Partners' limited liability and self-employment tax.

• Author: Nash, Claire Y.

In Renkemeyer, Campbell & Weaver, LLP, (1) the issues before the Tax Court were whether a special allocation of a limited liability partnership's (LLP's) income to an S corporation for 2004 should be disallowed and whether the LLP's income allocated to its three attorney partners for 2004 and 2005, as adjusted, was eligible for the exclusion from net earnings from self-employment under Sec. 1402(a)(13).The court disallowed the LLP's special allocation of income and determined that the net business income allocated to the LLP's partners was subject to self-employment tax. The court concluded that it was not Congress's intent to qualify a partner for the limited partner exclusion in Sec. 1402(a)(13) simply because he or she enjoys limited liability.

Background of the Case

Renkemeyer, Campbell & Weaver, LLP (the LLP), is a law firm whose practice emphasized federal tax law. During the years in question, 2004 and 2005, the firm's partners consisted of the three attorney partners (the partners) and RCGW Investment Management, Inc. (RCGW), an S corporation. RCGW was owned 100% by RCGW Investment Management, Inc., Employee Stock Ownership Plan and Trust (an ESOP). RCGW's primary business activity involved the purchase, sale, and rental of real estate. The LLP maintained its income tax records on a cash basis. The firm's partners were the beneficiaries of the ESOP.

For 2004, the partners each held a one-third capital interest and a 30% profits and loss interest in the LLP. RCGW held a 10% profits and loss interest in the LLP. The LLP's gross revenues for 2004 included $1,634,992 generated by the partners' performance of legal services. RCGW generated an insignificant amount of the gross revenues for 2004, $5,335, On its 2004 Form 1065, U.S. Return of Partnership Income, the LLP reported net business income of $1,165,770. Although substantially all the LLP's profits for 2004 were from legal fees, the LLP allocated 87.557% of its net business income to RCGW. The remainder of the income was allocated 6.367%, 3.660%, and 2.416% to Renkemeyer, Campbell, and Weaver, respectively. The LLP did not report any of its net business income as net earnings from self-employment. On audit, the IRS reduced the LLP's net business income for 2004 by $905,000 for a legal fee that the LLP did not receive during the tax year.

[ILLUSTRATION OMITTED]

For 2005, the partnership restructured the ownership interests in the partnership and eliminated RCGW's interest. The partnership agreement was amended, and two classes of ownership interests were created: general managing partner partnership units and investing partnership units. Owners of general managing partner partnership units would have full authority to act on behalf of the partnership. Following this change, the partners each owned a 1 % general managing partner interest and a 32% investing partner interest. Under the amended partnership agreement, the allocation of the partnership's profits and losses were to be in accordance with the partners' ownership interests. However, monthly allocations to a partner's account would be limited to the average monthly collections from the partner's clients, and a partner's allocation was not to be less than $5,000 each month. The agreement further provided that any fee in excess of $100,000 received from a single engagement would be allocated 30% to the partners (other than the partner whose client paid the fee), who would share in the excess fee equally. For 2005, the LLP allocated net business income in accordance with the amended partnership agreement, and it once again did not report any of its income as net earnings from self-employment.

The IRS asserted that the 2004 special allocation to the S...