Renkemeyer Case Sheds Light on Law Firm Tax Issues

A recent tax court case involving a law firm dealt with two issues that are relevant to many law firms. In this particular case, the taxpayer had a bad set of facts and consequently ended up with a bad result. However, the court's decision may have a far-reaching effect on other taxpayers taking less aggressive positions. The first issue is the allocation of partnership income to the partners in the absence of a written partnership agreement. The second issue is whether income generated by a limited liability partnership is subject to self-employment tax. This question is of particular interest to law firms as the limited liability partnership is the entity of choice for many law firms.

Allocation of Income

In Renkemeyer Campbell, and Weaver, LLP, et al. v. Commissioner (136 T.C. No. 7 2011), the taxpayer, a Kansas limited liability partnership, allocated 87.557% of its income on its 2004 tax return to RCGW, an S corporation partner that was wholly owned by an ESOP. The LLP also had three individual partners who were attorneys, providing legal services. The taxpayer claimed that the allocation was computed based on a written partnership agreement. The taxpayer was unable to provide a copy of the agreement. In 2005, the taxpayer amended the partnership agreement removing the interest of RCGW. Upon audit, the IRS adjusted the partnership income allocations to reflect the stated profit/loss percentages of 30% for each individual and 10% for the S corporation as stated on the forms K-1.

The tax court upheld the IRS adjustment. The court cited Internal Revenue Code Section 704(b), which indicates that partnership income is generally allocated to partners in accordance with the partnership agreement. The allocations as reflected in the partnership agreement will not be respected if it lacks substantial economic effect. In such a situation, the partner's distributive share is determined in accordance with the partner's interest in the partnership. In this case, the court found that there was no written partnership agreement for 2004, since the taxpayer could not produce a copy of the agreement. Furthermore, the 2005 written agreement did not support the special allocation to the S corporation. In the absence of a
partnership agreement in 2004, the court looked at four factors in allocating the income based on the Section 704 Regulations and case law. The factors were as follows:

• the partners' relative capital contributions;
• the partners' respective interests in profits and losses;
• the partners' relative interests in cash flow and non-liquidating distributions; and
• the partners' relative rights to distributions upon liquidation.

In applying these factors to the case at hand, the court found that the individual partners had made capital contributions and received distributions (presumably in proportion to the partners' economic interests and profits), whereas RCGW did not make any capital contributions or receive any distributions. Hence, the taxpayer's special allocation to RCGW was not consistent with the first and third factors. Furthermore, the individual partners each held a one-third capital interest and a 30% profit/loss interest, whereas RCGW held a 0% capital interest and 10% profits/loss interest. Therefore, the 87.557% allocation to RCGW could not be supported by the second factor. The court noted that there was no information in the record regarding the fourth factor and consequently this factor could not support the law firm's special allocation. Based on the application of the four-factor test, the court concluded that the facts and circumstances supported the reallocation of income according to the profit/loss percentages as determined by the IRS.

Lessons for Law Firms

Law firms can take away several lessons from this decision. First, every law firm partnership should have a written partnership agreement that provides a clear determination of how to allocate income, loss, capital, distributions, etc. Second, one should ensure that the allocations have substantial economic effect. Although the tax court did not elaborate in this opinion on substantial economic effect, it is highly doubtful that it would have respected the taxpayer's allocation even if it was in accordance with the agreement on grounds of a lack of substantial economic effect. The IRS Regulations in this area are highly complex. Therefore, it is advisable to have all partnership agreements reviewed by a competent tax professional. Last, in the absence of a partnership agreement, be prepared for the IRS to reallocate income based on the criteria discussed in this tax court opinion.

LLPs and Self-Employment Income

The second matter decided in this case was whether LLP income is subject to self-employment tax. The analysis begins with the definition of self-employment income according to Internal Revenue Code Section 1402(a). The definition includes trade or business income passed through from a partnership. IRC Section 1402(a) (13) excludes from the definition of self-employment income the income or loss of a limited partner. The taxpayer argued that the LLP interest is equivalent to a limited partner interest because the organizational documents designate the interest as a limited partnership interest. Additionally, the partners in the LLP enjoy limited liability pursuant to Kansas law. The tax court pointed out that there is fundamental difference between a limited partner and an LLP partner. Limited partners lack management powers and are akin to passive investors, whereas LLP partners may have management powers. The court also noted that the statute was enacted before entities such as LLPs even existed. In 1997, the Secretary issued Proposed Regulations defining the term “limited partner” for self-employment tax purposes. The Proposed Regulations specifically exclude from the definition of “limited partner” a partner that has authority to contract on behalf of the partnership or a partner who participates in the partnership's trade or business for more than 500 hours during the tax year. The Regulations also exclude service partners in a service partnership. The Regulations were never adopted after Congress indicated that the Treasury Department had exceeded its authority in attempting to define the term “limited partner.”

In absence of a statutory definition, the tax court applied accepted principles of statutory construction to ascertain Congress' intent. Based on the legislative history of IRC Section 1402(a), the court determined that the “limited partner” exception to self-employment income was instituted to ensure that individuals who merely invested in a partnership and who were not actively participating in the partnership's business operations would not receive credits toward Social Security coverage. The tax court concluded that in the present case the income allocated to the partners from the partnership was not considered a return of the partners' investments and was not earnings of an investment nature. Rather, the income allocation arose from legal services they performed on behalf of the law firm. As such, the income was subject to self employment tax.

What It Means

The implication of this case is that an active partner in a service-based LLP or an active member in a service-based LLC will be subject to self-employment tax. The case does not directly address the situation of an active partner in a business in which capital is also responsible for generating income. The likelihood is that the active participation would taint the entire partnership interest, although one could argue for a bifurcation of the interest between the “active” interest and the “investor” interest. An additional implication of this case is that the court can apply the same logic to an actual limited partnership interest in which the limited partner is somewhat active (for example, if applicable state law allows a certain level of activity). One former IRS associate chief counsel commented that this case is the most aggressive that the tax court has been in its narrow definition of the limited partner exception. In conclusion, although Renkemeyer clarified the tax court's position on self-employment income related to LLPs/LLCs, there still is considerable ambiguity. We will have to wait for the Treasury to issue Final Regulations.

Richard H. Stieglitz, CPA, a member of this newsletter's Board of Editors, is a Tax Partner and Martin Arking, CPA, is a Tax Manager in the New York accounting firm of Anchin, Block & Anchin LLP. The authors can be reached at 212-840-3456 or via e-mail at [email protected] and [email protected], respectively.

A recent tax court case involving a law firm dealt with two issues that are relevant to many law firms. In this particular case, the taxpayer had a bad set of facts and consequently ended up with a bad result. However, the court's decision may have a far-reaching effect on other taxpayers taking less aggressive positions. The first issue is the allocation of partnership income to the partners in the absence of a written partnership agreement. The second issue is whether income generated by a limited liability partnership is subject to self-employment tax. This question is of particular interest to law firms as the limited liability partnership is the entity of choice for many law firms.

Allocation of Income

In Renkemeyer Campbell, and Weaver, LLP, et al. v. Commissioner (136 T.C. No. 7 2011), the taxpayer, a Kansas limited liability partnership, allocated 87.557% of its income on its 2004 tax return to RCGW, an S corporation partner that was wholly owned by an ESOP. The LLP also had three individual partners who were attorneys, providing legal services. The taxpayer claimed that the allocation was computed based on a written partnership agreement. The taxpayer was unable to provide a copy of the agreement. In 2005, the taxpayer amended the partnership agreement removing the interest of RCGW. Upon audit, the IRS adjusted the partnership income allocations to reflect the stated profit/loss percentages of 30% for each individual and 10% for the S corporation as stated on the forms K-1.

The tax court upheld the IRS adjustment. The court cited Internal Revenue Code Section 704(b), which indicates that partnership income is generally allocated to partners in accordance with the partnership agreement. The allocations as reflected in the partnership agreement will not be respected if it lacks substantial economic effect. In such a situation, the partner's distributive share is determined in accordance with the partner's interest in the partnership. In this case, the court found that there was no written partnership agreement for 2004, since the taxpayer could not produce a copy of the agreement. Furthermore, the 2005 written agreement did not support the special allocation to the S corporation. In the absence of a
partnership agreement in 2004, the court looked at four factors in allocating the income based on the Section 704 Regulations and case law. The factors were as follows:

• the partners' relative capital contributions;
• the partners' respective interests in profits and losses;
• the partners' relative interests in cash flow and non-liquidating distributions; and
• the partners' relative rights to distributions upon liquidation.

In applying these factors to the case at hand, the court found that the individual partners had made capital contributions and received distributions (presumably in proportion to the partners' economic interests and profits), whereas RCGW did not make any capital contributions or receive any distributions. Hence, the taxpayer's special allocation to RCGW was not consistent with the first and third factors. Furthermore, the individual partners each held a one-third capital interest and a 30% profit/loss interest, whereas RCGW held a 0% capital interest and 10% profits/loss interest. Therefore, the 87.557% allocation to RCGW could not be supported by the second factor. The court noted that there was no information in the record regarding the fourth factor and consequently this factor could not support the law firm's special allocation. Based on the application of the four-factor test, the court concluded that the facts and circumstances supported the reallocation of income according to the profit/loss percentages as determined by the IRS.

Lessons for Law Firms

Law firms can take away several lessons from this decision. First, every law firm partnership should have a written partnership agreement that provides a clear determination of how to allocate income, loss, capital, distributions, etc. Second, one should ensure that the allocations have substantial economic effect. Although the tax court did not elaborate in this opinion on substantial economic effect, it is highly doubtful that it would have respected the taxpayer's allocation even if it was in accordance with the agreement on grounds of a lack of substantial economic effect. The IRS Regulations in this area are highly complex. Therefore, it is advisable to have all partnership agreements reviewed by a competent tax professional. Last, in the absence of a partnership agreement, be prepared for the IRS to reallocate income based on the criteria discussed in this tax court opinion.

LLPs and Self-Employment Income

The second matter decided in this case was whether LLP income is subject to self-employment tax. The analysis begins with the definition of self-employment income according to Internal Revenue Code Section 1402(a). The definition includes trade or business income passed through from a partnership. IRC Section 1402(a) (13) excludes from the definition of self-employment income the income or loss of a limited partner. The taxpayer argued that the LLP interest is equivalent to a limited partner interest because the organizational documents designate the interest as a limited partnership interest. Additionally, the partners in the LLP enjoy limited liability pursuant to Kansas law. The tax court pointed out that there is fundamental difference between a limited partner and an LLP partner. Limited partners lack management powers and are akin to passive investors, whereas LLP partners may have management powers. The court also noted that the statute was enacted before entities such as LLPs even existed. In 1997, the Secretary issued Proposed Regulations defining the term “limited partner” for self-employment tax purposes. The Proposed Regulations specifically exclude from the definition of “limited partner” a partner that has authority to contract on behalf of the partnership or a partner who participates in the partnership's trade or business for more than 500 hours during the tax year. The Regulations also exclude service partners in a service partnership. The Regulations were never adopted after Congress indicated that the Treasury Department had exceeded its authority in attempting to define the term “limited partner.”

In absence of a statutory definition, the tax court applied accepted principles of statutory construction to ascertain Congress' intent. Based on the legislative history of IRC Section 1402(a), the court determined that the “limited partner” exception to self-employment income was instituted to ensure that individuals who merely invested in a partnership and who were not actively participating in the partnership's business operations would not receive credits toward Social Security coverage. The tax court concluded that in the present case the income allocated to the partners from the partnership was not considered a return of the partners' investments and was not earnings of an investment nature. Rather, the income allocation arose from legal services they performed on behalf of the law firm. As such, the income was subject to self employment tax.

What It Means

The implication of this case is that an active partner in a service-based LLP or an active member in a service-based LLC will be subject to self-employment tax. The case does not directly address the situation of an active partner in a business in which capital is also responsible for generating income. The likelihood is that the active participation would taint the entire partnership interest, although one could argue for a bifurcation of the interest between the “active” interest and the “investor” interest. An additional implication of this case is that the court can apply the same logic to an actual limited partnership interest in which the limited partner is somewhat active (for example, if applicable state law allows a certain level of activity). One former IRS associate chief counsel commented that this case is the most aggressive that the tax court has been in its narrow definition of the limited partner exception. In conclusion, although Renkemeyer clarified the tax court's position on self-employment income related to LLPs/LLCs, there still is considerable ambiguity. We will have to wait for the Treasury to issue Final Regulations.

Richard H. Stieglitz, CPA, a member of this newsletter's Board of Editors, is a Tax Partner and Martin Arking, CPA, is a Tax Manager in the New York accounting firm of Anchin, Block & Anchin LLP. The authors can be reached at 212-840-3456 or via e-mail at [email protected] and [email protected], respectively.