There’s an ongoing legal debate taking place in the courts over the self-employment tax treatment of partnership income that is flying below the radar for many busy tax professionals.
The ramifications of this legal linguistic battle could have significant tax implications for partners with passthrough income that’s subject to self-employment taxes. And given rapidly approaching fall tax deadlines, practitioner awareness of this complex and evolving issue could potentially help clients by shielding income from the 15.3% self-employment tax.
The issue has been bouncing around in the courts, so much an observer might get whiplash trying to keep track of the development.
But regardless of the outcome, this underscores why it’s important for tax professionals and affected clients to review their situation. In some cases, this could mean a significant difference in self-employment taxes that could save clients tens or even hundreds of thousands of dollars.
The controversy began in January with a 5th Circuit decision in Sirius Solutions, LLLP v. Commissioner that rejected the Tax Court’s approach to deciding whether a limited partner’s distributive share of income is subject to self-employment tax. The government requested a rehearing of the case. And in a bit of a surprise move, the court on Aug. 12 withdrew that taxpayer-friendly opinion. Instead, the court replaced it with a new test focused on whether the partner played a significant role in managing or running the business.
For impacted partners, the decision creates uncertainty while opening the door to substantial tax savings for taxpayers in Texas, Louisiana and Mississippi – the states covered by the 5th Circuit.
And in a twist, the case is now named K Alain LLLP v. Commissioner because the partnership took on a new name this year.
The situation raises some interesting questions for tax professionals and their clients given the approaching Sept. 15 partnership deadline and the Oct. 15 individual deadline. This is especially true for taxpayers in the three states, but other cases carry implications for taxpayers in seven other states and Puerto Rico.
Practitioners should consider whether current-year treatment should change for impacted clients and, at the same time, review prior years before refund statutes expire.
How We Got Here
Partners generally include their distributive shares of income from a partnership’s trade or business in net earnings from self-employment.
But there’san exception to the rule. In the Internal Revenue Code, Section 1402(a)(13), excludes the distributive share of income from “a limited partner, as such,” other than guaranteed payments for services. Naturally, there’s a catch: The tax code provides no definition of “limited partner.”
And there’s an exception to the exception. For years, the Tax Court has used a functional analysis test that looks beyond a partner’s state-law title to examine the partner’s role in the business. In various cases, the Tax Court concluded that the exception was intended for the earnings of a passive investor, not income derived from a partner’s services.
As recently as 2023 in Soroban Capital Partners LP v. Commissioner, the Tax Court affirmed that reasoning to include limited partners in a state-law limited partnership. The Tax Court held that the limited partner’s formal status alone did not settle the question; their participation in the partnership still mattered.
And now, K Alain/Sirius puts a whole new twist on an already complex situation.
Sirius involved active limited partners in a state-law limited partnership who excluded their distributive shares from net earnings from self-employment. The Tax Court, applying the functional analysis it used in Soroban, ruled that the partners’ activities—not merely their state-law status—had to be considered.
But in a January 2-1 decision, the 5th Circuit rejected that approach looking instead at what “limited partner” meant when Congress enacted Section 1402(a)(13) and determining that, for a state-law limited partnership, limited liability was the characteristic that allows for the exclusion.
The court vacated the Tax Court’s decision and sent the case back for further proceedings. But in the August surprise, the 5th Circuit changed course and issued a new, substitute opinion under the new name, K Alain.
This time, the 5th Circuit withdrew its broad limited liability test and substituted a new standard for state-law limited partners for being able to exclude income from self-employment tax. The new test outlined by the court looks to the distinction between managerial and non-managerial participation of the partner in a partnership. The decision indicates that a limited partner may be allowed to perform services for the partnership without losing the Section 1402(a)(13) exception as long as they do not play a significant role in managing or running the business.
The court’s holding has important limits. The K Alain decision is binding precedent for only partners in a state-law limited partnership in the 5th Circuit’s Texas, Mississippi and Louisiana. The opinion does not address how its management-based standard would apply to LLC members or partners in an LLP.
Neither does thissettle the issue nationally. Related cases are pending in the 1st Circuit covering Maine, Massachusetts, New Hampshire, Rhode Island, and Puerto Rico and the 2nd Circuit’s Connecticut, New York, and Vermont. For now, the Section 1402(a)(13) exception depends not only on what a partner does, but also on where the resulting dispute would be heard.
This means that taxpayers – and tax professionals – should consider taking action.
Tax Pros: Actions to Consider
For individual-return preparers, the first task centers on identifying affected clients. That means looking beyond the words “limited partner” on a Schedule K-1 and considering the partner’s involvement as a decision maker in the partnership, and whether the taxpayer’s position would be appealable in the 5th Circuit.
Next comes the reporting decision. If a partnership reports an amount as net earnings from self-employment on Schedule K-1 but the partner takes a different position on Form 1040, the inconsistent treatment rules must be considered. Depending on the facts, Form 8082, Notice of Inconsistent Treatment or Administrative Adjustment Request, may be required. Other disclosure considerations may also arise. The K Alain case doesn’t take away the need to document why it applies to this taxpayer, this entity and this year.
Here’s another important point that could have significant financial implications. Practitioners should also review open prior tax years, particularly in the three affected states but potentially other areas as well.
A partner who paid self-employment tax on income that may fall within K Alain could have a potential refund claim. But statutes of limitation, centralized partnership audit rules and restrictions on partner-level adjustments can complicate what sounds like a simple amended return. In some cases, a protective refund claim may be worth considering while the issue continues to play out.
Given the complexities involved, it’s critical that practitioners don’t put this review off until the last minute before the Oct. 15 extension deadline.
An issue still under construction
Following the Sirius case, the IRS has not abandoned interest in this area. The agency’s compliance campaigns still include self-employment contributions tax for limited partners. That reflects the agency’s concern that service partners are improperly using the exception, and the active campaign suggests that the IRS will continue examining these arrangements. Within the 5th Circuit, the IRS must now consider the distinction outlined in K Alain between managerial and non-managerial participation by partners rather than relying on the Tax Court’s passive investor position.
For now, practitioners do not have the luxury of waiting for every circuit — or perhaps Congress — to produce one tidy national answer. But tax pros do have an opportunity to identify affected partners, document the reporting position and protect open tax years before time runs out. And in some cases, this could mean a sizable difference in self-employment taxes.
Tax law may be under construction and debate in the courts. The tax returns, inconveniently, are still due. After all, filing deadlines wait for no one.
ABOUT THE AUTHOR:
Catharine Drake Madeley, CPA owns Salling Madeley PLLC, a full-service accounting firm in Austin, Texas, where she has been a CPA for 18 years. She has spoken at numerous conferences on tax issues and serves on the Executive Committee of The Retreat Network, a community of small and mid-sized practitioners.
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