Fifth Circuit Reverses Tax Court on Treatment of Limited Partners for Self-Employment
On January 16th, the Fifth Circuit Court of Appeals issued a decision in Sirius Solutions LLP v. CIR. Sirius is a Delaware limited partnership. Its general partner is Sirius Solutions, G.P., LLC, which owned slightly less than a one percent interest in Sirius. The limited partners of Sirius were actively engaged in the business of the partnership whose primary business is business consulting, that is personal services.
The issue in the case was whether the limited partners share of partnership income was subject to self-employment tax or, exempt by virtue of Internal Revenue Code (IRC) §1402(a)(13). That Section provides that partnership distributions to limited partners “as such” are not treated as net earnings from self-employment with the exception of guaranteed payments. The Tax Court had held that the limited partners in Sirius were subject to self-employment tax on their distributive shares on the basis of its analysis in Soroban Capital Partners, L.P., 161 T.C. 310(2023) in which it applied a functional analysis to determine whether partners in a limited partnership are deemed to be limited partners for purposes of the IRC §1402(A)(13) exception. In the earlier decision, the Tax Court focused on whether the statutory language that distributions made to limited partners “as such” applied in the case of partners that were actively involved in the business of the partnership, so that they’re not considered limited partners for Section 1402 notwithstanding their legal status as State Law limited partners. Effectively, the Tax Court said that in order to come within the limited partnership definition for the purpose of the statute, the partner must effectively be a passive investor in the partnership. The Fifth Circuit, in a divided opinion, provided a very narrow application of the statute holding that “a limited partner for purposes of §1402(a)(13) is a partner in a limited partnership that has limited liability”. The Court was very critical of the functional analysis test and the need to examine the activities of partners in the partnership and based its decision on the language of the statute.
Note that IRC §1402(a)(13) was part of the Social Security Amendments of 1977 and was intended to prevent people that were not generating earnings from employment from being eligible to make contributions to social security because at that time the distributive share of all partnership income to a partner was treated as net earnings from self-employment. The new rule was designed to prevent passive investors in limited partnerships from being able to qualify distributive share income as earnings from self-employment and therefore paying employment taxes on the distributive share and making the limited partner eligible to obtain social security benefits.
For years the Internal Revenue Service has fought attempts by hedge fund managers, business consultants and even law firms from claiming that the distributive share of income received by them from tax partnerships was not subject to self-employment tax by virtue of IRC §1402(A)(13). In 2011 the Tax Court determined that attorneys could not avoid self-employment tax on their earnings simply because they were members of a limited liability partnership (Renkenmeyer, Campbell & Weaver, LLP v. CIR 136 T.C. 137 (2011).
With the proliferation of limited liability entities, including LLPs and LLCs, the character of distributive shares to tax partners has been an issue. The statue itself does not define a “Limited Partner” and in 1997, the Treasury issued proposed regulations to define when the distributive share of a tax partnership to its owner would qualify for the §1402(a)(13) exclusion. Because the regulations included as one of the tests 500 hours of service test, the regulations dubbed a “Stealth Tax” and Congress defunded IRS for a period of time from promulgating these regulations. Eventually the Treasury simply gave up and since that time Congress has not made any progress on the issue.
Since Renkenmeyer in 2011, much of the contested decisions of the Tax Court have applied the functional analysis test in a number of cases. The opinion of the Fifth Circuit in Sirius is fairly surprising and would seem to allow many businesses, even personal service businesses, the opportunity to avoid the imposition of employment taxes on significant amounts of distributive share income. In the view of the Fifth Circuit, the determination is basically limited to whether the person is a limited partner in a State Law limited partnership and has limited liability. In one part of the decision, the Court discussed Form 1065, which says that limited partners “generally” are not subject to self-employment tax said, “Form 1065 merely describes the commonsense notion that a limited partner’s share of limited income is not included in his self-employment earnings, unless those earnings are from services rendered to the partnership”. This sounds much like the analysis that the Tax Court was attempting to impose in determining the issue. However, later and on the same page of the Opinion the majority stated “as we have explained, the phrase “limited partner” refers to someone with limited liability. So, the fact that a partner with limited liability has varying levels of involvement is neither here nor there”. This would imply that simply having limited liability is enough without regard to services provided. It seems likely that the Treasury and the IRS will continue to challenge limited partners who are actually and regularly involved in a business, from being able to claim exclusion from self-employment tax. However, at this point at least one Circuit Court has held otherwise. The IRS is continuing challenges on this issue and currently cases pending in the First and Second Circuits, and the Government will no doubt be looking to obtain a split in Circuits.