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Self-Employment Tax Applies to LLC Member Guaranteed Payments, Tax Court Holds.
(Parker's Federal Tax Bulletin: November 9, 2012)

Guaranteed payments to an LLC member were subject to self-employment tax because the member was more than a passive investor. Howell v. Comm'r, T.C. Memo. 2012-303 (11/1/12).

In 1999, Michael Howell and his wife, Lauren, and Harold Bruzee formed a California limited liability company (LLC) named Intelemed. Intelemed is a medical technology company that provides software and hardware to hospitals. The software consists of a remote access system that enables doctors to access hospital records from outside the hospital. Michael and Harold came up with the concept that led to the formation of Intelemed. Like Michael, Harold had a background in computer networking. Harold also had the connection with the hospital to make Intelemed a success.

When Intelemed was first organized, Michael decided to make Lauren a member of Intelemed rather than himself, ostensibly because she had better credit and petitioners intended to use her credit and credit card to secure loans for Intelemed and/or to purchase items for the business. Consistent with that decision, the limited liability company operating agreement for Intelemed provided that Intelemed's members were Lauren and Harold; Lauren held 60 percent of the membership units and Harold held 40 percent. Under the operating agreement, Lauren was the record owner of a 60 percent capital interest and could dissolve Intelemed at any time and appoint the manager of Intelemed. Lauren was entitled to receive an allocation of net profits or losses in proportion to her capital interest. During the years at issue Intelemed's principal place of business was at the Howells' personal residence. Michael met with clients, set up service agreements, and handled marketing. Lauren signed Intelemed documents and discussed marketing strategies with Michael. She also allowed Michael to use her personal credit card to make purchases on behalf of Intelemed.

On its 2000 Form 1065, Intelemed reported guaranteed payments to Michael and Lauren of $35,000 and $64,000, respectively, and $57,000 to Harold. On its 2001 Form 1065, Intelemed reported guaranteed payments to Michael and Lauren of $0 and $149,000, respectively, and $80,000 to Harold. These were deducted in calculating the partnership's ordinary income. The Howells filed untimely joint federal income tax returns on which they reported Intelemed's payments to Lauren as distributive shares of partnership income properly classified as passive income not subject to self-employment tax. Michael paid self-employment tax on their distributive share of partnership income but not on the guaranteed payments. The IRS issued a deficiency notice assessing self-employment tax on the guaranteed payments of both Michael and Lauren. The Howells argued that, under Code Sec. 1402(a)(13), Lauren was a passive investor and not subject to self-employment tax and subsequently disavowed that the payments made were guaranteed payments. While a partner generally must include his or her distributive share of income in his net earnings from self-employment, Code Sec. 1402(a)(13) provides an exception for a limited partner. That exception provides that there is excluded from self-employment earnings the distributive share of any item of income or loss of a limited partner other than guaranteed payments to that partner for services actually rendered to or on behalf of the partnership, to the extent those payments are established to be in the nature of remuneration for those services.

The Tax Court held that the guaranteed payments were subject to self-employment tax and that Lauren was more than a passive investor in Intelemed. The court said the Howells could not subsequently disavow the form of the transaction as reported on the Forms 1065. While Code Sec. 1402(a)(13) does not define the term limited partner, the Tax Court noted that, in Renkemeyer, Campbell & Weaver, LLP v. Comm'r, 136 T.C. 137 (2011), it held that the taxpayers in that case were not limited partners for purposes of Code Sec. 1402(a)(13) because the distributive shares received arose from legal services they performed on behalf of a law firm and did not arise as a return on the partners' investment.

PRACTICE TIP: The Tax Court noted that Lauren contributed services that were relatively minimal in comparison to her husband's services and implied that, had there been documentation proving the extent to which the payments to her did not constitute payments for services rendered, such payments might have escaped self-employment tax. However, there was no such documentation.

For a discussion of partnership income and self-employment taxes, see Parker Tax ¶20,590.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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