Self-Employment Tax Issues

Employment Cases and Planning Implications

The self-employment tax issue for closely held businesses has become more important in light of a number of self-employment tax cases decided by the Tax Court in the last year.  Three recent cases look at the statutory provisions of self-employment tax: Fleischer v. Commissioner, T.C. Memo 2016-238 (December 29, 2016); Castigliola v. Commissioner, T.C. Memo 2017-62 (April 12, 2017); and Hardy v. Commissioner, T.C. Memo 2017-16 (January 17, 2017).

Self-employment income is defined under section 1402(a) as “gross income derived by an individual from any trade or business carried on by such individual, less the deductions…plus his distributive share (whether or not distributed) of income or loss…from any trade or business carried on by a partnership of which he is a member…” It does not include any net earnings over the contribution and benefit base ($137,700 in 2020), subtracting the wages paid to such individual during such taxable year (section 1402(b)(1)), or earnings less than $400 in a particular tax year (section 1402(b)(2)).

Section 1402(a)(13) states that “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.”

Tax practitioners have relied on Renkemeyer, Campbell, and Weaver LLP v. Comm’r, 136 T.C. 137 (2011) to advise partnership clients on self-employment tax issues.  In Renkemeyer, three attorneys formed a state law limited liability partnership.  One year later, the attorneys executed a written partnership agreement that created two classes of partnership units:  “General Managing Partner Partnership Units” and “Investing Partnership Units.”  Only General Managing Partner units had the authority to act on behalf of the partnership. The partners on their tax returns claimed that all of their distributive shares of partnership gain or loss attributable to their Investing Partner Partnership Units were items of income or loss of a limited partner for purposes of section 1402(a)(13).  The Tax Court disagreed.

In Fleischer,  a taxpayer attempted to use an S-Corporation to reduce self-employment tax, since S corporation income is not subject to the tax.  Ryan Fleischer was a registered financial consultant, certified financial planner, and licensed seller of variable health and life insurance policies who developed investment portfolios for clients.  After working as an employee of an investment firm and a bank, Fleischer decided to start his own business.  He entered into an agreement with LPL, a brokerage company that stated that he was an independent contractor.  Later, he incorporated Fleischer Wealth Plan (FWP) as its sole shareholder and elected S-Corporation status.  Three weeks after incorporating FWP, he entered into an employment agreement with FWP under which the company paid him a salary to “perform duties in the capacity of Financial Advisor.”  He then entered into a broker contract with MassMutual Financial Group (MassMutual).  The contract was between Fleischer and MassMutual, with no mention of FWP, and Fleischer signed the contract in his personal capacity.  The contract explicitly stated that there was no employer-employee relationship between Fleischer and MassMutual.  Neither Fleischer nor the companies modified the contracts to include FWP.  Fleischer did not report any self-employment tax on the returns.

The Court held that Fleischer was subject to self-employment taxes.  Fleischer, not his S corporation, had earned all of the income. There was no indicium for LPL to believe that FWP had any meaningful control over petitioner as FWP had not been incorporated and no purported employer-employee relationship between FWP and petitioner existed at the time petitioner signed the representative agreement with LPL. Moreover, there is no evidence of any amendments or addendums to the LPL agreement after FWP was incorporated. Although FWP had been incorporated before petitioner entered into the broker contract with MassMutual, FWP is not mentioned in the contract, and petitioner offered no evidence that MassMutual had any other indicium that FWP had any meaningful control over him.

Given the Fleischer decision, a reasonable question for practitioners is what steps can a financial consultant take to avoid self-employment taxes if he/she is unable to cause an S Corporation to contract directly for service commissions or fees.  One possibility would be to have the S Corporation receive a management fee for its staff that assist the primary employee, with the fee providing a reasonable corporate profit after staff compensation and related costs. The S corporation could also reinvest its profits or even use them to expand the business reach of the primary employee, rather than merely distributing them out to the primary employee whose earnings paid the management fee.

In Castigliola, three attorneys practiced law through a general partnership in Mississippi.  In 2011, they incorporated their partnership as a professional limited liability company (PLLC).  The PLLC’s only business was the practice of law, and petitioners practiced law solely in their respective capacities as partners of the PLLC.  The PLLC did not have a written operating agreement, but the attorneys did have a written compensation agreement.  The compensation agreement required guaranteed payments in the amount of the average salary of an attorney with similar experience in Mississippi.  The compensation agreement also stated that the partners would distribute to themselves the net profits of the PLLC in excess of guaranteed payments.  They reported the guaranteed payments as self-employment income but did not remit self-employment taxes on distributions in excess of the guaranteed payments.  The guaranteed payments were calculated based on a survey of legal salaries in the area and designed to represent the value of the services petitioners provided to the PLLC.

The Tax Court noted that a general partner has management power and unlimited personal liability, whereas limited partners lack control of a business and have limited liability.  A partnership therefore must have a least one general partner.  Since the PLLC had no written operating agreement and no specified general partner, no partner’s management power was limited in any way. All the partners participated in making management decisions, including decisions regarding distributions, borrowing funds, hiring, firing, rate of pay for employees, and expenditures.  The absence of a general partner in a member-managed LLC, the Tax Court held, meant that all the members function as general partners.

Castigliola also raises several questions for practitioners.  How much management power is too much management power for a limited partner? How does this holding apply to classic state-law limited partnerships wherein limited partners have management rights, often significant ones, yet retain state-law status as limited partners? Does focusing purely on management rights lead to any disparate treatment between shareholders of S corporations and limited partners of partnerships? Did congressional action to stop the proposed regulations lead to a less favorable outcome for taxpayers?  Perhaps the most significant conclusion from this case is that practitioners should advise their clients of the importance of a written partnership agreement or operating agreement in which the partnership has at least one general partner or, in the case of an LLC rather than state-law partnership, the LLC has a managing member who will be treated as the general partner.  The agreement can provide that all members other than the manager or general partner have limited rights to participate in management.  Election of the manager would be the only management right for non-managing members or partners.

In Hardy,  Dr. Hardy was a plastic surgeon performing pediatric constructive surgery in various facilities while maintaining his own medical practice as a single member PLLC (Northwest Plastic Surgery).  He performed surgery at his office or at two local hospitals.  The patients paid Dr. Hardy for the surgeries and paid a separate facility fee.  Dr. Hardy also invested $163,974 for a 12.5% minority interest in Missoula Bone & Joint Surgery Center, LLC (MBJ).  Each member was a manager of MBJ, but Dr. Hardy did not have any role in any management decisions or any day-to-day responsibilities at MBJ.  Dr. Hardy received a distribution from MBJ that was not dependent upon the number of surgeries that he performed at MBJ since MBJ did not have a minimum surgery requirement.

The Court held that the Hardys were not liable for self-employment tax for tax years 2008 and 2009 on Dr. Hardy’s distributive shares of income from MBJ. The Tax Court distinguished Hardy from Renkemeyer and determined that Dr. Hardy received MBJ income in the capacity only as an “investor.”  Accordingly, the MBJ income was not subject to self-employment tax.  Dr. Hardy received distributions based on fees that patients paid to use the facility. The patients paid Dr. Hardy’s surgeon fees separately.

What can we take away from the Hardy case? Hardy appears to contradict Renkemeyer and Castigliola.  In Hardy, the Tax Court focused on the actual daily management of the business rather than the Hardy’s legal rights to manage the LLC together with the other equal owners.  There was no operating agreement!  The LLC’s annual reports did not specify whether Dr. Hardy was a member or member-manager, but also failed to list a non-member manager.  It appears as though the LLC members together had exclusive legal authority to run the business.  No member had any more rights than any other member.  They did not have legal rights akin to limited partners!  They were more like passive general partners!  

If a taxpayer is operating a service firm (i.e. law firm, accounting firm) as a limited partnership, it is likely that the IRS will pursue a partner for self-employment taxes.  If a member of an LLC is an investor who does not perform any services related to operating the business, but has made a significant investment of capital, the IRS will likely treat the member as a limited partner for section 1402(a)(13) purposes.  One should note that the IRS has not distinguished between a service partnership and a partnership selling a good.

Hardy raises additional questions not resolved here.  What if an LLC member performs significant services and has a significant amount of invested capital?  Should all LLCs have a designated manager? What capital contribution amount should an LLC member make to be considered an investor so as to satisfy the section 1402(a)(13) exception?  Should one conduct business through a limited liability company that is owned by a limited partnership? What about net investment income issues?  Should a taxpayer just be an active limited partner in a limited partnership? Should tax practitioners rely only on Renkemeyer?  The self-employment tax enigma continues!

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