In an IRS chief counsel advice (CCA) memorandum ( CCA 201436049), the IRS concluded that the members (partners) of a management limited liability company (management company) did not meet the "limited partner" exception under Section 1402(a)(13) with respect to self-employment taxes. Thus, the IRS concluded that the partners are subject to self-employment tax on their distributive shares of management company income.
The partners are members of the management company (treated as a partnership for U.S. federal income tax purposes) that manages a family of investment partnerships (the funds) for a quarterly management fee. The management company also holds a general partner interest in each of the funds.
The management company generally had full authority and responsibility to manage and control the affairs and businesses of each fund and carried on all investment activities (e.g., purchasing, managing, restructuring and selling of the funds' investment assets). The partners worked full time for the management company; with certain of them providing a wide range of professional services for the funds on behalf of the management company, while others performed operational and support services for the management company itself. Each partner received Forms W-2 for both the years in issue from the management company for wage amounts. In addition to its small ownership interest in each of the funds, the management company's assets consisted primarily of cash, office equipment and an aircraft.
In the years addressed in the CCA, the net ordinary business income generated by the management company (i.e., income described in Section 702(a)(8)) related solely to income from the management fees and did not include a distributive share of income from the funds. Interestingly, in a footnote, the CCA explained that the management company did receive a distributive share of other items from the investment partnerships, including capital gains, interest, dividends and rents. However, those items were not the subject of the CCA.
The management company treated all the partners as limited partners not subject to self-employment tax on their distributive share of the net ordinary business income of the management company. The only amounts reported as subject to self-employment tax were guaranteed payments (representing health insurance premium and parking benefits paid by the management company on behalf of its partners). The management company stated that the "wage" amounts represented "reasonable compensation" to each partner. The management company reasoned that because the management company had the same role and business as the S corporation it succeeded, it could continue to apply the same "reasonable compensation" wage rules applicable to corporations.
The IRS cited Renkemeyer, Campbell, and Weaver LLP v. Commissioner, 136 T.C. 137 (2011) (holding that practicing lawyers in a law firm organized as a limited liability partnership were not limited partners within the meaning of Section 1402(a)(13) and thus were subject to self-employment taxes), and Riether v. United States, 919 F.Supp.2d 1140 (D. N.M. 2012) (granting government's motion for summary judgment on the issue of whether a husband and wife were subject to self-employment tax on their distributive shares from an LLC partnership).
In Renkemeyer, the Tax Court distinguished between income that is derived from services and earnings that are basically of an investment nature. In the Riether order, the district court, citing Rev. Rul. 69-184, said it was not persuaded by the taxpayers' argument that the receipt of Form W-2 made them employees of the partnership.
The IRS concluded in the CCA that all the partners are not limited partners within the meaning of Section 1402(a)(13) and they are subject to self-employment tax on their distributive shares of the management company's income described in Section 702(a)(8). The IRS explained that, like the situation in Renkemeyer, the partners' earnings were not in the nature of a return on a capital investment, even though the partners paid more than a nominal amount for their units in the management company. The IRS further explained that similar to Riether, the management company cannot change the character of its partners' distributive shares by paying portions of each partner's distributive share as amounts mislabeled as so-called "wages." Finally, since the management company is a limited liability company and not a corporation, the IRS stated that the "reasonable compensation" rules applicable to corporations do not apply.
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