For years, based on a specific section of the Internal Revenue Code, taxpayers and practitioners have treated the phrase “limited partner” as a potential shield against self-employment tax. That issue has now become much more complicated.

Recent rulings from the Tax Court and the Fifth Circuit Court of Appeals have taken very different approaches to the question of when a limited partner’s distributive share is subject to self-employment tax. The result is uncertainty for partnerships, LLCs, and other flow-through entities — especially those with owners who provide services to the business.

Why This Issue Matters
In general, a partner’s distributive share of partnership income is included in the partner’s net earnings from self-employment. But the tax code (Section 1402(a)(13) excludes “the distributive share of any item of income or loss of a limited partner, as such,” except for guaranteed payments for services actually rendered. That exception can produce significant tax savings, because self-employment tax generally applies at a 15.3% rate up to the Social Security wage base, plus Medicare tax and possibly a Medicare surtax.

The key question is simple to ask but hard to answer: when is someone truly a “limited partner” for self-employment tax purposes?

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