Attention: This is a machine-generated transcript. As such, there may be spelling, grammar, and accuracy errors throughout. Thank you for your understanding!
Jeremy Wells: In the last episode, we talked about partnerships and what actually qualifies as a partnership. It turns out there are a lot of different kinds of activities that can qualify as a partnership under federal tax law. And then there are a lot of activities that may not be [00:00:30] a partnership or don't have to be a partnership. If the partners decide they don't want to be treated as partnership under federal tax law. This episode, we're going to look at partners and specifically what makes an individual a partner in a partnership. What does it take to become a partner? Can you just point at someone and call them a partner? And now that individual is involved in the partnership, or is there something more to it? Also, we're going to look at what comes along [00:01:00] with being a partner, at least in terms of one particular aspect of federal tax that almost everybody in business tries to avoid as much as they can. Self-employment tax. So for this episode, we're going to look at partners. What the definition under federal tax law of a partner is and which partners are subject to self-employment tax. So first of all let's think about a scenario where you [00:01:30] have two individuals who register a limited liability company, an LLC, and they list each of them as a member. So the two of them are listed as members of this LLC. Now, in general, with no other information in general, under federal tax law, this would probably be a partnership that comes from the Check the Box Regulations of Treasury Regulation 377 7013, right? Okay.
Jeremy Wells: So two [00:02:00] individuals, they registered as limited liability company. Each of them is a member. One member works full time in the business while the other member just provided capital at the start of this activity. That member also works elsewhere and rarely, if ever, participates in the business. This is what we might consider a silent partner, just an investment of capital up front. The other member, though, [00:02:30] is working full time in that business, providing services, making sure that business, that activity stays up and running. Now, because both members own an equal interest in this business, the form 1065 partnership tax return and the K-1 show 50% allocations of income to each of them. Now, just take this as the way this particular partnership works. Obviously, it could be more complicated than [00:03:00] this, and we'll talk about that in a future episode. We'll talk about allocations, especially special allocations in an upcoming episode. But for now, both partners are equal. They each get 50% of all of the income and other partnership items reported to them on those k-1's. The question here is, are these two partners actually equal in terms of federal tax law? Should they be treated exactly the same both by the partnership and in [00:03:30] terms of their individual tax returns? One works in the partnership, the other one invested money up front.
Jeremy Wells: But really since then has had not much to do, if anything, with the partnership and in particular, should both partners income from the partnership be subject to self-employment tax? These are really two of the biggest questions when it comes to thinking about partners before we get into the complex issues dealing with [00:04:00] basis and losses and all of those kinds of things. So in this episode, we're going to specifically answer what a partner is. Under federal tax law, when an individual becomes a partner and what's required in order to become a partner in a partnership. Then we're going to look at the difference between the two types of partners. And this is one of those instances where a few different aspects of the complexity of partnership [00:04:30] law comes into play here. And that's whether we a partner is a general partner or a limited partner under federal tax law, because those terms have meanings that are different depending on the different context you're in. And we'll talk about some of that later on. And then finally, we're going to look Whether a partner's share of a partnership's income subject to [00:05:00] self-employment tax. And that's going to have to do with that difference between a general and limited partner as well. Okay. Who is a partner? So prior to 1951, federal statutory tax law, meaning the Internal Revenue Code did not have a definition of the term partner. This became a contentious [00:05:30] issue.
Jeremy Wells: There were some court cases that made it all the way to the Supreme Court. The US Supreme Court that involved and really centered on this question, whether certain individuals were partners and therefore whether they should have income allocated to them from the partnership, whether that income should have been reported by someone else involved with that partnership. So the courts had to step in in the absence of any real [00:06:00] statutory definition and define that term for federal tax law partner. So the court stepped in and they generally ignored state law labels. One of those ways that partnership taxation under federal tax law gets really complicated is the difference between federal and state government and tax and business law, because [00:06:30] we have these terms that exist at both the federal and the state level, and they can actually mean different things depending on the context we're in. This is one this is a great example of that. So the term partner can mean one thing under state law. But under federal law it can mean something different. And it's in these kinds of situations where the federal courts are going to have to get involved and make a distinction between what actually matters [00:07:00] under federal tax law. The courts, early on in these cases decided to just ignore, for the most part, state law labels, meaning you could be considered a partner in a partnership under state law. But that doesn't necessarily mean you're a partner in that partnership under federal tax law.
Jeremy Wells: So what did the courts focus on instead? They focused on the stated and implied intentions [00:07:30] of the individuals involved in these activities based on various sources such as partnership agreements, contributions of capital or services to the partnership, how they behaved once they were involved with the partnership. And then because we're talking about courts, their testimony in front of the courts in in these particular cases. Now, there are two precedential cases here that made it all the way to [00:08:00] the US Supreme Court in the 1940s on this question. The first one is tower V Commissioner, and the second one is Culbertson V Commissioner. Now, if you listen to the prior episode on partnerships, those two cases should sound familiar because those cases dealt not only with the definition of a partnership, but also the definition of a partner. In order to understand whether a partnership exists, we need [00:08:30] to understand who the partners are. And in order to understand whether someone is a partner, we need to look at the partnership itself, especially the partnership agreement, who participated in the partnership and how they participated. So it's almost a chicken versus egg question here, which comes first and rather which defines the other is an individual a partner because she is listed as a partner in a partnership? Or is the [00:09:00] activity a partnership because some individuals call themselves partners? Or is there really two completely separate concepts? And we have to look at them separately? And ultimately what the courts came down on is it's a facts and circumstances determination for each and every activity that it's really difficult to come up with.
Jeremy Wells: A set in stone blanket definition of this makes [00:09:30] an activity a partnership. And this makes an individual a partner. So in Tower and Culbertson, the US Supreme Court determined in those specific cases whether a legitimate partnership existed for tax purposes and whether the individuals involved were actually partners. So go back and listen to episode 31 on partnerships. If you haven't listened to that, whether you want to pause now and go back and listen to that or continue through this episode, [00:10:00] it's helpful to have that little bit of background from those cases. But in those cases, the court discussed the definition of a partnership under federal tax law. But they also looked at what made for a partner. Now in tower, the court framed the question as whether the partners, the individuals involved really and truly intended to join together for the purpose of carrying on business and sharing in the profits or losses of [00:10:30] both. The answer depends on a culmination of factors. None of them were individually determinative, the court said. So in other words, you can't just have a checklist. And if you check a certain box off, or if you check a certain number of boxes off, then you know for sure that that individual is a partner.
Jeremy Wells: That's not how it works. What the court came up with in tower was [00:11:00] a list of principals, and we need to look at each individual case to determine whether that individual actually meets the definition of a partner. More specifically, the court said that an individual may be a partner if, quote, she either invests capital originating with her or substantially contributes to the control and management of the business, or [00:11:30] otherwise performs vital additional services or does all of these things. So here are a few different things you can do to become a partner in a partnership. You can either contribute capital in exchange for capital interest Or you can involve yourself in the control and management of the business. Or you can provide services to the partnership or some combination of those three things. So really, there are a variety [00:12:00] of ways that an individual could involve herself in a partnership and therefore be considered a partner. Now, it's important to understand the court is clear on this, in the opinion that there is no bright line list of requirements to be a partner in this specific case. The husband made his wife, so Mr. Tower made Miss Tower a partner, but only to shift income away from [00:12:30] him and to her. There's actually a backstory in the tower case, where originally the business was organized as a corporation under state law. And Mr. Tower got some advice from a tax professional and a business attorney to convert that business to a partnership instead, that this would lead to a reduction in tax.
Jeremy Wells: And in the final part of that plan was to make his wife a partner and divert as much income from the [00:13:00] partnership to her as possible, because she would have less income than he would, and therefore she would pay less in tax than he would. She did not contribute any services or any of her own capital, and she never exercised any control or management authority in the business. And this is really what the case centered on for the court. The court essentially, through this partnership structure out and [00:13:30] said, no, the income that was assigned to Miss Tower is actually earned by Mr. Tower. And so it's his income. He needs to be taxed on it. The lesson from tower, from this opinion is that a partner for federal income tax purposes is a person who genuinely joins a together with others in carrying on a business enterprise and who [00:14:00] actually participates in the creation, control, or ownership of the income producing activity. Now you can have partners join the activity later. They can either provide some contribution of capital or some services. They can be there at the start. They can be there at some point in the middle. But that is the key here. They need to come in with a genuine intent to participate somehow [00:14:30] in that business activity. So in other words, it's the economic reality, not the formal ownership, not the paperwork that Determines whether a partnership exists, and especially important for this episode, whether an individual is a partner in that partnership or not.
Jeremy Wells: Now, a few years later, after several tax court cases attempted to apply the Supreme Court's logic and definition from tower, the Supreme Court had [00:15:00] to clarify its meaning again in Culbertson. What ended up happening was the Tax court took towers list of qualities of a partner and ran with it, and according to the Supreme Court, they ran a little too fast and too far because the Tax court took tower as a checklist of qualities that were required of a partner. And from that started saying that a lot of individuals that thought they were partners [00:15:30] weren't, and a lot of partnerships weren't actual partnerships. Therefore, the Supreme Court, a couple of years later had to review some of these cases and realize that the tax court had really misinterpreted what it meant in tower. So Culbertson is a clarification of what the Supreme Court said in tower. It's really important to recognize that these two cases go together. Essentially, there are only a couple years apart. They're only about three years apart. Tower was in 1946, Culbertson was in 1949. But in those couple years intervening, [00:16:00] the tax court really took the opinion in tower and ran with it. And according to the Supreme Court, the tax court quote, ignores what we said is the ultimate question for decision and makes decisive what we described as circumstances to be taken into consideration.
Jeremy Wells: So in Culbertson, the Supreme Court says that the question is not whether the services or capital contributed by a partner are of sufficient importance to meet some objective [00:16:30] standard supposedly established in the tower case. But whether considering all the facts, The parties in good faith and acting with a business purpose intended to join together in the present conduct of the enterprise. So in other words, it's that subjective intent, not a list of objective requirements that determines whether a partnership exists and if a particular member is a partner. Now, this obviously [00:17:00] led to some confusion because the tax court took the tower opinion and interpreted it a certain way. A lot of families that were forming and joining these partnerships, and a lot of business owners that were forming partnerships may have interpreted tower slightly differently. And the Supreme Court now needed two different cases over a few years, tower and Culbertson, to clarify its definition of a partnership and a partner. [00:17:30] And so now in 1951, Congress steps in and in section 340 of the Revenue Act of 1951, Congress amended section 3797 of the Internal Revenue Code of 1939 to include the following. A person shall be recognized as a partner for income tax purposes. If he owns a capital interest in a partnership in which capital is a material income producing factor. [00:18:00]
Jeremy Wells: Whether or not such interest was derived by purchase or gift from any other person. Now, like I said, that came from the Revenue Act of 1951, and it was an amendment of the Internal Revenue Code of 1939. The next Internal Revenue Code is 1954, and the 1954 IRC changed the ordering of a lot of the different sections of the tax code. So the numbers don't necessarily [00:18:30] line up between the 1939 version and the In the 1954 version. The 1954 version gave us the section numbers that are more familiar today, and the Internal Revenue Code of 1986 pretty much kept the same numbering system as far as the order of the sections that we had in the IRC of 1954. So what was under the 1939 IRC section 3797 that became section [00:19:00] 704 E one in the 1994. I see that then changed. That definition was dropped out of section 704 E one and moved to section 761 B, so that definition that I just read off that still exists in the IRC, it's just moved location a few times. Now, [00:19:30] in the wake of Tower and Culbertson, Congress stepped in to add that definition, in particular with regards to what are called family partnerships, because the question that was really motivating Tower and Culbertson and other similar cases in the 40s and 50s was if an individual receives the interest in a partnership by way of a gift. In other words, they did not make any kind of capital contribution into the partnership.
Jeremy Wells: They didn't even really provide services [00:20:00] to the partnership, but they were gifted an interest from someone who did. Usually a parent in the family then, does that make that individual a partner? Because up until then, it seemed that the court's definition of a partner was someone who contributed capital services or a combination of the two. And that was really the issue at stake in Tower. And Culbertson was, what do we do [00:20:30] with individuals who received their interest in a partnership, not by way of contributing capital or services, but by receiving that interest as a gift. Tower and Culbertson eventually get interpreted as meaning that it's the economic reality of the situation. It's not what is on paper that doesn't necessarily conflict with the idea that an individual can inherit or [00:21:00] receive a partnership interest by gift. But Congress felt the need to step in and clarify this issue, particularly for these family partnerships where spouses, children and other relatives acquired their interests as gifts. So these arrangements potentially allow higher earning family members, such as the patriarchs of the family, to divide their interests among lower earning relatives, Wives, sons [00:21:30] and daughters in order to avoid tax on that same income without sacrificing actual control of the enterprise. And so if you are the head of the family, the family has a family business that is highly profitable, and you want to make sure that you retain control of the business, but you also want to attempt to allocate some [00:22:00] of that income to other family members who aren't in the same tax bracket as you are.
Jeremy Wells: Then you have an incentive to try to allocate some of your interest by gift to those individuals. The income that is reported to them, they'll pay less tax on than you would have. But because they're close relatives of yours, you're not concerned about them taking over the family business. This [00:22:30] was essentially happening quite a bit in the 40s and 50s the IRS figured out what was happening, did not want these taxpayers doing this kind of thing. And this is why we get these court cases and eventually Congress stepping in in 1951. But now, according to Congress's Joint Committee on Taxation through what's called the Blue Book, or that Joint committees analysis of tax law, the Congress added the definition [00:23:00] to prevent the IRS from denying partner status to a taxpayer who shared actual ownership of the partnership's income producing capital on the basis that the interest was acquired from a family member. In other words, Congress stepped in to say, look, some of these situations are legitimate. We don't want the IRS or the courts overturning these partnership structures just because of the family A relationship among the partners. So in other words, it wasn't meant [00:23:30] to create an overriding definition of partner. Rather, it just merely carved out a specific transaction that could create a partner.
Jeremy Wells: The tests under Tower and Culbertson as to whether an individual was a partner, remained the principal definition of whether a person is a partner under federal tax law. Then we get regulations under what becomes IRC section 704 E one, which is that definition [00:24:00] that I read a moment ago that states that the production of income by a partnership is attributable to the capital or services, or both contributed by the partners. The provisions in subchapter K of the code are to be read in light of their relationship to section 61, which requires that income be taxed to the person who earns it through his or her own labor and skill and the utilization of his [00:24:30] or her own capital. So in other words, this preserves the assignment of income doctrine, which we haven't talked about on this show. But I might plan a future episode on that. Irc 61 is the definition of gross income. Basically, if you have some sort of acquisition of wealth, then that is income to you under federal tax law. And it's a lot more nuanced than that. But for now, for the purposes [00:25:00] of this episode, if you find yourself in receipt of some income via a partnership, then that income is taxable to you. On the other hand, if you didn't do anything to actually earn that income, if somebody else earned that income either through their contribution of capital or services to the partnership, and that income was just assigned to you, especially in [00:25:30] order to avoid tax.
Jeremy Wells: Then you didn't really earn that income. It's not your income. It's the income attributable to whoever actually earned it. This is a way that a lot of different kinds of tax shifting schemes are essentially broken down, is through this assignment of income doctrine, that the income belongs for tax purposes to whoever actually earned it, not just whoever the income gets assigned [00:26:00] to. Now, partnership can be recognized for income tax purposes for some partners, but not for others. Because think about a three person partnership where one is really earning all of the income. The other two are just there to be assigned income to shift that tax burden away from the first partner. In that case, the partnership might [00:26:30] really just consist of that one individual for federal tax purposes. So now we need to look at what a capital interest in a partnership actually means, because this is the term that keeps coming up in both the statutory and the judicial definition of a partnership. So capital interest in a partnership means an interest in the assets of the partnership, which is distributable to the owner [00:27:00] of the capital, interest upon withdrawal from or upon liquidation of the partnership. So in other words, think about it this way that you have an ownership stake in a partnership, or at least you're told you do some of that partnership income is assigned to you.
Jeremy Wells: But you know that if the partnership were to shut down operations. You didn't really contribute anything to it. You haven't participated in the management. You haven't provided any services to it. [00:27:30] So if the partnership shuts down and the assets are liquidated, do you really deserve to get anything out of that partnership? Well, you might if the partnership agreement says that you do or if that you have some sort of agreement when you became a partner that said you have a right to a distribution of some of the assets under liquidation. But without that, if you just hold that interest in the partnership without any real expectation of [00:28:00] some sort of distribution to you, especially upon liquidation, then are you really a partner? And this is what we get at with the definition of a capital interest in a partnership. The mere right to participate in the earnings and profits of a partnership is not considered a capital interest in the partnership. You might have a profits interest in that partnership, but you don't actually have a capital interest and therefore you don't necessarily have [00:28:30] an interest in that partnership. Under federal tax law. So the courts use this hypothetical liquidation test to determine whether a party actually holds a capital interest and is therefore a bona fide partner in that partnership. So now that we've looked at what it takes to actually be a partner, we need to think about what kinds of partners we can actually have, because there are several different ways that you can differentiate parties.
Jeremy Wells: There are lots of different ways that [00:29:00] you can differentiate among partners, but ultimately, when it comes down to it, other than their relative capital or profits interest in the business, right? That's going to be one of, if not the most important distinction among those partners. Another way to differentiate among partners, and this mainly comes from state law is the difference between general and limited partners. Now, in general, when we think about general versus limited partners, we think about a general partner having [00:29:30] unlimited liability for the partnership's debts. And a limited partner has liability just for the amount contributed into that partnership. In other words, a limited partner can't be held liable for a partnership's debt in excess of whatever that limited partner initially contributed into the partnership. And again, it can be more nuanced. [00:30:00] It can be more complicated than that. But when it comes to state law, that's essentially the difference between a general and a limited partner. We're talking about liability for the partnership's debts. So what does that have to do with federal tax law then? Well, it's because we have in the part of the IRC that deals with self-employment tax, a specific reference to partnerships and especially [00:30:30] to limited partners. So bona fide partners are considered self-employed for federal income and employment tax purposes, regardless of their roles in the partnership.
Jeremy Wells: Therefore, they can't be employees of the partnership. This is important to understand if you work with any partnerships or partners in practice, you should never have a partner getting both a W-2 and a K1 from the same partnership. There are some exceedingly rare cases [00:31:00] where that might actually be legitimate, but in general, the rule is partners should not be on the payroll of the partnership. Their income is reported on the K1. If a partner wants to receive a set amount of income from that partnership, then that needs to be an arrangement with the rest of the partners, and that would be reported as guaranteed payments for services. That's beyond the scope of this episode. We'll pick that up in a future episode, but a [00:31:30] partner cannot be an employee of the partnership in general. So partners are treated as self-employed with an exception, limited partners as such. And that's the exact phrase under IRC section 1402 A 13 that excludes certain groups from liability for self-employment tax. [00:32:00] Now, a quick note A general partner is subject to self-employment tax, regardless of whether the interest in the partnership is passive under IRC section 469 or the partnership elected to be excluded from subchapter K under IRC section 761 A. In the prior episode, we were talking about the election out of subchapter K. I mentioned that that election out of subchapter K only applies to that subchapter [00:32:30] of the code.
Jeremy Wells: It doesn't apply to any other parts of the code. Liability for self-employment tax is one of those parts of the code that that election out of subchapter K does not affect. So even if that partnership does elect out of subchapter K treatment, then general partners income from that partnership is still subject to self-employment tax. Now back to the exception here in [00:33:00] general partners considered self-employed not employed by the partnership. So that means that that partner's distributive share of income from the partnership is considered self-employment income Unless that partner is a limited partner as such. And also even if that individual is a limited partner, any guaranteed payments paid to that limited partner are subject to self-employment [00:33:30] tax for services rendered to or on behalf of the partnership. This has led to significant debate in the courts over who then is a, quote, limited partner as such for federal tax purposes. Because, and we'll discuss this here in a second. We don't actually know what that term means. In 1997, the Treasury Department proposed [00:34:00] regulations to define limited partner strictly for the purposes of IRC section 1402 a. However, that proposed regulation caused such a debate and such controversy that Congress actually stepped in and included a moratorium on any such regulation in 1997. And that moratorium was supposed [00:34:30] to last until July 1st, 1998. It's now 28 years later, and Congress, nor neither Congress nor Treasury has provided any sort of update on this question.
Jeremy Wells: We still don't have a definition, either statutory or regulatory, of limited partner. And all of this this, this, uh, section 1402 A 13, which [00:35:00] exempts limited partners as such from self-employment tax was written before we had limited liability companies or LLCs. So it's an open question as to whether an LLC member is a general or limited partner for purposes of federal tax law, and especially for self-employment tax. Because LLC members, by definition, are not personally liable for the entity's business debts. That's [00:35:30] the limited liability part of limited liability company. No individual member is has full liability for the company. They all have limited liability, yet they are all actively involved in the management of the business. They all provide services to the business. Typically, you might have some members who don't, but at least some of the members typically do. So what do we make of them? And [00:36:00] again, the courts had to get involved on in this question. First, we have a series of tax court cases that really looked at this question. The first one was Renkema Campbell and Weaver v Commissioner. This was a group of. This was a law firm. This was. 136 tax court. 137 in 2011, where [00:36:30] the Tax Court determined that the legislative history. Looking at the House report on the legislation that turned into this exemption of limited partners as such from self-employment tax, indicates Congress intended to ensure mere passive investors would not receive credits toward Social Security coverage.
Jeremy Wells: In other words, what Congress [00:37:00] meant was that limited partners usually are not involved in the operations of a business. They tend to be passive investors or even silent partners, and they should not earn Social Security credits through paying self-employment tax on the income that they generate from a partnership. The Tax Court explained that limited partnerships [00:37:30] generally have two kinds of partners. As we've discussed, general and limited general partners typically manage and have unlimited liability, while limited partners lack management authority or duties, they have that liability protection. They risk losing that liability protection generally under state law if they engage in partnership operations. And that makes their interests similar to that of passive investors. So the court concluded [00:38:00] Congress may have written limited partner as such, but it actually meant passive investor. And that's really what the. As such entails that we're not saying limited partners as is meant by. Under state law, we're saying those who operate as limited partners. That's what the. As such part means. So if you behave like a limited partner, meaning an individual [00:38:30] that just invests passively into the business and doesn't participate in the actual operations of the business, in that case, your income from the partnership shouldn't be subject to self-employment tax. Now, if that same individual then participates in the operations of the partnership, then that individual is now, under federal tax law, no longer a limited partner. That was the tax court's opinion in [00:39:00] Amaya.
Jeremy Wells: And that essentially set the precedent for how the tax court and the IRS would continue to interpret this limited partner as such. Exemption from self-employment tax and IRC. 1402 A 13. Then we get a more recent case, Soroban Capital Partners. This is 161 Tax Court 12 in 2023. [00:39:30] In Soroban, the court applied what has become known as its functional analysis test from Amaya and some other cases to determine whether that limited partner exception applies. In other words, we're going to analyze the functions of this individual partner. Does this partner functionally participate in the activity or does this partner pretty much stay out of it? If [00:40:00] that partner stays out of it. Then that partner is a limited partner as such and exempt from self-employment tax on those earnings. But Sorbon here presents a unique case. The entity is a state law limited partnership, not a limited liability partnership. And this is again where we get the complexity of the interaction of federal tax law and state law. So with [00:40:30] the federal tax law focusing on this phrase limited partner as such, and state law having a variety of definitions of partnership and limited partner, then what do we make of this phrase? What does this as such actually mean? The court found that, quote, Congress made clear that the limited partner exception applies only to a limited partner [00:41:00] who is functioning as a limited partner. That's what the tax court said.
Jeremy Wells: So a partnership's distributive share of income for a partner labeled as limited, but who functionally acts as a general partner is subject to self-employment tax. Now it's important to understand Sorbonne's currently on appeal in the second circuit as of this recording, and we've recently had another case [00:41:30] come up that has a similar set of issues. So in Serious Solutions LLP v Commissioner, this is in the fifth Circuit of Appeals. The Fifth Circuit appeals is Texas, Louisiana and Mississippi. This court tends to be different from a lot of the other appellate courts. And it's take. Especially on [00:42:00] federal legal issues. The Fifth Circuit rejected the Tax Court's passive investor and functional analysis tests from Renkema and Sorbon, and instead decided to focus on the contemporaneous meaning of the term limited partner in legal dictionaries, and is used by the IRS and Social Security Administration. Around the time that IRC section 1402 was [00:42:30] written by Congress. In particular, the paragraph 1402 A 13. So what was the meaning of limited partner? According to legal dictionaries, the IRS, Social Security Administration, at the time that Congress wrote that phrase into IRC section 1402. First of all, the appellate court. The Fifth Circuit found that the statutory carve out [00:43:00] for guaranteed payments in that particular paragraph makes it seem like Congress intended, intended not to have this sort of passive investor approach. In other words, if an individual is providing services to the partnership and therefore earning guaranteed payments, then how would that individual be a passive investor? It doesn't make sense [00:43:30] to have both of those points in the same paragraph of the tax code.
Jeremy Wells: So the court held that, quote, the text of the exception itself contemplates that limited partners would provide actual services to the partnership and thus participate in partnership affairs. So a strict passive investor interpretation would make the guaranteed payments clause entirely superfluous. The second Congress used terms like [00:44:00] passive investor and passive income in other sections of the Internal Revenue Code, but it didn't use that phrasing in section 1402. Why not? Moreover, Congress explicitly excluded partners who, quote, rendered no services in a paragraph just a few paragraphs above. 1402 A 13. That phrase comes from. 1402 A ten. Yet it didn't use that language in A 13. [00:44:30] So why two different paragraphs that use different phrasing if they're supposed to mean the same thing? According to the tax court. Why would Congress do that? Why wouldn't Congress mean different things in different paragraphs? And then finally, this phrase. As such, the Fifth Circuit held that the phrase refers to dual status partners, Not to passive investor partners, but rather partners [00:45:00] who act as both general and limited partners at different times. In other words, it clarifies rather than restricts or narrows without the qualification a dual status partner might think his entire distributive share is not subject to taxation, so the words as such avoid ambiguity by clarifying that when functioning as a limited partner, a taxpayer's distributive share is excluded.
Jeremy Wells: But when functioning as [00:45:30] a general partner, the distributive share is included. So Congress, according to the Fifth Circuit, wasn't thinking about limited partners as passive investors, but rather partners who sometimes act as general partners and at other times act as limited partners. So, in other words, Fifth Circuit looked to the legal attributes Associated with limited partnership status under state law, rather than coming up [00:46:00] with a federal definition of limited partner. The way the tax court did, federal law still prevails in terms of determining whether a an individual partner is subject to self-employment tax on some specific partnership income or not, according to the Fifth Circuit, but that's based on state law provisions, state law definitions of whether an individual's limited partner or not, not [00:46:30] necessarily the label limited partner, but what it means to be a limited partner under state law. That courts approach now directly conflicts sharply with the Tax Court's approach in brinkmeyer and Sorbon. So what we essentially have is a split in different appellate courts. That is likely going to turn into a potential Supreme [00:47:00] Court case when you have different appellate courts that disagree on the same fundamental issue of federal law. The only recourse then at that point is for at least one of the parties to ask the Supreme Court to make the final determination at that point. We would have a determination of what limited partner as such means under federal tax law.
Jeremy Wells: Right now we've got [00:47:30] a split. And very quickly, the actual functioning of the tax court is beyond the scope of this episode. But the tax court is a national court. The appellate courts are split up into different circuits. When a case comes up in the tax court, the tax court has to follow the rules of the appellate court that would have jurisdiction over that case. This is known as the Gossin rule. So if you have a case come up [00:48:00] in the fifth Circuit, go to the tax court, then the tax court is going to have to apply the opinion of the Fifth Circuit Court of Appeals to that case. Even if the tax court disagrees in all of the other circuits. So this could create some interesting situations for these kinds of cases involving limited partners and whether they're subject self-employment tax or not. Just [00:48:30] a quick note. Serious solutions now goes by K Lane. And so the name of that course that that court case might come up differently. If you see that referenced in the news that's been changed ever since March 31st, 2026. And now we have another case. This is Denham Capital Management. This just came up in the First Circuit recently. The First Circuit heard oral arguments on February [00:49:00] 5th, 2026, and as of this recording, there hasn't been any updates on this case. But this case is it's the same question but a different take on it.
Jeremy Wells: So the partners argue that under the Tax Equity and Fiscal Responsibility Act of 1982, or Tefra, which gave us the original partnership audit regime, that net earnings from self-employment, which is the whole topic of this discussion, is a partner, not a partnership level [00:49:30] item, which is true because individual partners calculate their self-employment tax burden. The partnership doesn't do that for them. Therefore, the tax court lacks jurisdiction over the question in a partnership level proceeding. Now, Denham Capital, the plaintiffs here aren't arguing that the that the tax court just lacks the authority to or jurisdiction over this question in general, but rather in these cases that are [00:50:00] about audits of partnership returns that is outside the scope of what the tax court can address, because it would be up to the individual partners to determine whether or not they have a self employment tax liability based on their partnership income. Not that doesn't happen at the partnership level. Now, what complicates this is that the partnership has to report self-employment earnings in box 14 [00:50:30] of the partner's K one. So according to the way filing a partnership tax return works. It is up to the partnership to determine how much of a partner's earnings are subject to self-employment tax. But really, it's up to the partner to determine that regulation. Section 301 6231A31A [00:51:00] that's kind of a long citation there. List partnership items for purposes of partnership adjustments under the partnership audit regime.
Jeremy Wells: The list does not include net earnings for self-employment from self-employment. However, the IRS argues that the next subsection in that regulation does. But this is this is the actual quote from that regulation section. Subsection. The term partnership item includes the accounting practices and the legal and factual determinations [00:51:30] that underlie the determination of the amount, timing and characterization of items of income, credit gain, loss deduction, etc.. So what the IRS is arguing is that it's the characterization of income as earnings from self-employment. That matters here. And because that subsection includes that word characterization, that makes it a partnership item, even though it isn't specifically listed out as a partnership item. So this could be an [00:52:00] interesting development in this question as well, whether the tax court even has the jurisdiction to settle this question at the partnership level. Now, let's go back to that case study at the beginning of the episode real quick. You've got two different LLC members, both equal. One provides services and works full time in the business. That one pretty likely is a partner under federal tax law. Also, [00:52:30] because that individual is providing services, we would likely consider the any share of the income coming from that partnership to that LLC member to be earnings from self-employment. But now the other partner who provided capital but works elsewhere and rarely participates in the business. In this case, that does seem to indicate a capital interest.
Jeremy Wells: Likely would not be much of an argument against considering that individual a [00:53:00] partner in the partnership. But whether that individual has earnings from self-employment, from the activity depends. Under the Tax court's current approach, likely not as long as that individual does not participate in the business, then the Tax Court's current precedent would consider that individual to be a passive investor and therefore the income not subject to self-employment tax. But [00:53:30] still, it's an open ended question as to whether an LLC member is for federal tax law purposes, truly a limited partner or not. There are some chief counsel advice memoranda that the IRS has provided. Looking at whether an LLC member is a limited partner for purposes of exemption from self-employment earnings. In general, those cases involve individuals who are actively [00:54:00] participating in the business, though they're just trying to avoid self-employment tax. The question of whether an individual who does not participate in the business at all, though, is a different one, and in this case, the tax court back in 2012 actually had a case in Howell V Commissioner, where a married couple reported the wife's earnings. Miss Howell from the LLC as not subject to self-employment tax. However, the Tax Court [00:54:30] found through her testimony that even though she wasn't regularly or full time active in the business, she did occasionally provide some managerial and even marketing advice to Mr. Howell, who was actually running the business.
Jeremy Wells: And so the tax court ultimately found that she was, in fact not a limited partner as such, under section 1402 A 13, and [00:55:00] her earnings were subject to self-employment tax. So a few a few takeaways here. First of all, federal tax law determines partner status based on the economic reality of the arrangement, not merely state law labels. When it comes to whether an individual is a partner or not. That's what we get from Tower and Culbertson. That's what we get from the US Supreme Court. But now current IRS and tax court precedent applies this functional analysis [00:55:30] or this passive investor test to determine whether a partner is limited for self-employment tax purposes. But we have some recent developments that have cast doubt on that question. It's going to be interesting to see what happens with these cases as they move through the federal court system. If you found value in this episode, please let me know by liking and leaving a comment in your podcast Application of Choice or on YouTube. Check out, [00:56:00] uh, the prior episode on partnerships if you haven't listened to that one yet. And for the next episode, we're going to start getting into a little bit more complex partner level issues, including accounting for partners such as capital accounts, and start looking at allocations, working our way toward thinking about special allocations and how those can be handled on the tax return, as well as for the individual partners.