United States

Reasonable compensation rules not intended to apply to partnerships

TAX ALERT  | 

According to unofficial statements by Treasury personnel at a May 2018 American Bar Association tax section conference, the requirement that S corporations pay reasonable compensation, to shareholders who provide services to the corporation, will not apply to partners who provide similar services to their partnerships when the partner or partnership is determining whether a partner is eligible for the new 20 percent pass-through deduction. This announcement could prompt some S corporations to restructure all or a portion of their activities as LLCs or limited partnerships to maximize their eligibility for the 20 percent deduction. Limited partnerships could be particularly attractive because the rules governing self-employment tax liability are evidently more liberal for state law limited partnerships than they are for LLCs.  Moreover, the IRS has indicated that it is stepping up its enforcement activities regarding the self-employment tax liabilities of LLC members.

The 20 percent deduction for owners of certain pass-through entities is calculated based on the entity’s qualified business income, which excludes “reasonable compensation.” The legislative history, as well as prior practice, suggests that this exclusion only applies to S corporations and does not apply to partnerships or LLCs. Some observers were concerned that the IRS might use the ambiguity in the statute to extend the reasonable compensation requirement, at least for purposes of the 20 percent deduction, to partnerships and LLCs. A comment letter submitted by RSM urged the IRS and Treasury to avoid such a conclusion. Although nothing is certain until formal guidance is issued, the public statement of IRS officials at the ABA tax section conference is reassuring on this point.  

A long line of cases and IRS rulings has established the requirement that S corporation shareholders who provide substantial services to the S corporation must be paid reasonable compensation in the form of W-2 wages subject to FICA taxes.[1] The need for this rule arose from the fact that a shareholder’s share of S corporation income was not subject to self-employment taxes, unlike the income of a partner in a general partnership or a sole proprietor. The intent of the rule was to prevent S corporations, particularly those wholly owned by a single individual or a group of related parties, from paying employee-shareholders  compensation that was disguised as a share of S corporation income. 

Independently, some “limited partners” in partnerships were exempted from self-employment tax in 1977 by section 1402(a)(13), but no “reasonable compensation” requirement was imposed. Thus, there is an anomaly in the disparate treatment of S corporations, general partnerships, limited partnerships, and sole-proprietorships, for self-employment tax purposes (see our tax alert for further discussion). Moreover, in recent years, questions have arisen over the extent to which the limited partner exclusion applies to LLCs or LLPs.

Be that as it may, until the passage of the new tax law in late 2017, it was well understood that the reasonable compensation requirement which applies to S corporations did not apply to partnerships or LLCs. The unofficial Treasury statements at the ABA conference confirming this conclusion, again, is reassuring, although definitive guidance in the form of an official announcement or regulation would be welcome. 

For more information on the self-employment tax issues associated with choosing between the S corporation form, the limited partnership form, the LLC or LLP form, and the option of organizing as a sole proprietorship (including an LLC owned by a single individual) see our alert, "Passthroughs should review self-employment and NII taxes."

[1] Spicer Accounting, Inc. v. U.S., 918 F2d 90 (9th Cir. 1990); Radtke, v. U.S., 712 F. Supp. 143 (E.D. Wis. 1989); Rev. Rul. 74-44.

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