IRS Audit Alert for LLCs and Partnership | USTaxAid

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IRS Audit Alert for LLCs and Partnership

Written by Diane Kennedy, CPA on January 14, 2022

This new IRS audit has to do with multi-member LLCs that are taxed like partnerships (LLC-P) and limited partnerships (LP). Let’s look at it, starting with the typical limited partnership structure.

In the case of limited partnerships, there are general partners and limited partners. The LP structure used to be used for real estate investments. The general partner handled all of the day-to-day decision making. The limited partner just puts up the money. In that case, the limited partner is just an investor. There is no earned income because the LP doesn’t really work in the business.

The GP, on the other hand, will receive a distribution which is earned income. She’s working hard for the money. Plus, she may also receive a guaranteed payment (GP). This is a term for the compensation that a partner receives from a partnership or LP. 

For example, let’s say the general partner owns 10% of the business that makes $50,000 in a year. Normally he would get $5,000 of income. But the partners all agree that there is no business without him, so they’re going to pay him a guarantee of $30,000. That would mean a guaranteed payment of $30,000. The remaining income of $20,000 ($50,000 – $30,000) was then divided among the partners. The general partner would have a total of $23,000.

The amount that the general partner (both guaranteed payment and his share of the partnership income) received would be subject to self-employment tax.

The limited partners just had an investment, and there was no earned income involved, so it was not subject to self-employment tax.

But then, things changed.

Professional offices such as lawyers, Drs, accountants and others started using the limited partnership structure. They’d set up someone to be the manager, or maybe even use a company to fill that role, and then all limited partners (who were active partners in the professional practice) could get income without self-employment tax.

And then the LLC came along and the same principal was used. The manager from a manager-managed LLC, for example, would receive a guaranteed payment and his share of the income. That would be taxed like earned income and the manager would pay self-employment tax. Usually the manager operated through a corporation so there would be no tax. Then the rest of the owners, or members, didn’t pay self-employment tax. 

In 2017, the Tax Court ruled that a particular law office had misused the LLC structure by using that strategy. Clearly the other law members operated participated in an LLC’s operation and management. They weren’t just investors. They participated and that made earned income.

The firm has recently contested this and filed a petition in Tax Court. Meanwhile, the IRS has doubled down on their statement that if you work in a limited partnership or LLC, even if you are a limited partner and a member in a manager-managed LLC, you still pay self-employment tax.

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