The Tax Court has reopened the question of whether limited partners are entitled to an exemption from self-employment taxes—an issue that’s been in hibernation for over 13 years. The February 9 opinion in Renkemeyer v. Commissioner, 136 T.C. No. 7(2011) concludes that status as a limited partner does not necessarily exempt a partner from self-employment taxes; the exemption depends on the partner’s level of participation in partnership business.

The Tax Code says that limited partners don’t have to pay self-employment tax. That sounds simple enough, but the Code doesn’t define “limited partner,” leaving the term open for interpretation. As a result, business owners with wildly divergent roles in their businesses have claimed limited partner status and the exemption from self-employment taxes that comes with it.

The IRS isn’t inclined to allow everyone who claims limited partner status to avoid self-employment taxes and frequently disputes those claims.

Who is entitled to claim the exemption?

There are two primary types of limited partnerships, both creatures of state law. The limited partnership (LP) has both general and limited partners and the limited liability partnership (LLP) has only limited partners.

Generally, limited partners in an LP do not actively participate in partnership business—they often provide capital in exchange for a partnership interest. Those limited partners are akin to the traditional concept of the silent partner. In contrast, limited partners in an LLP may actively participate in partnership business. They are “limited” in the sense that they have limited liability for the firm’s debts.

The question in Renkemeyer was whether limited partners in a LLP are entitled to an exemption from self-employment taxes. Renkemeyer was an attorney for a limited liability partnership engaged in the practice of law. In 2004, approximately 99% of the firm’s income was derived from legal work performed by the firm’s attorneys—in other words, the firm’s owners actively worked in the business. 

When Renkemeyer received 36% of the firm’s net income in 2005, he argued that his interest in the partnership should fall under the exemption from self-employment taxes.

Judge Julian Jacobs, who presided over the case, disagreed with Renkemeyer. He held that merely labeling oneself as a limited partner was insufficient to qualify for the exemption, and that the test for exemption should be whether the individual actively participates in the business. Thus, because Renkemeyer actively worked as an attorney for the LLP, he was not entitled to the exemption from self-employment taxes.

Although the ruling primarily affects limited partners in an LLP, it could also affect limited

 

partners in an LP when they have some role, however small, in the partnership business.

Future of the limited partner debate

In 1997, partnerships and self-employment taxes were headlined in the media when Steve Forbes heard about proposed regulations defining the term “limited partner.” He argued that the Treasury did not have the proper authority to pass the proposed regulation and that it was essentially “a major tax increase by a stealth regulatory decree” that could increase Social Security and Medicare taxes by over $1 billion over a period of 10 years.  Small business owners who would have been affected by the proposed legislation campaigned against it, and Congress reacted in 1997 by imposing a one-year moratorium to prevent the Treasury from taking such action.

Now, even with the moratorium lifted, neither the IRS nor the Treasury have clarified the “limited partner” dilemma.  Although Judge Jacobs’ opinion may have awoken this issue from hibernation, his opinion did not shed any new light on it. He didn’t define the term “limited partner” and didn’t rule on whether Section 1402(a)(3) applies solely to state law limited partnerships or whether it could be expanded to include limited partners in other types of entities.

The uncertainty revolving around the issue of limited partner exemption from self-employment taxes should signal to Congress the necessity of taking action to resolve the ambiguity. Passage of a regulation defining the term “limited partner” would give small business owners a clear standard for defining their relationships and reduce the uncertainty associated with the self-employment tax liability.

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See also The Law Professor's blog at AdvisorFYI.