The outright answer to the question above is not always clear, even if millions of American businesses legally organize themselves as limited liability companies (LLCs), partnerships, or similar entities.  This article will try to provide the answer.

What about General Partnerships?

If two or more people own a business together and do not form another entity such as an LLC or corporation, a general partnership becomes automatic.  Although it is a good idea, a written agreement is not required when a general partnership is formed.  Unfortunately, general partners are also personally liable for partnership debts.  This is why LLCs and limited partnerships have become the entity of choice over traditional general partnerships.

Unless it elects otherwise, the tax regulations treat any non-corporate business entity with two or more owners as a partnership.  Partnerships, therefore, include investment syndicates and pools, joint ventures, and other unincorporated organizations that carry on a business.

In the case that an individual is a general partner in a general partnership or other entity taxed as a general partnership, the individual must pay self-employment taxes on his entire distributive share of the ordinary income earned from the partnership’s business.  Line 14A of Schedule K-1 (Form 1065) shows this income.

Often mistakenly called “partner salaries,” a partnership generally makes guaranteed payments to partners for services rendered.  General partners must also pay the self-employment tax on any guaranteed payments they receive for services rendered to the partnership.  Partnerships are not required to pay guaranteed payments to the partners and the concept of “reasonable compensation” does not exist for partnerships and partners in the same way it does for S corporations and shareholders.

What about Limited Partnerships?

A limited partnership is formed under a state limited partnership law.  A limited partnership contains two classes of partners:

  • general partners who are personally liable for partnership debts and manage the business, and
  • limited partners whose personal liability for the partnership debts is limited to the money or other property they contribute.

The same as in a general partnership, general partners in a limited partnership must pay self-employment tax on their distributive share of limited partnership profits.

Limited partners, on the other hand, lack manage control over the partnership business and cannot enter into contracts on the business’s behalf.  Limited partners generally do not pay self-employment taxes on their distributive share of the partnership’s profits, but they do pay self-employment taxes on guaranteed payments for services rendered to the partnership.

What about LLCs?

Limited liability companies (LLCs) are relatively the new kids on the block.  They are the most popular business today with an estimate putting the number of LLCs at over 21 million.  They provide all their owners, even those who participate in the business, with the limited liability of a corporate shareholder.

This limited liability in LLCs is combined with the flexibility and pass-through tax treatment of a partnership.  LLCs are created by filing articles of organization with a state agency which is usually the Secretary of State.  LLCs can have one or many member-owners.

Other types of entities similar to LLCs are authorized in some states such as limited liability partnerships and limited liability limited partnerships.  Professionals must use limited liability partnerships instead of LLCs in some states.

An LLC is created under state law.  Federal tax law does not recognize the LLC as an entity.  It is disregarded and always taxed as something else.

Unless the owner elects taxation as a corporation (which is rare), the tax code treats the typical business LLC with a single member as a disregarded entity ordinarily taxed as a sole proprietor.  Owners of single-member LLCs therefore simply file Schedule C and pay self-employment taxes on their net profits.

Unless they elect taxation as a corporation, LLCs with multiple members are treated as partnerships for tax purposes.  Since the vast majority never file a corporate election.

The question becomes: Does the tax code require the multi-member LLC partnership to treat its members as general or limited partners?  In the discussion above,

  • Limited partners do not pay the self-employment tax on their share of the LLC’s profits.
  • General partners pay the self-employment tax on the LLC’s profits.

Lawmakers enacted the tax code’s limited partner exception to the self-employment tax before LLCs became widely used.  The exception does not define an LLC limited partner which explains the vague answer to the question above.

It has been proven difficult, but the IRS and courts have attempted to categorize the LLC member as a general or limited partner.  LLC members have some qualities of general and limited partners (e.g., they control the LLC business, but they also have limited liability).

IRS Proposed Regulations

Under the proposed IRS regulations, an LLC member is classified as a limited partner by default unless he

  1. has partial or total personal liability under state law for the LLC’s debts, or
  • has statutory or contractual authority to contract on behalf of the LLC, or
  • participates in the LLC’s business for more than 500 hours during the tax year.

If an LLC member fails any of the above situations, he or she is not a limited partner.

The Exceptions to the Three-Part Test

There are three exceptions to the three-part test for limited partnership states.

First Exception applies where an LLC has multiple ownership classes.  One class is the functional equivalent of a general partnership interest owned by manager-members providing services to the LLC.  The other class is the functional equivalent of a limited partnership interest at least 20 percent owned by members who satisfy the three-part test.

Take note that manager-members can own shares in both classes, and distributions to them from their interest in the limited partnership class is not subject to self-employment taxes.

Second Exception applies where an LLC has only one class of membership interest, and a member fails the three-part test solely because he or she works more than 500 hours in the LLC’s business during the year.  Ordinarily, this would apply only to a member in a manager-managed LLC.

When this is the case, the member is deemed a limited partner for self-employment tax purposes if at least 20 percent of the LLC interests are owned by other members who satisfied all three-parts of the proposed regulations test immediately after acquisition by that member of that member’s interest.

The second exception allows an LLC member to work more than 500 hours in the LLC’s business and avoid the self-employment tax.  But this particular member must not have the right to contract on the LLC’s behalf.

Third Exception is a special exception for “service LLCs.”  These are LLCs substantially engaged in health, law, engineering, architecture, accounting, actuarial science, or consulting.  Members of service LLCs who provide more than de minimis services to the LLC, under the proposed regulations, cannot be treated as limited partners.

Therefore exception 3 renders the proposed regulations useless for most service LLCs seeking to avoid self-employment taxes.

Tax Court Sample Case

Since the IRS won’t enforce its proposed regulations defining partners, and LLC members do not have to follow them, the tax court hasn’t followed them either.  It has, instead, come up with its own definition based on the ordinary meaning of a limited partner.

The Tax Court, in the leading case on this issue, held that the members of a professional limited liability partnership established by three tax attorneys did not qualify for the limited partnership exemption to self-employment taxes.  The attorneys enjoyed limited liability from firm debts but actively participated in the firm’s business.

The court held that an owner’s protection from debt is not enough to qualify him as a limited partner for self-employment tax purposes.  It said that an owner may be treated as a limited partner only if he is a passive investor who does not actively participate in the entity’s business.

The Tax Court’s interpretation of the limited partner exemption to self-employment taxes is that active members in an LLC must pay self-employment taxes on their distributive shares of LLC income.  There is no blanket elimination of service partnerships from limited partnership treatment in the courts as compared to the proposed regulations.

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