Partner Must Pay Self-Employment Tax on Guaranteed Payments From Partnership
A husband and wife who were partners in a general partnership owed self-employment taxes on guaranteed payments made by the partnership to the wife, the U.S. Tax Court has found. The court rejected the argument that the wife was a limited partner and did not provide any services to the partnership, and therefore did not owe self-employment taxes.
Take Away: Self-employment taxes are assessed on net earnings from self-employment. The latter term includes a partner’s distributive share of trade or business income from a partnership of which he or she is a member. The distributive share of a limited partner is not self-employment income, but guaranteed payments that are compensation for services actually rendered to the partnership are self-employment earnings. The Tax Court concluded that the payments to the wife were for services and were self-employment income.
Comment: Because the payments were made for services actually rendered, the court avoided deciding whether the wife was a limited partner.
In 1999, the husband and another person formed a limited liability company (LLC) that provided medical technology to hospitals. The wife was a 60 percent member of the LLC. She agreed to use her credit and credit card to secure loans for the LLC and purchase items for the business. She also signed documents on behalf of the LLC and discussed marketing strategies with her husband. The wife signed the LLC’s 2001 return as its tax matters partner.
On its 2000 and 2001 tax returns, the LLC reported gross receipts of $300,000 and $380,000 respectively; ordinary income of $12,000 and $18,000 respectively; guaranteed payments of $165,000 and $259,000 respectively; and substantial partnership distributions to the husband and wife. The IRS determined that the guaranteed payments were self-employment income and that the wife owed self-employment taxes on them.
The Tax Court found the payments identified on the LLC’s tax return as guaranteed payments should, in fact, be treated as guaranteed payments, and that the taxpayers could not disavow the form of the transaction that they had claimed. The court also found that the payments were made for services actually rendered to the partnership and must be treated as net earnings from self-employment.
Comment: A taxpayer is generally bound by the form of the transaction that the he or she has chosen. If a court allows the taxpayer to disavow the form of the transaction, the taxpayer must introduce “strong proof” to establish the substance of the transaction.
In this case, the taxpayers attempted to disavow the treatment of payments as guaranteed payments, but only after the IRS challenged the transaction by raising the self-employment tax issue. Therefore, the taxpayers could not disavow their treatment. Moreover, the taxpayers failed to offer strong proof to show that the LLC’s reporting was incorrect.
The taxpayers failed to prove that the wife did not receive the payments at issue in exchange for services. The LLC’s operating agreement indicated that she contributed intellectual property, a business plan, and organization design at the LLC’s formation. She also provided marketing advice and the use of her credit card, and executed documents on the LLC’s behalf. The court concluded that the wife provided services and was not merely a passive investor.
Comment: Although the wife’s services could be viewed as relatively minimal, the taxpayers failed to establish how much of the payments were for services. Therefore, the court accepted the IRS’s position that all the payments were for services.
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