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Bar News - February 17, 2012

Tax Law: Self-Employment Tax Liability as a Partner

The United States tax court recently decided an issue that may affect many law offices in this country. Generally, a partner in a law firm is required to pay the self-employment tax on their share of the firms’ income as they are not considered to be investors in the partnership but rather are active participants in the firm’s business operations. The back story of this case is this:

A Kansas-based, four-partner law firm was set up as follows. Three partners were attorneys performing legal services. The fourth partner was an S-Corporation owned by a tax-exempt ESOP whose beneficiaries were the three firm partners. Despite all of the work being rendered by the three partners, the firm allocated 88 percent of its net business income to the S-Corporation. Because the government felt that this did not reflect economic reality, it reallocated the business income to the partners and levied tax against them for the unpaid self-employment tax.

At bar were the returns for 2004 and 2005 and the amounts allocated to each partner and the tax-exempt S-Corporation. The firm effectively passed $1,000,000 worth of revenue from the partnership in 2004 through to the S-Corporation to avoid the self-employment tax. In 2005, the corporation partner was eliminated. The court applied the firm’s 2005 partnership agreement to the facts of the case and found the application of the firm’s income to the corporate partner did not comport with the terms of the agreement, which effectively divided the firm among the three partners evenly.

When deciding whether the allocation to the corporation in 2004 was proper, the court applied a four-part test addressing the following: partners’ interests in profits; relative interest in cash flow’ and partners’ rights to capital upon liquidation. Here, the court found that the partners’ interests were outweighed greatly by the corporation’s interest in each of the first three parts of the test. The fourth test was unsupported by the record, so the court did not apply it. Therefore, the court found that the allocation to the corporation was illegal.

With regard to the application of the self-employment tax allocation, the court found that the partners were liable for the self-employment tax because their earnings came from the performance of legal services. Just because the partners labeled themselves as limited or investment partners in the firm did not shield them from their self-employment tax liability.

Editor’s Note: This article first appeared in The Profit Counselor, a newsletter created by Brayman, Houle, Keating & Albright, PLLC – CPA, and is reprinted here with permission.

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