Business owners and fund managers are closely watching a historic, high-stakes tax debate that could dramatically alter self-employment tax liabilities for business owners.
At the heart of the issue is Internal Revenue Code § 1402(a)(13)—a provision that determines whether a partner’s share of partnership income is subject to Self-Employed Contributions Act (SECA) tax. If you are a partner in a partnership, LLC, or similar entity, this debate playing out in the courts could directly affect your tax obligations.
The stakes could be high for some businesses. For active business owners, pass-through profits are heavily exposed to self-employment taxes, which combine Social Security and Medicare allocations. With the full SECA tax rate at 15.3%, assuming the maximum Medicare tax at rate of 3.8%1, how your business is structured could potentially mean tens of thousands of dollars difference in taxes.
At the present time, the issue is particularly pressing for businesses in the Fifth Circuit Court of Appeals, meaning firms located in Texas, Louisiana, and Mississippi. But other court cases playing out in other courts could have implications for taxpayers in many other states.
This is a complex area where taxes and law intersect. To take advantage of this developing situation, there’s a window to structure your business and protect your hard-earned revenue—but it requires deliberate, expert planning. Contact the Frost Law legal team today at (410) 497-5947 or schedule a consultation to evaluate your current business framework and navigate these developing federal tax changes.
IRC § 1402(a)(13) provides that “there shall be excluded the distributive share of any item of income or loss of a limited partner, as such.” The interpretation of those two words “as such” may be instrumental in determining whether a standard LLC or general partnership structure is causing business owners to overpay the IRS by tens or hundreds of thousands of dollars annually in unnecessary SECA taxes. Importantly, this SECA liability exclusion under IRC § 1402(a)(13) does not apply to guaranteed payments described in IRC § 707(c), to the extent the payments constitute compensation for such services.
For years, the IRS has relied upon the “functional analysis” test, arguing that if you actively work in your business, your pass-through profits are automatically subject to self-employment tax.2 However, a series of ongoing federal court battles including Sirius Solutions, L.L.L.P. v. Commissioner in the Fifth Circuit are challenging the government’s theory, while similar disputes emerge in other circuits. That’s shifting the landscape of small-business tax planning.
The current legal battle lines are drawn between two opposing interpretations under IRC §1402(a)(13):
There’s also interaction between state and federal laws. While federal law ultimately determines how entities are taxed, it relies heavily on state law to define the legal interests and liability shields created by a limited partnership.
Despite aggressive auditing campaigns by the government, the final outcome of this litigation remains uncertain. Key cases including Soroban, Denham Capital Management LP, and Sirius Solutions L.L.L.P. are moving through various stages of federal litigation.
Because of the Golsen Rule, the Tax Court can reach different outcomes for otherwise similar taxpayers depending on which federal appellate circuit court would hear an appeal in the case. This ongoing conflict means we might see a significant variance in rulings in various circuits until Congress or the Supreme Court ultimately weighs in to resolve the dispute.3
While the courts iron out the final rules, business owners cannot simply change a line on their tax return without the correct legal architecture to withstand IRS scrutiny or an audit. Here are some tips:
For active business owners, pass-through profits are heavily exposed to self-employment taxes combining a capped 12.4% Social Security allocation and an uncapped Medicare tax. For an active partner drawing $500,000 in taxable income from a partnership, successfully qualifying for the limited partner exemption eliminates this self-employment tax burden entirely, translating to an annual tax savings of over $38,000.5
For the past two decades, the Limited Liability Company (LLC) has been the undisputed king of small business structures. However, this litigation may spark major structural changes.
Historically, the state-law Limited Partnership (LP) and Limited Liability Limited Partnership (LLLP) frameworks were heavily utilized by per-project, finite-horizon industries like oil and gas exploration, film production, and music management. Because the Sirius Solutions victory was won specifically on the definition of a state-law "limited partner" standard, LLC and LLP members cannot directly rely on it.
To safely capture these tax savings, businesses within the proper jurisdiction may need to look backward to move forward. That means deliberately transitioning their modern LLC frameworks back into meticulously drafted Limited Partnerships.
Although Sirius Solutions is a victory for taxpayers, the IRS is not giving up without a fight.
Because the government has petitioned for a rehearing before the full Fifth Circuit, this decision does not represent a final victory. Assuming Sirius Solutions is ultimately decided in favor of the taxpayer, the decision will be binding in the Fifth Circuit and accordingly would apply to taxpayers whose cases would be appealable to the Fifth Circuit Court of Appeals, which includes Texas, Louisiana, and Mississippi.6 Similar high-stakes cases are currently pending in the First and Second Circuit courts covering taxpayers in Maine, Massachusetts, New Hampshire, Rhode Island and the Commonwealth of Puerto Rico in the First Circuit and Connecticut, New York, and Vermont in the Second.
This potential regional split creates a critical timeline for business owners to take action:
Protective Refund Claims: If you are a partner within the Fifth Circuit’s jurisdiction who previously paid self-employment taxes on your pass-through distributions because of the IRS's generic “passive investor” interpretation, the clock is ticking. You may have a limited window to file amended tax returns and claim substantial refunds for open tax years.
With so much money at stake, a generic, off-the-shelf partnership agreement could be a major liability. To fully secure the Sirius Solutions exemption, your legal architecture must properly separate your compensation for services from your return on your ownership interest.
The prudent strategy requires a meticulous “belt-and-suspenders” drafting approach. Your partnership must pay a reasonable, market-rate guaranteed payment for any actual services you render to the business. That portion will correctly be subject to self-employment tax. However, the remainder of the business’s profits must be cleanly structured as distributive shares tied directly to your state-based “limited partner” status.
Once the window to restructure your business for the current tax year closes, the opportunity for those savings could be gone (or limited to a subsequent refund claim).
If you are currently operating as an LLC, a general partnership, or an active member of an investment fund, a prompt legal review of your entity structure is essential. Moving deliberately to transition into a state-law limited partnership, such as an LLLP, could make a substantial difference in what you owe the government versus what you keep in your pocket, depending on how the courts in your jurisdiction ultimately resolve this issue.
Contact our legal team today at (410) 497-5947 or schedule a consultation to evaluate your business structure and protect your hard-earned revenue from unnecessary taxation.
Business owners and fund managers are closely watching a historic, high-stakes tax debate that could dramatically alter self-employment tax liabilities for business owners.
At the heart of the issue is Internal Revenue Code § 1402(a)(13)—a provision that determines whether a partner’s share of partnership income is subject to Self-Employed Contributions Act (SECA) tax. If you are a partner in a partnership, LLC, or similar entity, this debate playing out in the courts could directly affect your tax obligations.
The stakes could be high for some businesses. For active business owners, pass-through profits are heavily exposed to self-employment taxes, which combine Social Security and Medicare allocations. With the full SECA tax rate at 15.3%, assuming the maximum Medicare tax at rate of 3.8%1, how your business is structured could potentially mean tens of thousands of dollars difference in taxes.
At the present time, the issue is particularly pressing for businesses in the Fifth Circuit Court of Appeals, meaning firms located in Texas, Louisiana, and Mississippi. But other court cases playing out in other courts could have implications for taxpayers in many other states.
This is a complex area where taxes and law intersect. To take advantage of this developing situation, there’s a window to structure your business and protect your hard-earned revenue—but it requires deliberate, expert planning. Contact the Frost Law legal team today at (410) 497-5947 or schedule a consultation to evaluate your current business framework and navigate these developing federal tax changes.
IRC § 1402(a)(13) provides that “there shall be excluded the distributive share of any item of income or loss of a limited partner, as such.” The interpretation of those two words “as such” may be instrumental in determining whether a standard LLC or general partnership structure is causing business owners to overpay the IRS by tens or hundreds of thousands of dollars annually in unnecessary SECA taxes. Importantly, this SECA liability exclusion under IRC § 1402(a)(13) does not apply to guaranteed payments described in IRC § 707(c), to the extent the payments constitute compensation for such services.
For years, the IRS has relied upon the “functional analysis” test, arguing that if you actively work in your business, your pass-through profits are automatically subject to self-employment tax.2 However, a series of ongoing federal court battles including Sirius Solutions, L.L.L.P. v. Commissioner in the Fifth Circuit are challenging the government’s theory, while similar disputes emerge in other circuits. That’s shifting the landscape of small-business tax planning.
The current legal battle lines are drawn between two opposing interpretations under IRC §1402(a)(13):
There’s also interaction between state and federal laws. While federal law ultimately determines how entities are taxed, it relies heavily on state law to define the legal interests and liability shields created by a limited partnership.
Despite aggressive auditing campaigns by the government, the final outcome of this litigation remains uncertain. Key cases including Soroban, Denham Capital Management LP, and Sirius Solutions L.L.L.P. are moving through various stages of federal litigation.
Because of the Golsen Rule, the Tax Court can reach different outcomes for otherwise similar taxpayers depending on which federal appellate circuit court would hear an appeal in the case. This ongoing conflict means we might see a significant variance in rulings in various circuits until Congress or the Supreme Court ultimately weighs in to resolve the dispute.3
While the courts iron out the final rules, business owners cannot simply change a line on their tax return without the correct legal architecture to withstand IRS scrutiny or an audit. Here are some tips:
For active business owners, pass-through profits are heavily exposed to self-employment taxes combining a capped 12.4% Social Security allocation and an uncapped Medicare tax. For an active partner drawing $500,000 in taxable income from a partnership, successfully qualifying for the limited partner exemption eliminates this self-employment tax burden entirely, translating to an annual tax savings of over $38,000.5
For the past two decades, the Limited Liability Company (LLC) has been the undisputed king of small business structures. However, this litigation may spark major structural changes.
Historically, the state-law Limited Partnership (LP) and Limited Liability Limited Partnership (LLLP) frameworks were heavily utilized by per-project, finite-horizon industries like oil and gas exploration, film production, and music management. Because the Sirius Solutions victory was won specifically on the definition of a state-law "limited partner" standard, LLC and LLP members cannot directly rely on it.
To safely capture these tax savings, businesses within the proper jurisdiction may need to look backward to move forward. That means deliberately transitioning their modern LLC frameworks back into meticulously drafted Limited Partnerships.
Although Sirius Solutions is a victory for taxpayers, the IRS is not giving up without a fight.
Because the government has petitioned for a rehearing before the full Fifth Circuit, this decision does not represent a final victory. Assuming Sirius Solutions is ultimately decided in favor of the taxpayer, the decision will be binding in the Fifth Circuit and accordingly would apply to taxpayers whose cases would be appealable to the Fifth Circuit Court of Appeals, which includes Texas, Louisiana, and Mississippi.6 Similar high-stakes cases are currently pending in the First and Second Circuit courts covering taxpayers in Maine, Massachusetts, New Hampshire, Rhode Island and the Commonwealth of Puerto Rico in the First Circuit and Connecticut, New York, and Vermont in the Second.
This potential regional split creates a critical timeline for business owners to take action:
Protective Refund Claims: If you are a partner within the Fifth Circuit’s jurisdiction who previously paid self-employment taxes on your pass-through distributions because of the IRS's generic “passive investor” interpretation, the clock is ticking. You may have a limited window to file amended tax returns and claim substantial refunds for open tax years.
With so much money at stake, a generic, off-the-shelf partnership agreement could be a major liability. To fully secure the Sirius Solutions exemption, your legal architecture must properly separate your compensation for services from your return on your ownership interest.
The prudent strategy requires a meticulous “belt-and-suspenders” drafting approach. Your partnership must pay a reasonable, market-rate guaranteed payment for any actual services you render to the business. That portion will correctly be subject to self-employment tax. However, the remainder of the business’s profits must be cleanly structured as distributive shares tied directly to your state-based “limited partner” status.
Once the window to restructure your business for the current tax year closes, the opportunity for those savings could be gone (or limited to a subsequent refund claim).
If you are currently operating as an LLC, a general partnership, or an active member of an investment fund, a prompt legal review of your entity structure is essential. Moving deliberately to transition into a state-law limited partnership, such as an LLLP, could make a substantial difference in what you owe the government versus what you keep in your pocket, depending on how the courts in your jurisdiction ultimately resolve this issue.
Contact our legal team today at (410) 497-5947 or schedule a consultation to evaluate your business structure and protect your hard-earned revenue from unnecessary taxation.
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