LLC Partnership with one general and one limited partner

[JoshinNC]

Disagree Jim

Every Member of an LLC is a limited partner, even the court case cited recognized this to be true

[Bees Knees]

This is something I predicted years ago would happen. Congressional inaction would lead to courts eventually deciding for themselves. The court is not that far out on a limb. Code Section 1402(a)(13) says:

…there shall be excluded the distributive share of any item of income or loss of a limited partner, as such, other than guaranteed payments described in section 707 (c) to that partner for services actually rendered to or on behalf of the partnership to the extent that those payments are established to be in the nature of remuneration for those services;

Thus, although the code clearly exempts the distributive share of profits of a limit partner from SE tax, it also clearly subjects guaranteed payments to SE tax, even if such payments are paid to a limited partner. The code associates remuneration for services as guaranteed payments.

It doesn’t take a rocket scientist to figure out what happens next. All the court has to do is say not enough guaranteed payments were paid to the limited partners for the services they rendered. You can’t pay all the profits to a service partner in the form of distributions in order to avoid SE tax.

Does this not sound EXACTLY like the S corp reasonable compensation argument?

[Bees Knees]

Here is another way to look at this court case:

The court noted that 99% of the law firm’s revenues were derived from legal services performed by the three attorney-partners. It is assumed all three partners performed similar services. But what if one of the partners was an investing partner who performed no services? Would the partnership still allocate a third of the profits to each partner and not allocate a portion of those profits to the two service partners in the form of guaranteed payments?

I think not. If one of those partners was a silent investor and did not perform any services, the other two partners would have received guaranteed payments for services rendered, and anything left over would have been divided up one third to each.

Courts often look at substance over form. You can’t call a payment for services something else in order to avoid tax.

[JoshinNC]

But what if one of the partners was an investing partner who performed no services? Would the partnership still allocate a third of the profits to each partner and not allocate a portion of those profits to the two service partners in the form of guaranteed payments?

I think not. If one of those partners was a silent investor and did not perform any services, the other two partners would have received guaranteed payments for services rendered, and anything left over would have been divided up one third to each.

Absolutely they would, it's called a hedge fund. This is the crux of the argument for hedge funds as well, except that instead of arguing SE tax they are arguing "carried interest". The fund manager is a limited partner, just like all the other limited partners, but the fund manager is the only one providing services to the LLC. Does this now mean that hedge fund managers are subject to SE tax on their distributive share?

[JoshinNC]

Guaranteed Payments are specifically defined in the Code

This is something I predicted years ago would happen. Congressional inaction would lead to courts eventually deciding for themselves. The court is not that far out on a limb. Code Section 1402(a)(13) says:



Thus, although the code clearly exempts the distributive share of profits of a limit partner from SE tax, it also clearly subjects guaranteed payments to SE tax, even if such payments are paid to a limited partner. The code associates remuneration for services as guaranteed payments.

It doesn’t take a rocket scientist to figure out what happens next. All the court has to do is say not enough guaranteed payments were paid to the limited partners for the services they rendered. You can’t pay all the profits to a service partner in the form of distributions in order to avoid SE tax.

Does this not sound EXACTLY like the S corp reasonable compensation argument?

The walks like a duck, talks like a duck argument for guaranteed payments doesn't work. Guaranteed payments are specifically defined as meeting specific requirements in the Code. If Congress intends to create Sub-S type reasonable comp for LLC active limited partner then Congress should pass legislation saying as such, but the courts cannot arbitrarily decide, "well, if Congress isn't going to make a law we'll just make it for them". That's an overreach of judicial authority.

[Burke]

Absolutely they would, it's called a hedge fund. This is the crux of the argument for hedge funds as well, except that instead of arguing SE tax they are arguing "carried interest". The fund manager is a limited partner, just like all the other limited partners, but the fund manager is the only one providing services to the LLC. Does this now mean that hedge fund managers are subject to SE tax on their distributive share?

IMO, they darn well should be. It's remuneration for services, period. Or at least a certain percentage of it is. They are not working for free. I think their argument is how the "distributive share" is taxed, i.e, ord income vs capital gains @15%, is it not?

[Bees Knees]

Absolutely they would, it's called a hedge fund. This is the crux of the argument for hedge funds as well, except that instead of arguing SE tax they are arguing "carried interest". The fund manager is a limited partner, just like all the other limited partners, but the fund manager is the only one providing services to the LLC. Does this now mean that hedge fund managers are subject to SE tax on their distributive share?

I don't agree with what hedge fund managers are able to do. I think it is a tax loophole that Congress never intended to happen. The fund manager is converting what in reality is compensation for services into "carried interest," taxed at a lower rate.

Compensation is compensation. The fact that one loophole exempts it from being taxed as compensation doesn't open the door for other loopholes to appear out of thin air.

[Bees Knees]

The walks like a duck, talks like a duck argument for guaranteed payments doesn't work. Guaranteed payments are specifically defined as meeting specific requirements in the Code. If Congress intends to create Sub-S type reasonable comp for LLC active limited partner then Congress should pass legislation saying as such, but the courts cannot arbitrarily decide, "well, if Congress isn't going to make a law we'll just make it for them". That's an overreach of judicial authority.

The code I cited says guaranteed payments are remuneration for services rendered. The walks like a duck, talks like a duck argument does work. That’s what the courts are for; to prevent people from calling compensation something else just to avoid tax.

[Burke]

I agree. And to jump into the OP's question, how can a 50% partner be limited? I would think if the other member does not participate in the business, and has no financial interest in the business, you can't arbitrarily attribute 50% of the income to that person and declare it be a distributive share, freeing up the other member from half of the SE tax. It's is so obvious a tax avoidance procedure, as he would not be doing this if it were not a family member in his own household. It might fly a little higher if he made actual guaranteed payments to himself on a periodic basis, on a steady basis, and it was specified as such under the LLC agreement.

[Bees Knees]

The walks like a duck, talks like a duck argument for guaranteed payments doesn't work.

I have an idea…I will tell all my tax clients I will do their return for free, if they agree to give me a cash gift. That way, I can avoid having to pay tax on the money.

Code § 102(a) says:

Gross income does not include the value of property acquired by gift, bequest, devise, or inheritance.

You think the courts don't have the right to use the “walks like a duck, talks like a duck” argument on me?

[Gary2]

Every Member of an LLC is a limited partner, even the court case cited recognized this to be true

That's not the way I read the case.

Every member of an LLC has limited liability. But LLCs have members, not partners, and having limited liability is not the complete definition of a limited partner. What the court found was that the term limited partner wasn't explicitly defined by Congress in a way that could apply to new types of entities, so it had to look at Congressional intent. And they found that Congressional intent was based on services provided, not liability.