also determined that the three attorney-partners’ distributive
share of the law firm’s net business income was net earnings from selfemployment
subject to SE tax.

The court ruled in favor of the IRS. For purposes of deciding whether
or not the special allocation to the S corporation partner should be allowed,
the court considered the following factors.
• The partners’ relative capital contributions to the
partnership. There was no evidence that the
S corporation partner contributed capital to
the partnership in any year. Consequently,
this factor does not support the special
allocation to the S corporation partner
for the year in question.
• The partners’ respective interests in partnership profits and losses.
The three attorney-partners each held a 33.3333% capital interest and
a 30% profits and loss interest, whereas the S corporation partner
held a 10% profits and loss interest. Consequently, this factor does not
support a special allocation of the partnership’s net business income
to the S corporation partner for the year in question.
• The partners’ relative interests in cash flow and other non-liquidating
distributions. The record shows no distributions were made to the S
corporation partner during the year, whereas the three other partners
did receive distributions. Consequently, this factor does not support the
special allocation to the S corporation partner for the year in question.
• The partners’ rights to capital upon liquidation. There was no evidence
presented with respect to this factor during the year in question. Consequently,
this factor does not support the special allocation to the S
corporation partner for the year in question.

Thus, based on these four factors, the court ruled in favor of the IRS’
reallocation of the partnership business income to be consistent with
the partners’ profits and loss interests.

For purposes of deciding whether the partnership business income
was subject to self-employment tax, the court considered the argument
that the three attorney-partners were limited partners in a limited
partnership and as such should not be subject to self-employment tax
under section 1402(a)(13). The partners argued they should be treated
as limited partners because:
• Their interests were designated as limited partnership
interests in the law firm’s organizational documents, and
• They each enjoyed limited liability protection under
state law.

The court said a limited partnership has two fundamental classes of
partners. General partners typically have management power and
unlimited personal liability. On the other hand, limited partners lack
management powers but enjoy immunity from liability for debts of the
partnership. The court said a limited partner could lose limited liability
protection if he or she were to engage in the business operations of the
partnership. Loss of limited liability protection could occur if the partner
takes on substantially the same control as that of a general partner.
Consequently, the interest of a limited partner in a limited partnership
is generally that of a passive investor.

In contrast, all partners of an LLP enjoy limited liability protection and
may have management powers under state law. In essence, an LLP is
a general partnership that affords a form of limited liability protection
for all its partners. The court noted that IRC section 1402(a)(13) was
originally enacted in 1977 before entities such as LLPs (and LLCs) were
contemplated. The law still does not define a limited partner.

The court also made reference to the proposed regulations issued by
the IRS on January 13, 1997, and the law enacted by Congress that
repealed those regulations.

Since Congress had not issued any other pronouncements with respect
to the definition of a limited partner for purposes of the self-employment
tax, nor has the IRS issued any regulations since, the court said: “We
therefore are left to interpret the statue without elaboration.”

Congressional intent of section 1402(a)(13) was to ensure that individuals
who merely invest in a partnership and who are not actively participating
in the partnership’s business operations would not receive
credits toward Social Security coverage. Legislative history does not
support a holding that Congress contemplated excluding partners who
performed services for a partnership in their capacity as partners from
liability for SE tax.

Since all of the law firm’s revenues were derived from legal services
performed by the three attorney-partners in their capacities as partners,
the court said it was clear that the partners’ distributive shares
of the law firm’s income did not arise as a return on the partners’ investment
and were not earnings which are basically of an investment
nature. Instead, the attorney-partners’ distributive shares arose from
legal services they performed on behalf of the law firm. As a result of
these facts, the court ruled the distributive share of profits arising from
the legal services performed in their capacity as partners in the law
firm was subject to self-employment tax. (Renkemeyer, 136 T.C. No. 7,
February 9, 2011)

[Gretel]

Thank you so much, Bees. That supports a number of things I just advised a client on.

[JoshinNC]

That court case is for an LLP

I think the days of claiming LLC members are exempt from SE tax are over.

From TTB, page 26-2:

the question related above was an LLC. There is a difference. An LLP may have a general partner, an LLC does not.

[Bees Knees]

the question related above was an LLC. There is a difference. An LLP may have a general partner, an LLC does not.

The issue was whether the LLP partners were subject to SE tax since ALL of them had limited liability protection under state law. No different than LLC members, who have the same limited liability protection under state law.

It's the same issue for both. The court said limited liability protection is not what determines SE tax. It's the level of services that are performed by the partner that matters.

[JoshinNC]

The summary you have cited has holes in it

The issue was whether the LLP partners were subject to SE tax since ALL of them had limited liability protection under state law. No different than LLC members, who have the same limited liability protection under state law.

It's the same issue for both. The court said limited liability protection is not what determines SE tax. It's the level of services that are performed by the partner that matters.

I will take the time to review the ruling before I comment further.

[JoshinNC]

I just read Renkemeyer

It is clear that this decision is contradictory to Congressional intent, as stated by the specific Senate quotes in the decision which specifically stated that the IRS had no authority to impose SE tax on limited partners and that such an imposition is solely the authority of Congress.

How do these judges keep their jobs if they blatantly flout the authority granted to them?

[AJsTax]

I will disagree

The legislature has held that self employed individuals are subject to SE tax. The disagreement is over if the simple fact that a person is a limited partner simply because they are members of a LLC. This court case says no. LLC are state law based. The taxing of those entities are federal law. By default the multi member LLC is a partnership. Partners actively involved in the business of the partnership are subject to SE tax on their guaranteed payments as well as their share of the profits generated by their work. I still believe that is only logical way to apply the rules.

[JoshinNC]

Last time I checked the US Congress passes tax law

The quotes specifically included in the court's written opinion include the Senate's voted on comments regarding this issue where the Senate clearly stated that the IRS has NO authority to tax limited partners on SE tax, except for guaranteed payments, only Congress has this authority, which Congress has expressly decided not to change laws on, leading to the opinion of many, including myself, that the inaction is purposeful because Congress is satisfied with the status quo.

[jimenright]

Is limited liability being confused

with limited participation? I don't think being a limited partner has anything to do with whether or not the partnership is an LLC.

[JoshinNC]

Explain

with limited participation? I don't think being a limited partner has anything to do with whether or not the partnership is an LLC.

Please, thanks

[jimenright]

A

limited partner in a partnership is someone financially invested in the partnership who does not participate in its operation. A limited liability company is created under state law to limit the liability of the members to their investment in the partnership.