A Brief History of Limited Partner Self-Employment Tax

 

There is a case going through the courts that caught my eye.

It has to do with limited liability companies (LLCs). More specifically, it has to do with LLC members.

LLCs started coming into their own in the 1990s. That gives us about 35 years of tax law to work with, and in many (if not most) cases practitioners have a good idea what the answers are.

There is one question, however, that still lingers.

Let’s set it up.

Before there were LLCs there were limited partnerships (LPs). The LPs will forever be associated with the tax shelters, and much of the gnarliness of partnership taxation is the result of Congress playing whack-a-mole with the shelters.

The LPs tended to have a similar structure.

(1)  Someone set up a partnership.

(2)  There were two tiers of partners.

a.    The general partner(s) who ran the show.

b.    The limited partner(s) who provided the cash but were not otherwise involved in the show. It is very possible that the limited was a well-to-do investor placed there by a financial advisor. The limited partner was basically investing while hoping for a mild/moderate/lavish side dish of tax deduction goodness.

The liability of the limited partners in the event of disaster was capped, generally to the amount invested. They truly were limited.

A tax question at this point was:

Is a limited partner subject to self-employment tax on his/her share of the earnings?

This question was not as simple as it may sound.

Why?

Did you know there was a time when people WANTED to pay into social security?

Let’s do WAYBAC machine.

When first implemented, social security only applied to certain W-2 workers.

This was an issue. There was a significant tranche of workers, such as government employees and self-employeds, who did not qualify. Enough of these excluded workers wanted (eventual) social security benefits that Congress changed the rules in 1950, when it introduced self-employment (SE) taxes. FICA applies to a W-2 worker. SE taxes apply to a self-employed worker. Both FICA and SE are social security taxes.

Congress also made all partners subject to SE tax: general, limited, vegan, soccer fan, whatever.

This in turn prompted promoters to peddle partnerships for the primary purpose of paying self-employment tax.

It sounds crazy in 2023, but it was not crazy at the time. During the 1950s the SE rate varied between 2.25% and 3.375% and the wage base from $3,600 to $4,200. Take someone who had never paid into social security. Getting an annual partnership K-1 and paying a little bit of SE tax in return for a government-backed lifetime annuity sounded appealing. The value of those benefits likely far exceeded the cost of any SE taxes.

It was appealing enough to catch Congress’ attention.

In 1977 Section 1402(a)(13) entered the tax Code:

There shall be excluded the distributive share of any item of income or loss of a limited partner, as such, other than guaranteed payments … 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 renumeration for those services.”

You see what Congress did: they were addressing the partnerships gaming the social security system. One could earn social security benefits if one was involved in business activities, but not if one were just an investor – that is, a “limited” partner.

But things change.

Social security tax rates kept going up. The social security wage base kept climbing. Social security was becoming expensive. Rather than opt-in to social security, people were trying to opt out.

And businesses themselves kept changing.

Enter the LLCs.

Every member in an LLC could have “limited” liability for the entity’s debts. How would that play with a tax Code built on the existence of general and limited partners? LLCs introduced a hybrid.

Taxwise, it was problematic.

In 1994 the IRS took its first shot. It proposed Regulations that would respect an LLC member as a limited partner if:

(1) The member was not a manager of the LLC, and

(2) The LLC could have been formed as a limited partnership, and, if so, the member would have been classified as a limited partner.

It was a decent try, but the tax side was relying very heavily on the state law side. Throw in 50 states with 50 laws and this approach was unwieldy.

The IRS revisited in 1997. It had a new proposal:

         An individual was a limited partner unless

(1) He/she was personally liable for partnership debt, or

(2)  He/she could sign contracts for the partnership, or

(3) He/she participated in partnership activities for more than 500 hours during the year.

Got it. The IRS was focusing more on functional tests and less on state law.

I was in practice in 1997. I remember the reaction to the IRS proposal.

It was intense enough that the politicians got involved. Congress slapped a moratorium on further IRS action in this area. This was also in 1997.

The moratorium is still there, BTW, 26 years later.

And now there is a case (Soroban Capital Partners LP v Commissioner) coming through and returning attention to this issue.

Why?

Sure, there have been cases testing the SE tax waters, but most times the numbers have been modest. There has been no need to call out the National Guard or foam the runways.

Soroban upped the ante.

Soroban is challenging whether approximately $140 million (over several years) is subject to SE tax.

Soroban also brings a twist to the issue:

Can a partner/member wear both hats? That is, can the same person be a general partner/member (and subject to SE tax) and a limited partner/member (and not subject to SE tax)?

It is not a new issue, but it is a neglected issue.

We’ll return to Soroban in the future.