A November 2023 ruling in the U.S. Tax Court specifies that limited partners are not necessarily exempt from self-employment tax.
The court ruled that a “functional analysis test” must be applied to determine whether a limited partner, or a member of an LLC, qualifies for the exception to self-employment tax. The court determined, in part, that someone listed as a limited partner, but who participates in management decisions, cannot use their limited partner status to shield themselves from self-employment tax obligations.
The ruling marks a shift in the practice in which limited liability company (LLC) members claim their shares of LLC income aren’t subject to self-employment tax.
It also marks a victory for the Internal Revenue Service (IRS), which has been pursuing what it believes to be underreported self-employment taxes. Because the definition of who serves as a limited partner has been ambiguous, the IRS believes some people are limited in name only but are otherwise active participants in a partnership, and therefore subject to self-employment tax.
The Tax Court ruled that active participants, regardless of their title, are not exempt from the self-employment tax on their business profits. Each situation must be examined, through a “functional inquiry into the roles and activities” of those limited partners, to determine whether a person should be considered a limited partner for tax purposes.
Self-employment Tax Background
General partners are subject to self-employment tax on their business income from the partnership, whether or not it’s distributed. In contrast, limited partners are only subject to self-employment tax on guaranteed payments they receive for services provided to the partnership. Limited partners, who don’t have management authority within the partnership, are considered similar to passive investors for tax purposes.
Some states allow limited partners to provide services to businesses they invest in, further blurring the lines of who qualifies for the exception.
Self-employment income is subject to a 12.4% Social Security tax (up to the wage base) and a 2.9% Medicare tax. In most cases, members of partnerships are considered self-employed for tax purposes.
Limited Partners vs. LLC Members
Many LLC members say they are functionally the same as limited partners and, therefore, exempt from self-employment tax for income other than guaranteed payments for services.
But while limited partners and LLC members both have limited personal liability, LLC members (unlike limited partners) can actively participate in management without jeopardizing their liability protection.
Review Your Situation as an LLC Member
The law in this area remains uncertain, particularly for capital-intensive businesses. However, given the IRS’s aggressiveness in recent years in collecting self-employment taxes from LLCs, members should assess their potential obligations.
People who wish to avoid or reduce these taxes may have some options, including restructuring their ownership interests or converting their entity into a different structure. Contact us to discuss your specific situation.
