It's late spring and you receive a K-1 from a Limited Liability Company (LLC) of which you are a member. On line 14 of the K-1 is a number that is reported to you: self-employment income.
Is it right? Do you need to report your share of LLC income as self-employment income? If you do this, you will now have to pay an additional tax called self-employment tax. This self-employment tax is levied on top of the regular income tax you already pay and is levied on your self-employment income. The self-employment tax rate for self-employment income is typically 15.3%. However, for 2011 the rate has been reduced to 13.3%.
Generally, a taxpayer's share of ordinary income reported on a Schedule K-1 from a partnership engaged in a trade or business is subject to self-employment tax. However, as with any general rule, there are numerous exceptions, including one that excludes a limited partner's share of ordinary partnership income. Should the term “limitative partner” be interpreted to mean members of an LLC? What about partners in a Limited Liability Partnership (LLP)?
When Congress added the exception some thirty years ago, it did not define “limitative partner.” There was probably no need for a definition. Limited partner essentially meant one thing under the laws of most states: a limited liability partner who did not participate in the management or control of the partnership. However, the legal landscape has changed since Congress added the exception, and some argue that the tax landscape needs to catch up.
What legislative changes have taken place? First, revised partnership statutes in most states have redefined the term limited partner to expand the extent to which such a partner can participate in the control or activities of the partnership without compromising the partner's limited liability. Second, all states have added at least two new types of legal entities since the exemption made its way into the Internal Revenue Code: LLCs and LLPs. While there are similarities between LLCs, LLPs and traditional limited partnerships, the comparison is far from exact.
In an LLC, each member has limited liability. Depending on the type of LLC (i.e., member-managed versus manager-managed) and the terms of the operating agreement, members are free to participate in the control and operations of the LLC to any extent.
LLPs emerged as a means of protecting professionals from the liability of their partners who are guilty of negligence. Unlike a limited partnership, an LLP does not require a general partner to remain fully liable for the partnership's obligations; instead, each partner remains solely responsible for their own actions. In some states, the privilege of operating within the LLP form is reserved for certain professions (e.g. lawyers, doctors, architects, etc.), but in all cases the partners of an LLP are free to participate in its control and activities of the LLP. LLP. device without compromising their liability protection.
Using the term “limited partner” in the changing legal landscape has proven to be a difficult problem for the Internal Revenue Service (IRS). Despite two sets of proposed regulations, there is still no definitive meaning. Following their latest regulatory efforts, several taxpayers complained that the Treasury Department had exceeded its regulatory authority in defining “limitative partner.” Congress agreed and imposed a one-year moratorium on finalizing any regulations. The Senate went so far as to pass a resolution urging the Treasury Department to withdraw the proposed regulations. And although the moratorium has long since expired, neither the Treasury Department nor the IRS have offered a revised proposal.
Informally, attorneys within the IRS have suggested that taxpayers who follow the latest proposed rules will not be challenged in audits. In practice, some taxpayers and professionals rely on the proposed rules, while others rely on an acceptable interpretation of the term 'limited partner' in the articles of association.
In a recent tax lawsuit involving an LLP, taxpayers relied on such an interpretation. They argued that since they had limited liability as partners in an LLP, they fell within the intended definition of limited partners. Using its own interpretation of the law, the Tax Court held that the intent of the limited partnership exception was to ensure that taxpayers who merely invested in a partnership did not receive credits for Social Security coverage. In other words, Congress' intent did not support the argument that Congress intended to exclude partners who performed services for a partnership in their capacity as partners (that is, who acted in the same manner as self-employed persons). Accordingly, the Court held that taxpayers' LLP income constituted self-employment income and must be reported on line 14 of their K-1s.
So what is the correct answer to the question of whether ordinary income on a K-1 constitutes self-employment? Perhaps the reason Congress, the Treasury Department, the IRS, and the courts have found this such a difficult question is that finding the right answer depends so much on the facts and circ*mstances of each case. The recent tax lawsuit appears to have focused on the nature of the taxpayer's activities and not on the title "limited" or the liability protections he enjoys. When determining self-employment income, such a tactic seems appropriate. Unfortunately, this means that unless Congress comes up with a clear definition, each situation will have to be carefully analyzed to determine whether self-employment income constitutes income.
