Partners weren’t limited partners for purposes of self-employment tax exclusion

Castigliola, TC Memo 2017-62TC Memo 2017-62

The Tax Court has held that, while neither the Code nor any regulatory authority define “limited partner” for purposes of the Code Sec. 1402(a)(13) rule that excludes certain partnership income earned by limited partners from the self-employment tax base, under the ordinary meaning of the term “limited partner”, the taxpayers—attorneys who were members of a professional limited liability company (PLLC)—were not limited partners under Code Sec. 1402(a)(13). The Court also held that unidentified moneys in the PLLC’s attorney trust account were not partnership taxable income.

Background. In general, a partner must include his distributive share of partnership income in calculating his net earnings from self-employment, for purposes of the self-employment tax.

Under Code Sec. 1402(a), a partner’s net earnings from self-employment are generally his distributive share of the partnership’s taxable income arising out of the trade or business of the partnership plus his guaranteed payments. There are several exclusions from the general self-employment tax rule. In particular, Code Sec. 1402(a)(13) provides that the distributive share of any item of income or loss of a limited partner is excluded. This exclusion doesn’t apply to guaranteed payments to that partner for services actually rendered to or on behalf of the partnership, to the extent the payments are established to be remuneration for those services.

Facts. The taxpayers, Mr. Castigliola, Mr. Banahan, and Mr. Mullen, were Mississippi attorneys. They practiced as a PLLC. In 2005 the PLLC’s office and many of its records were destroyed in Hurricane Katrina, but the taxpayers recovered and continued their practice.

The taxpayers were members of the PLLC; the PLLC was member-managed. The PLLC never had a written operating agreement. The members divided up the management duties, with each having significant management duties.

The members’ compensation agreement required guaranteed payments to each member; the guaranteed payments were commensurate with local legal salaries. Any net profits of the PLLC in excess of amounts paid out as guaranteed payments were distributed among the members in accordance with the members’ agreement.

The PLLC maintained a lawyer’s trust fund account in compliance with Mississippi law. The majority of transactions in the account involved the PLLC’s work in obtaining subrogation payments for its client State Farm Insurance —the PLLC collected money from uninsured individuals involved in automobile accidents with State Farm policyholders, and then periodically transferred a portion of the funds to State Farm and a portion to the PLLC’s regular bank account. At the end of 2010 the trust account held $15,167 of undistributed funds; the members did not know to whom this amount belonged.

IRS issued notices of deficiency in which it found that all of the members’ 2008-2010 income from the PLLC was subject to self-employment tax and that the monies in the trust fund at the end of 2010 was taxable income to the PLLC.

The partners weren’t limited partners for self-employment tax purposes. The Court held that none of the partners were limited partners for purposes of Code Sec. 1402(a)(13) and that therefore their full shares of PLLC income were subject to self-employment tax.

The Court first noted that previously, in Renkemeyer, Campbell & Weaver, LLP, (2011) 136 TC 137136 TC 137 (see Weekly Alert ¶ 15 02/17/2011), the Tax Court had stated that no statutory or regulatory authority defines limited partner for the purposes of Code Sec. 1402(a)(13). The Court then said that, because the term is not defined, it would apply accepted principles of statutory construction to ascertain congressional intent and that it is a well-established rule of construction that if a statute does not define a term, the term is to be given its ordinary meaning at the time of enactment.

Renkemeyer also indicated  that  the   meaning  of  “limited  partner”  in Code  Sec.  1402(a)(13) is not necessarily  confined  solely  to  the   limited  partnership  context. As a result, the Court said that it then had to consider whether any person claiming the Code Sec. 1402(a)(13) exemption held a position in an entity treated as a partnership for Federal tax purposes that is functionally equivalent to that of a limited partner in a limited partnership. The taxpayers were all members of a member-managed PLLC. Consequently, the issue was whether a member of such a PLLC is functionally equivalent to a limited partner in a limited partnership.

Citing a legal treatise and case law, the Court said that a limited partnership has two classes of partners, general and limited. General partners typically have management power and unlimited personal liability. On the other hand, limited partners typically lack management power but enjoy immunity from liability for debts of the partnership.

The Court then considered the Uniform Limited Partnership Act in 1916, the Revised Uniform Limited Partnership Act in 1976, and Mississippi’s limited partnership law. Each of these sources provided language to the effect that a limited partner would lose limited liability protection if “in addition to the exercise of his rights and powers as a limited partner, he participates in the control of the business”.

The respective interests in the PLLC held by the taxpayers made each a member of the PLLC, which was member-managed. Therefore management power over the business of the PLLC was vested in each of them through the interest each held. The PLLC had no written operating agreement, nor was there any evidence to show that any member’s management power was limited in any way. Furthermore, all members participated in control of the PLLC. For example, they all participated in collectively making decisions regarding their distributive shares, borrowing money, hiring, firing, and rate of pay for employees. They each supervised associate attorneys and signed checks for the PLLC. The respective interests held by Mr. Castigliola, Mr. Banahan, and Mr. Mullen could not have been limited partnership interests under any of the limited partnership acts.

Moreover, a limited partnership must have at least one general partner. See, e.g., Miss. Code Ann. sec. 79-14-801 (2009). This is logical because limited partners, as discussed above, cannot participate in control of the business and maintain their limited liability. Because there must be at least one partner who is in control of the business, there must be at least one general partner. The members testified that all members participated equally in all decisions and had substantially identical relationships with the PLLC. But since by necessity at least one of the members must have occupied a role analogous to that of a general partner in a limited partnership, and because all of the members had the same rights and responsibilities, they must all have had positions analogous to those of general partners in a limited partnership.

Undistributed trust account funds weren’t taxable income. The Court rejected IRS’s argument that the money in the PLLC’s trust fund account at the end of 2010 was taxable income to the PLLC for 2010.

Mr. Banahan testified credibly that the funds in the trust account were not PLLC funds and could not be withdrawn as fees by the members. He was not sure to which clients the funds belonged but was certain that it would be a violation of professional ethics to withdraw the money as fees (the consequences of which might have included disbarment). He was not sure how the discrepancy arose but stated that it may have been attributable to losing the PLLC’s office in Hurricane Katrina. He also stated that at some point the money might be deposited into Mississippi’s fund for unclaimed moneys. Mr. Banahan’s testimony was corroborated by the credible testimony of Mr. Castigliola.

The members testified credibly that the funds IRS identified did not belong to the members. Rule 1.15 of the Mississippi Rules of Professional Conduct requires that a lawyer keep client funds — and funds the ownership of which is disputed — separate from the lawyer’s own property. The members argued that, because they knew they did not own these funds, the funds had to be kept separate in the trust account. IRS offered no evidence or arguments to support its contention that the members were entitled to withdraw these funds as fees.

Take away..it is incredibly  important to review the partnership agreements of every entity and the duties of each member when trying to  understand how the tax court applied under Code Sec. 1402(a)(13). Limited partners will continue examined as a potential source of  Self Employment tax.