Partners’ Limited Liability and Self-Employment Tax

By Claire Y. Nash, Ph.D., CPA


  • Renkemeyer, Campbell & Weaver is a law firm organized as a limited liability partnership that had three individual partners and an S corporation partner in 2004 and the same three individual partners (each with a general partner and investing partner interest) but no S corporation partner in 2005.
  • In 2004, the LLP allocated the bulk of its net income, which was primarily attributable to legal fees earned by the individual partners, to the S corporation. In 2004 and 2005, the LLP did not report any of its business income as net earnings for self-employment. The IRS on audit reallocated the LLP’s income for 2004 and treated the income from the LLP as net income from self-employment for both years.
  • The Tax Court sided with the IRS, holding that the LLP must allocate its 2004 income according to the individual partners’ interests in the LLP and that the income from the LLP for 2004 and 2005 was self-employment income for the partners.

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.

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 corporation did not have substantial economic effect and consequently that the net business income, as adjusted, should be allocated to each partner in accordance with the profits and loss sharing percentage reported on their respective Schedule K-1s. However, the IRS did not challenge the LLP’s allocation of income under the amended 2005 partnership agreement. The IRS further asserted that each partner’s distributive share of the LLP’s earnings for 2004 and 2005 was subject to self-employment tax under Secs. 1401 and 1402.

Special Allocation Issue

Sec. 704(a) provides that a partner’s distributive share of income, gain, loss, deduction, or credits is generally determined by the governing partnership agreement. If the partnership agreement does not indicate how a partner’s distributive share is to be determined, or if the allocation provided in the partnership agreement does not have substantial economic effect, the partner’s distributive share is determined in accordance with the partner’s interest in the partnership. 2

A partner’s interest in a partnership refers to how the partners have agreed to share the economic benefit or burden. 3 Regs. Sec. 1-704-1(b)(3)(i) provides that all partners’ interests in a partnership are presumed to be equal on a per capita basis unless the facts and circumstances relating to the economic arrangement of the partnership show otherwise. The regulations provide a list of factors to use in the determination of the partners’ respective interests in the partnership: (1) the partners’ relative capital contributions to the partnership; (2) the partners’ respective interests in partnership profits and losses; (3) the partners’ relative interests in cashflow and other nonliquidating distributions; and (4) the partners’ rights to capital upon liquidation. 4

The LLP argued that the special allocation for 2004 was under the provisions of the LLP’s partnership agreement and therefore proper. However, the partners could not produce the partnership agreement. Thus, the Tax Court applied the factors from the regulations to determine the partners’ respective interests.

Applying the factor test, the Tax Court decided that the special allocation of 87.557% of the LLP’s income to RCGW for the 2004 tax year was improper. The Tax Court found that the partners’ assertions regarding the partnership agreement were not enough to give the special allocation substantial economic effect. Further, there was no evidence that RCGW had ever contributed capital to the LLP, it held only a 10% profits and loss interest in the LLP, and it did not receive any distributions from the LLP in 2004. In addition, the partnership agreement for 2004 was not available, so there was no evidence that RCGW had liquidation rights. Therefore, the Tax Court sustained the IRS’s reallocation of the partners’ distributive shares in accordance with their profits and loss interests.

Self-Employment Tax

The LLP argued that its interests in the law firm should be considered limited partner interests for purposes of the Sec. 1402(a)(13) exception because the LLP’s organizing documents designated them as such and the partners enjoyed limited liability under state law. 5 The Tax Court first considered the definition of an LLP under state law and then determined through an analysis of legislative history if the Sec. 1402(a)(13) exception should apply to LLP partners.

State Law and LLPs

In its analysis, the Tax Court found that the concept of a limited partner had become obscured over time because of the increasing complexity of partnerships and other flowthrough entities. Entities such as LLPs and limited liability companies (LLCs) were not widely used when the limited partner exclusion in Sec. 1402(a)(13) was enacted. The Tax Court first examined the characteristics that distinguish an LLP from a limited partnership. As the court explained, a limited partnership has two fundamental classes of partners: general and limited. General partners can be engaged in the activity of the partnership and have unlimited personal liability.

Under most state laws, limited partners are merely investors, and state laws generally forbid the limited partners from participating in the management of a partnership as a condition of limiting their liability in their investment in the partnership. 6 In contrast, the court noted that “under most state laws an LLP is a general partnership that affords a form of limited liability protection for all its partners by filing a statement of qualification with the appropriate state authorities.” Consequently, an LLP is distinguished from a limited partnership because all the LLP’s partners enjoy limited liability protection and may have management powers.

Proposed Regulations

Treasury attempted to define “limited partner” for the purpose of Sec. 1402(a)(13) in proposed regulations issued in 1997. 7 However, the language in the proposed regulation ignited controversy, and Congress placed a moratorium on the proposed regulation shortly after it was issued. The legislation provided that “no temporary or final regulation with respect to the definition of a limited partner under section 1402(a)(13) of the Internal Revenue Code of 1986 may be issued or made effective before July 1, 1998.” 8 In a Sense of the Senate resolution that accompanied the legislation, the Senate expressed its opinion that Treasury should withdraw the proposed regulation. 9 Since then, Congress has not passed legislation on the issue, and Treasury has not attempted to finalize the regulation. Given the controversy surrounding its issuance in 1997, the Tax Court did not give any deference to the proposed regulation in deciding Renkemeyer and instead looked to the legislative history of Sec. 1402(a)(13) to ascertain Congress’s intent with respect to the limited partner exclusion.

Sec. 1402(a)(13) Analysis

As the Tax Court explained, in general, Sec. 1401(a) imposes self-employment taxes on the net income derived from self-employment (i.e., the net earnings of an individual from any trade or business). Sec. 1402(a) defines net earnings from self-employment to include not only the income of sole proprietors but also partnership trade or business income that is attributed to partners, whether it is actually distributed or not. Sec. 1402(a)(13) provides that earnings from partnerships that are attributed to a limited partner, as such, are excluded from the definition of net earnings from self-employment unless the earnings are Sec. 707(c) guaranteed payments for services actually rendered to or on behalf of the partnership. However, neither Sec. 1402(a)(13) nor its related regulations define limited partner. 10

Sec. 1402(a)(13) was enacted by the Social Security Amendments of 1977. 11 The Tax Court found that the following excerpt from the committee report provided insight regarding Congress’s intent when it enacted the limited partner exception:

Under present law each partner’s share of partnership income is includable in his net earnings from self-employment for social security purposes, irrespective of the nature of his membership in the partnership. The bill would exclude from social security coverage, the distributive share of income or loss received by a limited partner from the trade or business of a limited partnership. This is to exclude for coverage purposes certain earnings which are basically of an investment nature. However, the exclusion from coverage would not extend to guaranteed payments (as described in 707(c) of the Internal Revenue Code), such as salary and professional fees, received for services actually performed by the limited partner for the partnership. 12

According to the Tax Court, the congressional report revealed that the intent of Sec. 1402(a)(13) was to exclude individuals from Social Security coverage who merely invested in a partnership and were not actively engaged in the partnership’s activity.

Following this interpretation of congressional intent, the Tax Court rejected the LLP’s argument that the partners should be considered limited partners and thus be able to exclude their distributive shares of earnings under Sec. 1402(a)(13). The court found that a limited partner’s interest is generally akin to that of a passive investor. The LLP is not a limited partnership but an LLP formed under the Kansas Uniform Partnership Act, 13 which governs general partnerships. A Kansas partnership that elects to become an LLP “continues to be the same entity that existed before the filing of a statement of qualification under” the Kansas Uniform Partnership Act. 14 In addition, the court found that the partners’ distributive shares of the LLP’s income did not arise as a return on the partners’ investment and were not “earnings which are basically of an investment nature.” The partners’ distributive shares arose from services they performed on behalf of the LLP. Thus, the court held that the respective distributive shares of the partners were subject to self-employment taxes for the 2004 and 2005 tax years.


The Tax Court’s decision in Renkemeyer signals that special allocations that are not supported by a written partnership agreement and are without substantial economic effect will not withstand an IRS challenge. The decision also signals that the classification of an interest in a partnership as a limited partner interest should not be predicated simply on a partner’s enjoyment of limited liability.

Even though the increasing complexity of partnerships and other flowthrough entities has caused the concept of a limited partner to become obscured over time, the court relied on existing authority for its decision. The legislative history of Sec. 1402(a)(13) shows that Congress intended for the provision to exclude only the distributive shares of earnings of individuals who merely invest in a partnership and are not engaged in the partnership’s activity. An individual’s involvement in the partnership’s activity must be considered in determining the classification of his or her partnership interest. Under Renkemeyer, individuals who are not merely passive investors are not eligible for the exclusion under Sec. 1402(a)(13); consequently, their distributive shares of earnings would be subject to the self-employment tax.

The Renkemeyer decision is a victory for the IRS, which will certainly use the decision as guidance in the absence of action by Congress. While it is a lower court decision and could be appealed, it should cause taxpayers who have taken aggressive tax positions regarding the exclusion under Sec. 1402(a)(13) to reconsider those positions. Individuals with interests in profitable LLPs and LLCs who have excluded from self-employment their distributive shares of the entity’s earnings from net earnings under Sec. 1402(a)(13) should reconsider whether there is justification beyond the enjoyment of limited liability for doing so.


1 Renkemeyer, Campbell & Weaver, LLP, 136 T.C. No. 7 (2011).

2 Sec. 704(b).

3 Regs. Sec. 1.704-1(b)(3)(i).

4 Regs. Sec. 1.704-1(b)(3)(ii).

5 Interestingly, a similar argument was advanced by the IRS in recent Sec. 469 cases regarding limited liability company members. For a discussion of the decisions in these cases, see Nash and Parker, “Taxation of LLC Members as General Partners,” 41 The Tax Adviser 612 (September 2010).

6 “A fundamental concept of limited partnerships is that a limited partner may lose limited liability by taking part in control of the partnership.” Garnett, 132 T.C. No. 19 (2009), citing Bromberg and Ribstein, 3 Bromberg and Ribstein on Partnership §11.02(c) (Aspen 1998).

7 See Prop. Regs. Sec. 1.1402(a)-2, 62 Fed. Reg. 1704 (1/13/97).

8 Taxpayer Relief Act of 1997, P.L. 105-34, §935.

9 H.R. Conf. Rep’t No. 220, 105th Cong., 1st Sess. 765 (7/30/97), to accompany the Taxpayer Relief Act, P.L. 105-34.

10 Black’s Law Dictionary defines “limited partner” as a “partner whose liability to third party creditors of the partnership is limited to the amount invested by such partner in the partnership.” General partners, on the other hand, are “personally liable for all debts of the partnership.” Black’s Law Dictionary (West 5th ed. 1979).

11 Social Security Amendments of 1977, P.L. 95-216, §313(b), 91 Stat. 1536.

12 H.R. Rep’t No. 702, 95th Cong., 1st Sess., Part 1 at 11 (1977) (emphasis added).

13 KS Stat. Ann. ch. 56a.

14 KS Stat. Ann. §56a-201(b).


Claire Nash is an assistant professor at Florida Atlantic University in Boca Raton, FL. For more information about this article, contact Prof. Nash at

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