Properly structured retirement payout avoids SE tax.

• Author: Robbins, Valerie C.
• Position: Self-employment

At long last, a letter ruling approves a retirement payout strategy used by many personal service firms, so that the recipient avoids self-employment (SE) tax. It identified a specific set of facts under which payments to retired partners of a professional limited liability partnership met Sec. 1402(a)(10) requirements and, thus, were not subject to SE tax.

Facts

In Letter Ruling 200403056, a partner, who meets all of the firm's requirements for retirement payments, would receive five annual payments, based on a written formula. After that, the partner would receive $100 per month for life. All of the partner's capital would be paid out by the end of the partnership's year in which retirement payments begin. The partner would render no services to the firm during that year.

Analysis

Sec. 1402(a)(10) specifically excludes payments to partners on account of retirement from the definition of "net earnings from self employment" as long as the section's requirements are met. Under Sec. 1402(a)(10) and Regs. Sec. 1.1402(a)-17, all of the following criteria have to be met to exclude retirement payments from the definition:

* The payments to the retiring partner must be made pursuant to a written plan that sets forth the terms and conditions for making retirement payments.

* The plan must provide for retirement payments to partners in general, or to a class or classes of partners.

* The payments must be made on a periodic basis and continue at least until the partner's death. For this purpose, payments must be made at least annually.

* Under the plan, the payments must constitute bona fide retirement payments. Thus, plan benefits not customarily included in a pension or retirement plan (e.g., layoff or severance benefits) do not qualify. Regs. Sec. 1.1402(a)-17(b)(1) points out that retirement benefits are generally measured by, and based on, years of service. Formulas reflected in public or broad-based private pension plans would be acceptable in determining if a plan is providing retirement benefits. However, the regulation does not overtly exclude plans in which benefits are based on something other than years of service.

* The plan must establish criteria for retirement on the basis of age, physical condition, years of service or a combination of these.

Assuming a partnership makes retirement payments under a plan that meets the above requirements, three additional continuing annual criteria have to be met, for the partner to exclude the...