SECA and the Limited Partner Exemption Again

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Monte Jackel, Of Counsel at Leo Berwick, discusses the absence of guidance or a legislative solution concerning self employment tax for a partner’s income derived from services performed as a partner on behalf of the partnership. As Monte discusses, the issue prompted proposed regulations and a Congressional backlash over two decades ago. Since then, neither Congress or IRS has had the appetite to address this issue on a systemic basis.  Les

Section 1402(a) of the Internal Revenue Code defines the term “net earnings from self-employment” as including the taxpayer’s distributive share of income or loss under section 702(a) from any trade or business carried on by a partnership of which the taxpayer is a member. However, section 1402(a)(13) excludes the distributive share of a limited partner from self-employment tax other than guaranteed payments to the limited partner for services rendered. Neither the statute nor any final or temporary regulations defines the term “limited partner” for this purpose.

The situation has cried out for regulations with respect to who is a “limited partner” for SECA purposes for over two decades now. Proposed regulations were issued in 1994 and reissued in 1997. Both sets of regulations were never finalized and prompted adverse Congressional reaction. There was a Congressional moratorium on finalizing the 1997 proposed regulations until July 1, 1998. That date has come and passed with no further IRS regulation activity. The 1997 proposed regulations can, however, be relied upon by taxpayers but cannot be enforced by the IRS against them. 


In Renkemeyer (136 T.C. 137 (2011)), the taxpayers, lawyers in a Kansas limited liability partnership law firm, argued that their distributive share of law firm income [post 1997] was not subject to SECA because the taxpayers were limited partners who enjoyed limited liability under applicable state law despite actively performing legal services on behalf of the partnership. The Tax Court rejected this contention, noting that a limited liability partnership is merely a general partnership where the members have limited liability. The court summarized the situation this way:

As of 2005 Congress had not issued any other pronouncements [referencing the 1997 proposed regulations] with respect to the definition of a limited partner for purposes of the self-employment tax, nor had the Secretary. We therefore are left to interpret the statute without elaboration…. “Limited partner” is a technical term which has become obscured over time because of the increasing complexity of partnerships and other flowthrough entities as well as the history of section 1402(a)(13). We therefore must look to the legislative history for guidance…. [T]he intent of section 1402(a)(13) was to ensure that individuals who merely invested in a partnership and who were not actively participating in the partnership’s business operations (which was the archetype of limited partners at the time) would not receive credits toward Social Security coverage. The legislative history of section 1402(a)(13) does not support a holding that Congress contemplated excluding partners who performed services for a partnership in their capacity as partners (i.e., acting in the manner of self-employed persons), from liability for self-employment taxes….  [I]t is clear that the partners’ distributive shares of the law firm’s income did not arise as a return on the partners’ investment and were not “earnings which are basically of an investment nature.” Instead, the attorney partners’ distributive shares arose from legal services they performed on behalf of the law firm.”

It is true that Renkemeyer has expansive language in it, quoted above, to treat a partner as not being a limited partner for SECA purposes when his income is derived from services performed as a partner on behalf of the partnership. However, it is also true that unless the Congress finally acts on the SECA issue as part of the current administration’s priorities, the IRS will be either forced to litigate the issue until it is resolved by enough courts to conclude on this issue, or it will have to muster up the political courage and finalize the 1997 proposed regulations. 

Should the IRS be allowed to effectively enforce the 1997 proposed regulations through audit and litigation in the courts and never risk political outrage again by the Congress if it comes to it? Is that the way the IRS should be administering the tax law, playing political games with the tax system and expending government resources to litigate cases that would not have arisen if the 1997 proposed regulations had been finalized? I think the answer is a clear and resounding no. 


  1. Robert Kantowitz says

    Allow me respectfully to disagree, or at least to take a more nuanced view.

    First, procedurally. If Treasury knows that Congress does not agree with the 1997 Proposed Regulations, it is not for Treasury to finalize them. Regulations are intended to fill in gaps in the statute in accordance with the will of Congress, not to “correct” Congress’s actions or align them with what Treasury thinks is better tax policy. Go back to square 1 and write something that would not ignite a firestorm on Capitol Hill. If Treasury thinks that Congress today would not be upset with the 1994/97 Proposed Regulations, then by all means finalize them now. I doubt that that is the case, though.

    Now, as a matter of substance. Consider the words of the statute:

    “there shall be excluded the distributive share of any item of income or loss of a limited partner, as such, other than guaranteed payments described in section 707(c) 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 remuneration for those services.”

    Can anyone pretend that Congress does not know what a service partnership is (see section 1202(e)(3)(A)), and did not intend to carve that out, or that not all profits that a limited partner is allocated are within “guaranteed payments”? Hence, a good case can be made that the three-prong test of the Proposed Regulation is in part void under the first prong of Chevron because, although the statute may be ambiguous as to whether a member of an LLC is a “limited partner” or how much management authority is inconsistent with limited partner status, there is no doubt that for the purpose of this statute, a person who is a limited partner under state law does not lose that status because the partnership is a service partnership.

  2. Monte, thanks! It’s so frustrating when issues of this kind go unresolved, allowing the risk-takers to file LLC returns taking whichever of the two positions is the more favorable for their particular situations. So few partnership tax returns are audited that the Government is losing more revenue than if either of the two possible positions were consistently taken and enforced through automated selection of nonconforming returns. I remember hearing talk at an ABA Tax Section meeting within the past 5-10 years that Treasury and the Hill were “oh-so-close” to an agreed solution. I wonder if the new administration – after it deals with the huge tax proposals they have on the table now – might try to resolve this ridiculous uncertainty.

    Ron Wiener

  3. Joseph M. Erwin says

    This is not the first or only issue where the IRS plays the “Gotcha” game. For instance, despite being directed to issue regulations on sourcing and tax residency in the U.S. territories in the Tax Reform Act of 1986, the IRS did not do so until Congress told them again in 2005. In the meantime, in 2003, the IRS began an aggressive enforcement effort against Virgin Islands taxpayers challenging — yes, you guessed it — their positions on residency and source of income.

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