LLC, husband (GP) wife (LP)

[DaveinTexas]

I have seen this three times this year, maybe I am out of the loop. 3 new clients, all the same situation. They have someone (a CPA each time in these cases) form an LLC for their small business. The ownership structure is usually 50/50 ownership where the husband is the GP and the wife is the LP as indicated on the K-1s. The husband in each case is the bread winner and the wife is the homemaker whom also performs services for the company. This arrangement (though it may be improper) effectively cuts the taxpayers' self employment taxes in half with just a simple click of the mouse.

Now, I know there is a LOT of confusion over who is and isn't considered a limited partner in an LLC taxed as a partnership. But reading a proposed regulation (see link here: http://www.journalofaccountancy.com/Web/20114830.htm), it appears the IRS may treat LLC members who call themselves limited partners but yet have rights to manager as a non limited partner for the passive activity rules. This article goes on to say that this proposed reg does not make the distinction between a general partner and a limited partner.

So, where do we as the tax preparers turn to for the answer...the operating agreement. In two of the cases above, there is no operating agreement. All I have is a previous year tax return filed with the arrangement mentioned above. The other clients have an operating agreement that lists both taxpayers as managers, and, both taxpayers have an active role in the business and perform services for the business.

This is why I, personally, do not like LLCs taxed as partnerships. I have yet to meet with a lawyer that knows anything about bifurcating membership interests (the only clear cut way to determine a member's tax treatment). The lawyers are the ones advocating the LLCs but they have no idea how the client's tax situation will be affected. It is left up to us.

So my question is, how do you determine whether to treat an LLC member as a GP or LP when you are preparing the partnership return?

Thanks in advance for responses.

[JoshinNC]

All LLC Members are limited partners

Period. There is no GP in an LLC, by definition.

[Burke]

Not so fast. While they all may be "limited liability partners" there is much dissension on the self-employment tax issue. See Renkemeyer vs Commissioner, 136 TC No. 7 where the Tax Court held that partners were subject to self-employment tax on their distributive share of pass- through income, under IRC 1402(a)(13). Facts & circumstances determined regarding personal services rendered to the LLC/LLP. Had any of these partners been mere investors and non-participating in the operations of said LLC, the outcome would have been different. NATP TaxPro Monthly has an extensive review of this case in the June 2012 issue. Very interesting.

[DaveinTexas]

Too easy

Period. There is no GP in an LLC, by definition.

Good luck in the audit. I liken this response to trying to justify a low, unreasonable salary for a one shareholder S corp. The IRS will spend thousands of dollars (see forensic economic analyst) converting a profit distribution to a wage. I have to assume the IRS will try the same approach in converting ordinary income from 1065 profits into SE income.

I know that by most State law there is no member of an LLC that is considered a GP but you can't rely on that provision to avoid SE tax. The bottom line is the IRS must established a bright line test, otherwise there will continue to be confusion.

[JoshinNC]

Burke and Dave

go find me the part of the tax code that says a limited partner is subject for SE tax on their distributive share of profits (except in the case of guaranteed payments). And, then, go find me the definition of a limited partner in the tax code (hint: it ain't there).

[Burke]

And the article I referred to above mentions this -- along with the rev ruling that never got issued by the IRS -- but that doesn't negate the fact that the Tax Court ruled that the partners were indeed subj to SE tax. The Court reverted back to the intent of Congress under 1402(a)(13). The article delved into the history of LLC's and how the issue of "limited partner" has evolved. I understand your position on this, and feel it needs to be addressed within the tax code to be clear, but I agree with DaveInTexas. Personal services need to be assessed by the preparer in each instance.

[Gary2]

Since the case cited by Burke is so interesting and relevant, I ran down its URL at the Tax Court web site to make it easier for everyone to find (though the name is unique enough that a web search works well). The case covers tax years 2004 and 2005; only the latter year is directly relevant to this thread.

Ironically, this case involves a law firm that specializes in Federal tax law. They lost.

[JoshinNC]

I have read the court's decision

IIRC it wasn't a tax court case though, it was a Federal court? I also remember reading some interesting justifications for why this doesn't apply to the majority of taxpayer's, I'll need to go run those down and post them here.

I agree, the issue if "iffy", but once I explain both sides of the coin to my clients and the potential for IRS scrutiny, almost all agree to go forward with the more aggressive position that LLC Members are only liable for SE tax on GP, not their distributive share.

[Gary2]

IIRC it wasn't a tax court case though, it was a Federal court?

The case I linked to was specifically the Tax Court. Perhap you have a different case in mind?

I agree, the issue if "iffy", but once I explain both sides of the coin to my clients and the potential for IRS scrutiny, almost all agree to go forward with the more aggressive position that LLC Members are only liable for SE tax on GP, not their distributive share.

What precisely do you mean by "potential for IRS scrutiny"?

[DaveinTexas]

Take a look at this article

http://www.nysscpa.org/cpajournal/2006/606/essentials/p32.htm

This article mentions the bifurcation of the member's interest. The summary is that a member of an LLC can issue two classes of shares, a membership class and a management class (effectively dividing the ownership into a limited share and a GP share).

The article goes on to state, "The IRS, however, has privately stated that until it issues further guidance in this area, it will not challenge LLC members on SE tax if the members and the LLC conform to the proposed regulations."

This is not concrete but it would seem to me that an aggressive position like the one Josh mentions should have some sort of documentation supporting it (i.e. Operating Agreement). I would feel more comfortable having an attorney draft such a document. The problem is, most attorneys have no clue what you are talking about when you mention bifurcation.

Josh, do you help the client draft the Operating Agreement?

[Burke]

http://www.nysscpa.org/cpajournal/20...ntials/p32.htm

This article mentions the bifurcation of the member's interest. The summary is that a member of an LLC can issue two classes of shares, a membership class and a management class (effectively dividing the ownership into a limited share and a GP share).

The article goes on to state, "The IRS, however, has privately stated that until it issues further guidance in this area, it will not challenge LLC members on SE tax if the members and the LLC conform to the proposed regulations."

Good information and I am adding it to my file. It appears the members of the LLC referred to in the TC decision mentioned above did not meet these qualifications. Note that professional entities, of which Law was one, were specifically prohibited from qualifying. Thanks to Gary2 for posting the URL. If you click on this, you can skip to pages 15-23 for a thorough discussion of how they came to the decision they did regarding the SE tax issue. Although this applied to TY 2004 & 2005, it was just rendered in 2011, so is pretty current.

[Gary2]

http://www.nysscpa.org/cpajournal/20...ntials/p32.htm

This article mentions the bifurcation of the member's interest. The summary is that a member of an LLC can issue two classes of shares, a membership class and a management class (effectively dividing the ownership into a limited share and a GP share).

The article goes on to state, "The IRS, however, has privately stated that until it issues further guidance in this area, it will not challenge LLC members on SE tax if the members and the LLC conform to the proposed regulations."

Thanks for digging up this link. It sheds much more light on the issue.

[JoshinNC]

A few intricacies of Renkemeyer

Not so fast. While they all may be "limited liability partners" there is much dissension on the self-employment tax issue. See Renkemeyer vs Commissioner, 136 TC No. 7 where the Tax Court held that partners were subject to self-employment tax on their distributive share of pass- through income, under IRC 1402(a)(13). Facts & circumstances determined regarding personal services rendered to the LLC/LLP. Had any of these partners been mere investors and non-participating in the operations of said LLC, the outcome would have been different. NATP TaxPro Monthly has an extensive review of this case in the June 2012 issue. Very interesting.

The entity was an LLP, this discussion revolves around an LLC, two different types of entities.

The LLP included an S-Corp partner (not Member because it's not an LLC), through which the natural partners attempted to flow the majority of the LLP profits.

The Court relied upon its own interpretation of a proposal by the Senate, not an actual law.

[Gary2]

The entity was an LLP, this discussion revolves around an LLC, two different types of entities.

The LLP included an S-Corp partner (not Member because it's not an LLC), through which the natural partners attempted to flow the majority of the LLP profits.

The S-Corp was only a factor for the 2004 tax year, and as I pointed out previously, it was the 2005 tax year part of this case that's relevant to this thread. As for LLP vs. LLC, I don't see that the distinction is relevant to this case.

The Court relied upon its own interpretation of a proposal by the Senate, not an actual law.

Only to a minor extent. I'm not sure it's critical to the argument. The key component is the House Report, whose interpretation is clear.

The court's reasoning was this:

1. The law uses the term "limited partner" without defining it. (IRC 1402(a)(13))
2. With no explicit definition, courts look first at the ordinary meaning, but will turn to Congressional intent if the meaning is ambiguous.
3. The Senate resolution establishes that the meaning, though not ambiguous when written, has become ambiguous due to the invention of LLCs and LLPs.
4. Therefore the court is permitted to turn to Congressional intent.
5. The House report on the original legislation establishes that the intent was to exclude investment earnings from self-employment tax. (H. Rept. 95-702 (Part 1), at 11 (1977))

I don't believe the logical steps are unassailable, but they're good enough. I don't know that the use of the Senate resolution in point 3 is either necessary or sufficient.