Partnership partners-employees: Do self-employment taxes apply to wages earned in connection with services performed for an LLC treated as a partnership?

In Riether v. United States of America, 919 F. Supp. 2nd 1140 (D.N.M. 2012), the court agreed with the IRS that all of a general partner’s income from the partnership business is subject to self-employment taxes. In the case, the taxpayers (husband and wife) performed services for their wholly-owned LLC, and reported on their 2006 federal income tax return approximately $25,000 each as W-2 wages and $77,000 as a distributive share of the partnership income for that year. The $25,000 in wages, having been reported on Form W-2, had (in addition to income tax) FICA and FUTA taxes properly withheld. However, no self-employment taxes were withheld or paid with respect to the LLC profit distribution.

In agreeing with the IRS that the $77,000 was subject to self-employment taxes, the court relied on an old IRS ruling (Rev. Rul. 69-184), which held that all of a partner’s partnership income is subject to self-employment taxes because a partner cannot be considered a bona fide employee of the partnership. Thus, even if the partner provides services to the partnership, he is self-employed, not employed by the partnership, according to the IRS and the court.

The court also noted that the IRS’s position was consistent with IRC section 1402(a), which excepts from the definition of ‘net income from self-employment’ only a limited partner’s distributive share of partnership income. Since the court found that the husband and wife did not possess the traits of limited partners, their LLC income did not qualify for this exception.

Finally, while the court recognized that the entity was an LLC for state law purposes, in choosing not to elect “corporation” status for federal tax purposes, the court found that the owners implicitly conceded to the treatment of their LLC as a partnership for such purposes. Thus, the fact that the entity was not formed as a partnership under state law was of no moment in the partnership self-employment tax context.

Observation

As an initial matter, the court’s reliance on Rev. Rul. 69-184 seems at odds with its ultimate conclusion that the taxpayers underpaid federal taxes. According to Rev. Rul. 69-184, partners are per se ineligible to be characterized as employees with respect to a partnership for which they perform services. Thus, any amounts received by a partner for services performed are not subject to FICA, FUTA or income tax withholding. Instead, such amounts are subject to the self-employment tax, which does not include the FUTA tax, and which is generally remitted to the government later than when comparable taxes are withheld from employees’ wages. While the self-employment FICA tax rate is twice that of an employee’s FICA tax liability, a partner treated as an employee is ultimately liable for the employer’s FICA portion as well. Thus, it is unclear what benefit to any similarly-situated taxpayer the court was trying to avoid bestowing by referring to the IRS’s position in Rev. Rul. 69-184.

Finally, while the court in this instance found that the LLC members did not possess the characteristics of limited partners, it is important to note that depending on the particular circumstances, some LLC members may be properly characterized as limited partners. Thus, in those cases, it will be appropriate to exempt from self-employment taxes the LLC member’s distributive share of profits.

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