IRS Scores a Tax Court Win in its All-or-Nothing Approach to the Self-Employment Taxation of Limited Partners

Last year IRS Chief Counsel declared that a “partnership is not a corporation” and that the “wage and reasonable compensation rules which are applicable to corporations…do not apply.” Therefore once a partner is no longer a “passive investor,” his or her entire distributive share of partnership income is subject to self-employment tax. IRS Chief Counsel Advice 201640014. This approach is at odds with common practices, where service partners receive “reasonable compensation” for their services to the partnership in the form of a guaranteed payment and treat their share of partnership income as a return on investment that is not subject to self-employment tax. Succinctly stated, whereas service partners seek to bifurcate their partnership income between salary and investment returns, the IRS has embraced an all-or-nothing approach. In Castigliola v. Comm’r, T.C. Memo 2017-62, decided on April 12, 2017, the IRS’ approach proved to be a winning one.

Castigliola involved a law practice organized and operated as a professional limited liability company (PLLC) taxed as a partnership. The three attorney-taxpayers were members of the PLLC during the tax years at issue and were engaged in the practice of law solely through the PLLC, which was member managed. The taxpayers reported guaranteed payments from the PLLC each year ranging from $125,000 to $150,000, and treated the remainder of their distributive share of partnership income as not subject to self-employment tax. The IRS challenged the taxpayers’ bifurcation, arguing that because the attorneys practiced law through and participated in the management of the PLLC, they did not qualify as a “limited partner” under Section 1402, and therefore their entire share of partnership income was taxable self-employment earnings. The Tax Court agreed. Looking at the Revised Uniform Limited Partnership Act as enacted by Mississippi, the Court observed that a limited partner is defined by its liability protection, which is lost if the partner participates in control of the business. Looking at the operations of the law practice, the Court had little difficulty finding that the attorneys – who collectively made decisions on profit sharing, hiring, firing, and pay of employees, and who each signed PLLC checks – participated in the control of the business. They could not have been limited partners under applicable state law, and therefore the Court held that they were not limited partners for purposes of the Section 1402 self-employment rules. For a full copy of the Court’s decision, click here. Although reaching a different outcome, the Court’s analysis dovetails with its decision earlier this year in Stephen P. Hardy v. Comm’r, TC Memo 2017-16, holding that a doctor who owned an interest in a surgery center was a passive investor not subject to self-employment tax on the center’s earnings, notwithstanding the fact that the doctor performed surgeries at the center.

While the Castigliloa Court looked to state law rather than the legislative history of Section 1402 (advocated by the IRS) to support its holding, this decision represents a significant win for the IRS. Tax practitioners would be well-advised to discuss the IRS’ all-or-nothing approach with their owner-operated partnership clients and explore whether a conversion to a Subchapter S corporation may be a viable option.

This topic is part of a more comprehensive exploration of reasonable compensation for partnerships, C Corporations and S corporations. For a video clip from a recent presentation Planning and Defending Reasonable Compensation, click here. Also, for written materials from this presentation, please email me at adaddino@meadowscollier.com.

If you have any questions about this topic, or any other tax-related issue, please do not hesitate to call me at (214) 749-2464 or email at adaddino@meadowscollier.com.