Posted by Courtney Kopec, CPA
While the headlines parsed the effects of the Tax Cuts and Jobs Act of 2017, other important tax issues affecting the owners of pass-through entities were being scrutinized. Over the past year, the U.S. Tax Court modified self-employment (“SE”) tax guidelines to firm up the limited partner and LLC pass-through rules previously used to avoid self-employment tax on income earned by certain taxpayers.
S corporation ordinary income is not subject to SE tax
In Fleischer v Commissioner (TC Memo 2016-238), the taxpayer created an S corp entity to report non-employee compensation from a service provider contract he entered into with MassMutual as a financial services provider. The intended result was to exclude self-employment income tax because S-corp pass-through income is not subject to SE tax. The Court determined the income should have been reported on Schedule C and subject to SE tax. The Court applied two tests to determine whether the corporation was the controller of the income: first, the individual providing the services must be an employee of the corporation; and second, a contract must exist recognizing the corporation’s controlling position. The Court determined that the taxpayer, not his S corporation, had earned all the income.
A partner’s power is either general or limited, but not both
In Castigliola v Commissioner (TC Memo 2017-62), a law practice that was incorporated as a professional limited liability company by three attorneys had a compensation agreement that was reasonable based on average salaries in their area. The partners reported the guaranteed payments they received as subject to self-employment tax. However, the net profits distributed in excess of the guaranteed payments were reported as not subject to SE tax. The taxpayers argued that the guaranteed payments reflected reasonable compensation for their services and the earnings in excess were attributable to the partner’s investment and were akin to the items of income or loss of a limited partner. The Court determined that in the absence of a written operating agreement that identified a general partner, all three attorneys had equal management power that was in no way limited. None of the partners could be considered as limited and classify their additional income as limited partner income. Therefore, all three attorneys were general partners and all income was subject to SE tax.
A surgeon successfully separates out his passive activities
In Hardy v Commissioner (TC Memo 2017-16), a surgeon (Hardy) performed surgeries at a facility in which he held a 12.5% minority interest and so considered himself a limited partner. He held no management authority at the facility and his distributions were not related to his performance. Hardy reported the income as passive and, at first, also paid self-employment tax on the income. The core issue was whether Hardy properly reported the income as passive and the activities should treated as a single activity and “constitute an appropriate economic unit for the measurement of gain or loss for the purposes of Section 469.” The IRS argued that Hardy’s payment of SE tax implied that the activities were non-passive and should be grouped as a single activity. The Court rejected the IRS argument and held that Section 1.469-4(c)(2) permits a taxpayer to use any reasonable method of “applying the relevant facts and circumstances” to group activities and, therefore, the taxpayer was not liable for the SE tax. He would have been liable for SE tax and could not use the passive losses if the Court determined the activities were to be grouped as a single activity.
Tax planning considerations
The implications of the three cases presented are clear: the IRS wants to subject pass-through entity income to self-employment tax, where appropriate. The owners of S corps who do not take reasonable compensation are easy prey for IRS auditors. If you are an entrepreneurial owner of an S corporation and are not taking salary, or if you are a managing partner in a partnership entity, you should consult your CPA tax advisor to review your tax exposure under these types of situations.
- Employment Cases and Planning Implications, ABA Tax Times, American Bar Association, Vol. 37 No. 1, November 2017
- Tax Court Decision Addresses Self-Employment Taxes of LLC Members, BDO Insights, May 2017
- Tax Court finds no self-employment tax for passive LLC member
- Tax Court finds self-employment tax for active LLC member