Attorneys are not limited partners

The Tax Court ruled that attorneys who were member-managers of a law firm organized as a Mississippi professional limited liability company (PLLC) were not limited partners within the meaning of Sec. 1402(a)(13). Thus, that section’s exclusion of a limited partner’s distributive share of partnership income from self-employment earnings subject to self-employment tax did not apply.

Facts: In 2001, three attorneys reorganized their law firm from a general partnership to a PLLC. Each attorney practiced law through the PLLC and was a member-manager of it. The PLLC never had a written operating agreement, no member’s management power was limited in any way, and all members participated equally in control of the PLLC.

Relying on a CPA’s advice, each attorney reported guaranteed payments received from the PLLC for legal services as self-employment income subject to self-employment tax but excluded his distributive share of partnership income above that. For 2008, 2009, and 2010, the IRS issued each attorney a notice of deficiency, asserting that the distributive share was subject to self-employment tax.

Issue: Sec. 1401(a)imposes a tax on self-employment income. Sec. 1402(b) defines self-employment income as the net earnings from self-employment, with maximum and minimum threshold limitations. Sec. 1402(a) requires a partner to include his or her distributive share of partnership income in net earnings from self-employment.

Sec. 1402(a)(13) excludes from net earnings from self-employment a limited partner’s distributive share of partnership income other than guaranteed payments made for services. Neither Sec. 1402(a)(13) nor any statutory or regulatory authority defines “limited partner” for this purpose.

The issue was whether the attorneys, as member-managers of the PLLC, could exclude their distributive shares of partnership income from self-employment income pursuant to the exclusion for limited partners under Sec. 1402(a)(13).

Holding: The Tax Court held that the attorneys were not entitled to the exclusion because management power over the PLLC’s business was vested in each of them as member-managers, and all members participated in control of the PLLC. Following the approach taken in Renkemeyer, Campbell, & Weaver, LLP, 136 T.C. 137 (2011), the court held that the attorneys’ interests as member-managers were not functionally equivalent to those of limited partners in a limited partnership, as limited partners typically have limited liability and lack control of the business. Citing the Revised Uniform Limited Partnership Act, its predecessor, and Mississippi law, the court noted that if a limited partner participates in the control of a business beyond the exercise of his or her rights and powers as a limited partner, the partner loses limited liability protection. It ruled that the attorneys participated in control of the PLLC, as they all collectively made decisions regarding their distributive shares; borrowing money; and hiring, firing, and compensating employees, and each attorney supervised associate attorneys and signed checks for the PLLC.

Furthermore, the court reasoned that a limited partnership must have at least one general partner, and since all of the members had the same rights and responsibilities, their positions were analogous to those of general partners in a limited partnership. The court observed that this was consistent with the firm’s history; the members had originally operated their business as a general partnership, and when they reorganized it as a PLLC, there was no change in the way they managed the business.

In a separate matter, the court ruled that funds remaining in the PLLC’s trust account at the end of 2010 were not income to the attorneys, as they did not own the funds. Additionally, the attorneys were not liable for any penalties under Sec. 6662(a) because they reasonably relied in good faith upon the advice of a competent tax professional. The court also noted that Renkemeyer was decided after the years at issue in this case.

• Castigliola, T.C. Memo. 2017-62

—By Mark Aquilio, CPA, J.D., LL.M., professor of accounting and taxation, St. John’s University, Queens, N.Y.