General partners are subject to self-employment tax on their distributive share of partnership interest (Code Sec. 1402(b)). In contrast, limited partners are not subject to self-employment tax on their distributive share (Code Sec. 1402(a)(13); they only pay self-employment tax on guaranteed payments. Should members of limited liability companies be treated as general partners or limited partners for purposes of self-employment tax?

This is a question that?s been unsettled for 20 years. The IRS had proposed legislation that was subject to a moratorium until July 1, 1998. Even though that date has passed, there has been no additional IRS guidance on the question. It remains on the 2016-2017 Priority Guidance List.

The Tax Court recently shed some light on the issue (Vincent J. Castigliola,?TC Memo 2017-62). The case involved three attorneys of a professional limited liability company (PLLC). Each attorney was a member-manager, which meant each one had management power over the business. There was no written operating agreement that limited this power in any way. All of the members participated in relevant decision-making, including decisions about distributive shares, borrowing money, hiring and firing, and the rate of pay for employees. They all supervised associate attorneys and each signed checks.

The court determined because they were managers, they were?not??functionally equivalent? to limited partners and could not rely on the exemption from self-employment tax that applies only to the distributive share paid to limited partners. The court noted that the Uniform Limited Partnership Act says that a limited partner can lose personal liability protection if he or she takes part in the control of the business. In contrast, a member-manager does not lose personal liability protection when he or she exercises control. Thus, a member-manager more closely resembles a general partner. As such, their distributive shares were subject to self-employment tax.