The Tax Court ruled that guaranteed payments were subject to self-employment tax in a case where the two partners in a Limited Liability Company were husband and wife. In this case taxpayers were husband and wife. The wife owned a 60% in the partnership and made some management decisions and allowed the use of her credit to secure loans. Her management decisions included signing documents. The partnership made 300,000 and $380,000 in 2000 and 2001 restively.
Ordinary income was reported at 12,000 and 18,000 respectively and guaranteed payments of $165,000 and $259,000 respectively as well.
The IRS’s position was that the taxpayer wife was not a passive member of the partnership as she was allowing her credit to be used and was making management decisions. The taxpayer’s position was that the wife was a passive member of the organization. The Court ruled for the IRS because of exactly the facts as professed. She was making management level decisions.
This case is important because it shows how abusing mechanisms to limit self-employment tax can backfire if used under the wrong circumstances: I.e. giving guaranteed payments when the shareholder is clearly an active member of the organization.
The applicable law states that guaranteed payments to a passive, limited partner are not self-employment tax, but are ordinary income subject to self-employment tax. We recommend that in this situation, taxpayers should analyze whether the ownership / employment arrangement are legitimate enough and whether further action should be taken to protect the interest of the partnership and the taxpayer.
By: Basi & Basi at the Center for Financial, Legal and Tax Planning for Transworld M&A Advisors