November 17, 2017 Practice Point

Employment Cases and Planning Implications

By Adam Abrahams, Meyers Hurvitz Abrahams LLC, Rockville MD; Sabrina Strand, Law Offices of Joseph H. Thibodeau, P.C., Denver, CO; and Kevin Bender, McGuireWoods, Richmond, VA

The self-employment tax for closely held businesses has become more important in light of a number of self-employment tax cases decided by the Tax Court in the last year.  This article, based on a panel at the Joint Fall meeting in Austin, Texas, looks at the statutory provisions and the impact of three of these cases:  Fleischer v. Commissioner, T.C. Memo 2016-238 (December 29, 2016); Castigliola v. Commissioner, T.C. Memo 2017-62 (April 12, 2017); and Hardy v. Commissioner, T.C. Memo 2017-16 (January 17, 2017).

Self-employment income is defined under section 1402(a) as “gross income derived by an individual from any trade or business carried on by such individual, less the deductions…plus his distributive share (whether or not distributed) of income or loss…from any trade or business carried on by a partnership of which he is a member...” It does not include any net earnings over the contribution and benefit base ($127,200 in 2017), subtracting the wages paid to such individual during such taxable year (section 1402(b)(1)), or earnings less than $400 in a particular tax year (section 1402(b)(2)).

Section 1402(a)(13) states that “there shall be excluded the distributive share of any item of income or loss of a limited partner, as such, other than guaranteed payments described in section 707(c) to that partner for services actually rendered to or on behalf of the partnership to the extent that those payments are established to be in the nature of remuneration for those services.”

The Code and Treasury Regulations do not provide any guidance on how to treat a member of a limited liability company (LLC) for purposes of the self-employment tax rules.  The key provision, section 1402(a)(13), was added to the statute in 1977 to cover conventional partnerships, including limited partnerships.  This was before the existence of limited liability companies.  In 1994 and 1997, the IRS issued proposed regulations to determine whether distributive shares of partnership income of LLC members are included in self-employment income.1   The intent of the proposed regulations was to treat owners of an LLC interest in the same manner as similarly situated partners in a state law partnership.

Because the proposed regulations were never finalized, tax practitioners have relied on the 2011 Renkemeyer case2 to advise partnership clients on self-employment tax issues.  In Renkemeyer, three attorneys formed a state law limited liability partnership.  One year later, the attorneys executed a written partnership agreement that created two classes of partnership units:  “General Managing Partner Partnership Units” and “Investing Partnership Units.”  Only General Managing Partner units had the authority to act on behalf of the partnership.  Each partner had a 1 percent General Managing Partner Partnership Unit and a 32 percent Investing Partner Partnership Unit.  The partners on their tax returns claimed that all of their distributive shares of partnership gain or loss attributable to their Investing Partner Partnership Units were items of income or loss of a limited partner for purposes of section 1402(a)(13).  The Tax Court disagreed.

In determining the partners’ respective interests in the partnership, the Tax Court considered the following factors relevant: (i) partners’ relative capital contributions to the partnership; (ii) partners’ respective interests in partnership profits and losses; (iii) partners’ relative interests in cash-flow and other non-liquidating distributions; and (iv) partners’ rights to capital upon liquidation.3   Noting that the statute did not define the term “limited partner,” the Tax Court suggested that the term had “become obscured over time because of the increasing complexity of partnerships and other flow-through entities, as well as the history of §1402(a)(13).”4   The Tax Court determined that the section’s purpose was to ensure that individuals who merely invest in a partnership and are not actively participating in the partnership’s business operations would not be subject to self-employment tax.  Those who perform services for a partnership in the capacity of a partner would not be exempt from liability for self-employment taxes.5   The exclusion of certain earnings that are of an investment nature from self-employment income does not include guaranteed payments such as salary and professional fees that are received for services actually performed by the limited partner for the partnership.6   The Tax Court noted that almost all of the law firm revenues were derived from legal services performed by the law partners in their respective capacities as partners in the law firm.  Furthermore, each partner contributed only a nominal amount ($110) for their respective partnership units.

On September 5, 2014, the IRS Office of Chief Counsel released a memorandum considering whether partners in a management company LLC were limited partners for the purpose of the section 1402(a)(13) exception.7   Chief Counsel concluded that they were not because each partner worked full-time for the management company, whereas the exception protected partners who held a passive investment interest in the partnership.

On August 19, 2016, the IRS issued further guidance providing its most expansive application of the self-employment tax rules to an LLC member.8   The facts outlined by the IRS were as follows. The taxpayer purchased restaurant franchises and transferred ownership of the restaurants to an LLC.  The other members of the LLC were the taxpayer’s wife and a trust.  The restaurant franchise agreements required the taxpayer to devote full time to the management of the restaurants, including hiring/firing employees, buying/selling property, establishing pension plans, and hiring professionals such as attorneys.

The taxpayer argued that the LLC should not be subject to employment tax because the taxpayers were not directly responsible for LLC revenue; the restaurant business generated revenue from sales of a good, rather than from providing a service.  If the taxpayer did not show up to work on a particular day, the restaurant would still make food and generate sales.  The taxpayer also stated that his contribution of substantial capital to the restaurant and delegation of significant management responsibilities to executive-level employees sufficed to make his distributive share a mere return on investment exempt from self-employment tax.  The TAM did not concur with the taxpayer’s arguments.

In Fleischer,9 a taxpayer attempted to use an S-Corporation to reduce self-employment tax because S corporation income is not subject to the tax.  Ryan Fleischer was a registered financial consultant, certified financial planner, and licensed seller of variable health and life insurance policies who developed investment portfolios for clients.  After working as an employee of an investment firm and a bank, Fleischer decided to start his own business.  He entered into an agreement with LPL, a brokerage company, that stated that he was an independent contractor.  Later, he incorporated Fleischer Wealth Plan (FWP) as its sole shareholder and elected S-Corporation status.  Three weeks after incorporating FWP, he entered into an employment agreement with FWP under which the company paid him a salary to “perform duties in the capacity of Financial Advisor.”  He then entered into a broker contract with MassMutual Financial Group (MassMutual).  The contract was between Fleischer and MassMutual, with no mention of FWP, and Fleischer signed the contract in his personal capacity.  The contract explicitly stated that there was no employer-employee relationship between Fleischer and MassMutual.  Neither Fleischer nor the companies modified the contracts to include FWP.  Fleischer did not report any self-employment tax on the returns.

The IRS issued Fleischer a notice of deficiency for 2009 through 2011.  In determining how much should be treated as reasonable compensation and how much should be treated as a distribution from an S-Corporation, the IRS requires the business owner to first prove that the S-Corporation, rather than the individual, provided the services.  In Fleischer’s case, the IRS determined that Fleischer’s income for the entire period—reported as pass-through income from FWP on Schedule E—was actually self-employment income that he should have reported each year on a Schedule C, Profit or Loss from Business, and on which he should have reported and paid self-employment tax.

In response to Fleischer’s Tax Court petition challenging the IRS determination, the Tax Court applied the following test:

For a corporation, not its service-provider employee, to be the controller of the income, two elements must be found: (1) the individual providing the services must be an employee of the corporation whom the corporation can direct and control in a meaningful sense; and (2) there must exist between the corporation and the person or entity using the services a contract or similar indicium recognizing the corporation’s controlling position.10

The court held that Fleischer did not satisfy the second element because Fleischer, not his S corporation, had earned all of the income.

There was no indicium for LPL to believe that FWP had any meaningful control over petitioner as FWP had not been incorporated and no purported employer-employee relationship between FWP and petitioner existed at the time petitioner signed the representative agreement with LPL. Moreover, there is no evidence of any amendments or addendums to the LPL agreement after FWP was incorporated. Although FWP had been incorporated before petitioner entered into the broker contract with MassMutual, FWP is not mentioned in the contract, and petitioner offered no evidence that MassMutual had any other indicium that FWP had any meaningful control over him.11

Given the Fleischerdecision, a reasonable question for practitioners is what steps can a financial consultant take to avoid self-employment taxes if he or she is unable to cause an S Corporation to contract directly for service commissions or fees.  One possibility would be to have the S Corporation receive a management fee for its staff who assist the primary employee, with the fee providing a reasonable corporate profit after staff compensation and related costs.  Commentators have concluded that the IRS should not view a reasonable profit in respect of management services as “a deflection of the financial consultant’s earned income.”12   The S corporation could also reinvest its profits or even use them to expand the business reach of the primary employee, rather than merely distributing them out to the primary employee whose earnings paid the management fee.

In Castigliola,13 three attorneyspracticed law through a general partnership in Mississippi.  In 2011, they incorporated their partnership as a professional limited liability company (PLLC).  The PLLC’s only business was the practice of law, and petitioners practiced law solely in their respective capacities as partners of the PLLC.  The PLLC did not have a written operating agreement, but the attorneys did have a written compensation agreement.  The compensation agreement required guaranteed payments in the amount of the average salary of an attorney with similar experience in Mississippi.  The compensation agreement also stated that the partners would distribute to themselves the net profits of the PLLC in excess of guaranteed payments.  They reported the guaranteed payments as self-employment income but did not remit self-employment taxes on distributions in excess of the guaranteed payments.  The guaranteed payments were calculated based on a survey of legal salaries in the area and designed to represent the value of the services petitioners provided to the PLLC.

The IRS claimed that the firm’s self-employment tax determinations were erroneous because the entire amount paid to the partners was subject to the tax.  The firm made three claims in its defense: (i) the guaranteed payments represented the total value of services provided by the partners to or on behalf of the partnership; (ii) any PLLC earnings in excess of the guaranteed payments were attributable to the partners’ investment in the partnership and were items of income or loss of a limited partner under section 1402(a)(13); and (iii) all the members of the PLLC enjoyed limited liability under state law and thus did not possess an essential characteristic of a general partner.

In rejecting the taxpayer’s arguments, the Tax Court noted that a general partner has management power and unlimited personal liability, whereas limited partners lack control of a business and have limited liability.  A partnership therefore must have a least one general partner.  Since the PLLC had no written operating agreement and no specified general partner, no partner’s management power was limited in any way: all the partners participated in making management decisions, including decisions regarding distributions, borrowing funds, hiring, firing, rate of pay for employees, and expenditures.  The absence of a general partner in a member-managed LLC, the Tax Court held, meant that all the members function as general partners.14

Castigliola also raises several questions for practitioners.  How much management power is too much management power for a limited partner to lose his or her status as such? How does this holding apply to classic state-law limited partnerships wherein limited partners have management rights, often significant ones, yet retain state-law status as limited partners? Does focusing purely on management rights lead to any disparate treatment between shareholders of S corporations and limited partners of partnerships?  Perhaps the most significant conclusion from this case is that practitioners should advise their clients of the importance of a written partnership agreement or operating agreement in which the partnership has at least one general partner or, in the case of an LLC, the LLC has a managing member who will be treated as the general partner.  The agreement can provide that all members other than the manager or general partner have limited rights to participate in management.  Election of the manager would be the only management right for non-managing members or partners.

Finally, in Hardy,15 Dr. Hardy was a plastic surgeon performing pediatric constructive surgery in various facilities while maintaining his own medical practice as a single member PLLC (Northwest Plastic Surgery).  He performed surgery at his office or at two local hospitals.  The patients paid Dr. Hardy for the surgeries and paid a separate facility fee.  Dr. Hardy also invested $163,974 for a 12.5% minority interest in Missoula Bone & Joint Surgery Center, LLC (MBJ).  Each member was a manager of MBJ, but Dr. Hardy did not have any role in any management decisions or any day-to-day responsibilities at MBJ.  Dr. Hardy received a distribution from MBJ that was not dependent upon the number of surgeries that he performed at MBJ since MBJ did not have a minimum surgery requirement.

Dr. and Mrs. Hardy filed a joint return for the tax years in question.  The Hardys reported the MBJ income as passive for 2008-2010, the tax years at issue in the case.  They also reported passive losses and carried over unused passive losses to subsequent tax years.  The Hardys did pay self-employment tax of $26,745 in 2008 for income from MBJ and NPS.  The issues addressed at court were whether the Hardys properly reported the MBJ income as passive, whether they could deduct a passive activity loss carryover from previous years against the positive income, and whether they overpaid self-employment tax.

The Tax Court considered whether it was appropriate to group the ownership interest in MBJ with Dr. Hardy’s medical practice under regulations that permit “one or more trade or business activities or rental activities [to] be treated as a single activity if the activities constitute an appropriate economic unit for the measurement of gain or loss for purposes of Section 469.” 16   The regulations set forth five factors for determining an appropriate economic unit: similarities and differences in types of trades or businesses; extent of common control; extent of common ownership; geographical location; and interdependencies between or among activities.17

Section 1.469-4(c)(2) permits a taxpayer to use any reasonable method of “‘applying the relevant facts and circumstances’ to group activities and not all of the five factors are ‘necessary for a taxpayer to treat more than one activity as a single activity.’”18   Therefore, the Hardys had flexibility in determining what constituted an appropriate economic unit.19 The IRS claimed that the Hardys had previously reported Dr. Hardy’s MBJ income as non-passive, and therefore asked the Tax Court to infer that Dr. Hardy grouped his ownership interest in MBJ with his medical practice as a single unit in order to treat the income as non-passive.20

The Tax Court, in rejecting the IRS Commissioner’s argument, stated that it “would not infer that the Hardys grouped Dr. Hardy’s regular medical practice with his MBJ interest, because that grouping is not supported by the evidence.”21   The Court held that the Hardys did not regroup their activities for 2008 when they began reporting Dr. Hardy’s MBJ income as passive.22

The Tax Court then considered the application of the rules allowing the IRS to regroup a taxpayer’s activities if “any of the activities resulting from the taxpayer’s grouping is not an appropriate economic unit and a principal purpose of the taxpayer’s grouping (or failure to regroup under paragraph (e) of this section) is to circumvent the underlying purposes of Section 469.”23   A regulatory example24   permits the Commissioner to regroup a taxpayer’s activities in a scenario involving doctors—all of whom participated in other activities that generated passive losses—who formed a partnership, with a general partner selected by the doctors, to buy and operate X-Ray equipment in which they were limited partners. Substantially all of the partnership’s services were provided to the doctors or their patients in proportion to the doctors’s interests in the partnership.  The doctors treated their services as a separate activity from their medical practices so that they could offset their partnership income against their passive losses.  The example concludes that treating the partnership service income as a separate economic unit from the medical practice income was not appropriate.

The government argued that the Hardys’ situation was identical to the regulation example and supported regrouping, but the Tax Court disagreed because the Hardys were not trying to circumvent the underlying purposes of the passive activity loss rules.25   The Hardys considered opening their own medical facility but decided that joining MBJ was a cost-efficient alternative to affiliating with a hospital.  MBJ was not undertaken to generate passive activity losses.26 Instead, the Tax Court found the Hardys’ facts similar to those in the self-employment tax TAM.27   Recognizing that the TAM cannot serve as precedent, the Tax Court noted that it revealed “the interpretation put upon the statute by the agency charged with the responsibility of administering the revenue laws.”28 The governing regulation and the facts in the case supported that there could be more than one reasonable method of grouping Dr. Hardy’s ownership interest in MBJ and his medical practice.29   The “weight of the evidence supports treating [the two] as separate economic units.”30

The passive activity issues discussed in Hardy are unusual in that a taxpayer typically seeks to group activities together in order to use any losses to offset active income.  The Hardys were paying self-employment tax on income earned from Dr. Hardy’s medical practice.  If the Tax Court determined that the Hardys needed to group Dr. Hardy’s MBJ distribution with his medical practice, the Hardys would have also been liable for self-employment tax on that distribution.

The Court held that the Hardys were not liable for self-employment tax for tax years 2008 and 2009 on Dr. Hardy’s distributive shares of income from MBJ.  Although the Hardys did not expressly plead this issue, the Hardys moved that the Tax Court conform the pleadings to treat the issue of self-employment tax.  The Tax Court granted the motion because factual issues giving rise to the motion were raised during trial with the Commissioner’s consent; evidence on which the Hardys based their motion was admitted at trial in the parties’ stipulation of facts; and the Commissioner addressed the liability for self-employment tax in his opening brief.

The Tax Court distinguished Hardy from Renkemeyer and determined that Dr. Hardy received MBJ income in the capacity only as an “investor.”  Accordingly, the MBJ income was not subject to self-employment tax.  Dr. Hardy received distributions based on fees that patients paid to use the facility. The patients paid Dr. Hardy’s surgeon fees separately.

What can we take away from the Hardy case? Hardy appears to contradict Renkemeyer and Castigliola.  In Hardy, the Tax Court focused on the actual daily management of the business rather than the Hardy’s legal rights to manage the LLC together with the other equal owners.  There was no operating agreement.  The LLC’s annual reports did not specify whether Dr. Hardy was a member or member-manager, but also failed to list a non-member manager.  It appears as though the LLC members together had exclusive legal authority to run the business.  No member had any more rights than any other member.  They did not have legal rights akin to limited partners.  They were more like passive general partners. 

Hardy also appears to contradict Methvin,31 which found the taxpayer liable for self-employment tax in connection with an unincorporated venture in which the taxpayer had no management rights.  The facts in Methvin also appeared to be more favorable for the taxpayer than in Hardy.

If a taxpayer is operating a service firm (i.e. law firm, accounting firm) as a limited partnership, it is likely that the IRS will pursue a partner for self-employment taxes.  If a member of an LLC is an investor who does not perform any services related to operating the business, but has made a significant investment of capital, the IRS will likely treat the member as a limited partner for section 1402(a)(13) purposes.  One should note that the IRS has not distinguished between a service partnership and a partnership selling a good.

Hardy raises additional questions not resolved here.  What if an LLC member performs significant services and has a significant amount of invested capital?  Should all LLCs have a designated manager? What capital contribution amount should an LLC member make to be considered an investor so as to satisfy the section 1402(a)(13) exception?  Should one conduct business through a limited liability company that is owned by a limited partnership? What about net investment income issues?  Should a taxpayer just be an active limited partner in a limited partnership? Should tax practitioners rely only on Renkemeyer?  The self-employment tax enigma continues!


7 Chief Counsel Advice (CCA) 210436049.

10 Johnson v. Commissioner, 78 T.C. 882, 891 (1982) (citing Vnuk v. Commissioner, 621 F. 2d 1318, 1320-1321 (8th Cir. 1980) aff’g T.C Memo 1979-16478 T.C. 882, 891 (1982) and citing Pacella v. Commissioner, 78 T.C. 604 (1982) and Keller v. Commissioner, 77 T.C. 1014 (1981), aff’d 723 F. 2d 58 (10th Cir. 1983).

11 Fleischer, supra, at 12.

12 Steve Gorin, LISI Business Entities Newsletter #159 (Apr. 10, 2017), at 6.

14 Castigliola, supra, at 12-13. 

16 See Treas. Reg. § 1.469-4(c) (discussing grouping tax items under the passive activity loss rules).

17 Hardy, supra n. 15, at 14.

18 Id. at 15.

19 Id.

20 Id. at 16.

21 Id.

22 Id. at 17.

25 Hardy, supra n. 15, at 24-25.

26 Id.at 25.

27 TAM 201634022 (providing that there are multiple ways that activities may be grouped – medical practice and surgical center can be treated as separate activities).

28 Hardy, supra n. 15, at 25.

29 Id. at 23.

31 T.C. 2015-81.