Episode 34: A Deeper Look at Self-Employment Tax
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In this episode, we’ll look at what’s currently happening with self-employment tax. We welcome Craig Kuechenberg, a managing director in our Washington National Tax Office, to share his insights.
If you have any questions or need any assistance, please reach out to a professional at Forvis Mazars.
Transcript
IRIS LAWS
On this episode, we take a deeper look at what’s going on in self-employment tax. We welcome Craig Kuechenberg, a managing director in our Washington National Tax Office, to give us his insights. From your one stop for tax updates and analysis, I’m Iris and this is “Tackling Tax.”
We are lucky to have Craig Kuechenberg on the podcast today. He is our partnership tax guru here at the Washington National Tax Office, so he’s the perfect one to have to talk about everything going on right now with self-employment tax. He’s been with the firm his whole career and comes to us just down the road from me in Greenville, South Carolina. If you don’t know him personally, you’ve most definitely seen him at a Pearl Jam concert or on a golf course in Ireland.
So, with that, welcome to the pod, Craig.
CRAIG KUECHENBERG
Thank you. Iris, it’s great to be here. Thank you for the invitation.
IRIS LAWS
Of course. Well, you know, we come from similar worlds, right? We both come from partnership world. And while I would love to nerd out with you about, you know, all the nitty gritty parts of this issue, I think is probably best for the sake of our listeners to start from the thousand-foot view, let’s take it all the way back.
What exactly is self-employment tax and why, maybe, do business owners, you know, care about it so much?
CRAIG KUECHENBERG
Sure. So, maybe instead of in the partnership context, maybe just talk about if you were an employee, someone was an employee in a company, a corporation, or a partnership. And so, they’re getting a W-2, they’re not a partner in the partnership. Well, they will be subject to payroll taxes. And that’s the FICA tax, and then you have the Medicare tax component.
And so, the way that works is the FICA and the Medicare, there’s the business portion. The business pays half of it. And then the other half is deducted from the employee’s compensation that they receive. And so, the same thing applies similarly called self-employment tax for partners in partnerships, because technically partners in a partnership, if they’re direct partners in that partnership, aren’t allowed to be employees.
So, they’re not getting W-2s, but rather they’re getting what’s called guaranteed payments. So, their salary component of their interest is paid through the guaranteed payment and not through a W-2. So then, that partner will then report the guaranteed payment as income on their return and then pay taxes on it. So, the partners, the one responsible for making income tax payments on that through estimated payments rather than withholding like and W-2.
And so, in this case, since there is no payroll tax being taken out of the guaranteed payment, the partner is then responsible for paying both what would have been the businesses half and then the employee’s half. And so, essentially that’s what self-employment is. And the partner pays that on their individual income tax return directly to the IRS.
And so, the question comes then is, is are all partners required to pay this self-employment tax on their income from the partnership, or are there exceptions? And there are certain exceptions depending on the type of income, but the one that is being talked a lot about now is this limited partner exception.
IRIS LAWS
So, great transition. You know, it sounds like self-employment tax on its face really makes being a partner maybe not as advantageous, right? Because you’re having to pay both the employer and the employee portion like you talked about.
But you know, historically LLCs, limited liability companies and LLPs, limited liability partnerships, have been super attractive and people love to become partners in them. So, why is that? This limited partner exception sounds like the ultimate reason, but can you explain what that is?
CRAIG KUECHENBERG
Yeah, and so the LLCs and partnerships have become popular just because there’s a lot of flexibility on who can be a partner in the entity and then how income is allocated and profits are distributed. You can have a lot more flexibility. If you were an S-corporation, you can only have one class of unit.
And so, in an S-corp yes, an owner can get a W-2, pay the payroll tax and then their distributive share of income isn’t subject to self-employment tax like it may be for a partner, but an S-corp may not work for all scenarios where you want to have different types of ownership and you want to share things that aren’t in that, you know, one class of interest, pro-rata result.
And so, you see partnerships are very popular. But again, you can’t be an employee in a partnership if you’re a direct owner and providing services to the partnership. And so, one of the exceptions from the income allocated to you being subject to self-employment taxes is called the limited partner exception. And that’s in the statute and the Internal Revenue Code statutes and regulations.
And so, the controversy is that it’s not well defined in the statute, and thus there’s a lot of disagreement between the IRS, tax courts, and taxpayers as to who meets this limited partner exception.
IRIS LAWS
Okay. Great background. So, that’s generally, right, the benefit of a partnership overall. What about the benefit of this limited partner exception that we’ve been talking about though?
CRAIG KUECHENBERG
The benefit of the limited partner’s exception is that if a partner is allocated income on their schedule K-1 and this would—guaranteed payments are always subject to self-employment tax if they’re for services. But if their partner’s allocated just ordinary income on their K-1, if they’re considered a limited partner under this statute, then that income is not subject to self-employment tax.
And the controversy around this is that when the statute was written, it was before LLCs were very prevalent and there’s some disagreement on whether the statute’s limited partner is meant to be, are you a limited partner under the state law, or if you’re a limited partner in just how much you manage the business and your involvement in the business?
And so, the IRS and Tax Court typically says, no, that statute wasn’t intended to be if you’re a limited partner under state law, that now you’ve met this exception, you know, the IRS and Tax Court would have stated that it’s more of a functional analysis test; are you a passive investor in this business, or functionally, based on your involvement in the business, you’re an active, you’re a person in this business, you’re managing the business, that type of thing.
And in prior cases, they’ve proposed, you know, using a functional analysis test to figure out if a partner is not purely a passive investor, whereas in some of the cases, taxpayers have been saying no, the statute’s written that if I’m a limited partner in a limited partnership under state law, then I should meet this limited partner exception. It was purely meant to be under state law, are you a limited partner?
IRIS LAWS
So, what we’re really talking about now is form versus function, right? I think that’s really what we’re talking about. So it’s, you know, this whole active/passive/what are you substantively actually doing to be a part of this company versus how are you by state law? Are you, quote, “limited in your liability” based on how it’s formed? That’s what you’re saying?
CRAIG KUECHENBERG
Exactly. And the IRS issued proposed regulations previously that were never finalized and they included a functional analysis test. And part of that was a 500-hour test. And so, but those regs were never finalized and in the court cases to date, there hasn’t really been a defined functional analysis test that you can use. It’s they just, kind of, you know, put it back to the Tax Court to determine, you know, what is the level involvement in that specific case with that specific taxpayer to determine if they meet, if they’re a passive investor or not.
IRIS LAWS
And that makes sense. But you mentioned a court case, right? And I think this comes to, sort of, the crux of why we’re having this discussion today and sort of what’s been going on in the courts up to this point. The case sort of threw things into question.
Sounds like we were par for the course a little bit; LLCs, people claiming this limited partner exception. And then what case put this into the hemisphere?
CRAIG KUECHENBERG
Yeah. So, right now there’s there are several cases in the courts, but there’s three of them in the First, Second, and Fifth Circuit that are being, that were appealed up to those circuits. And the first circuit to rule was in the Sirius case. This was in January ‘26 in the Fifth Circuit. And in all of these cases, the Tax Court has said there’s a functional analysis test.
It’s not, you know, the statute isn’t saying that purely just because they’re limited partners under state law, that their limited partners under this exception. And so, in Sirius, there’s a three-judge panel in the Fifth Circuit. In January, they ruled that, you know, based on the definitions of at the time, based on how they viewed the definitions at the time in their ruling, whenever the statute was written, limited partner was intended to be a partner that had limited liability.
So, in a limited partnership, depending on that state’s rules, you know, limited partner would have liability protection from the partnership’s liabilities. And so, that’s, in the Sirius ruling, that is how they determine what a limited partner is.
IRIS LAWS
So, it’s great background on Sirius, which focuses, right, as you’re saying, on the level of control and management. But then there’s also the Soroban case, right? Can you tell me a little bit about what that one focuses on and the differences between the two?
CRAIG KUECHENBERG
Yeah. So, in the Sirius case, whether a partner was able to meet the limited partner exception was based more so on their level of control and management in the business. In the cases in front of the First and Second Circuit, the Tax Court is saying that, like Soroban, for example, is one of the cases that it’s more of a passive investor standpoint and, and how much involvement that person has in the business.
And so, kind of a good example of the differences between that, because they might sound a little similar, it’s all based on level of involvement. In the passive investor example, you might have a CFO or a controller that are partners in the partnership, and they’re certainly spending, you know, potentially 2,000-plus hours in that job. And so, from a passive standpoint, they might be considered non-passive based on their level of involvement in the business.
And so, under the Soroban case and the U.S. Tax Court’s focus on passive investor test, you know, they may not meet the limited partner exception. Now, in the Sirius case where the Fifth Circuit has said it’s based on a level of management and control of the business, well, that means that this controller who works 2,000 hours and may be considered non-passive in the passive test, well, they may not have any control or management of the business for their responsibilities.
And so, then potentially depending on how you know what the criteria is to determine the amount of level of control and management, that controller may not be considered or may be considered a limited partner because they don’t have any control or management responsibilities. And so, I think that’s a kind of a good example of the two differences right now.
IRIS LAWS
So, for our listeners who might be glazing over a little bit from all this tax talk, I think it’s important to understand what kind of entities maybe are going to be affected by this, right? So, is it how, you know, does it apply to accounting firms, right? I mean, our firm is an LLP. And how does that affect us versus how might it affect a manufacturing company, right?
Like, I know we start playing with passive, active, limited, general and it gets a little confusing based on maybe the different kinds of companies. So, what kind of entities do you see being most affected by this?
CRAIG KUECHENBERG
I mean, ultimately, it’s going to be, I mean, in service companies, certainly service partnerships like accounting firms, law firms, they certainly will be heavily impacted by this. But it can be any industry really, you know, if you’re a partner in a partnership, whether it’s a manufacturing company or a service company or wholesaler, you could potentially have your income subject to self-employment if you are managing the business or not considered a passive investor for this exception.
So, one of the key things in the Sirius case is before in the January ruling, you could look and see they were kind of applying under state law, are you a limited partner? Do you not have liability? Whereas now they’ve gone closer to what the U.S. Tax Court has said and having a functional analysis test to determine if they’re passive. They haven’t gone that far, but they have, you know, had their ruling be based on what level of activity, you know, the partner is participating in. And so, it’s going to, you know, whether you’re an LLC or a limited partnership, you’re still going to have this same test.
IRIS LAWS
So, talking about this, you know, I come from real estate a little bit and it’s quirky and I’ve, you know, I’m sure a lot of people have heard of like the material participating test or whatever for real estate. Is that kind of similar? Is that what we’re talking about?
CRAIG KUECHENBERG
It’s not the same test as like determining if you’re a material participant under those rules. In the IRS proposed regs, they did have a 500-hour test. So, that’s similar to one of the tests for material participation in the regs. But it’s not exactly the same, and again there’s been no definition yet of, you know, what is a functional analysis for this limited partner exception.
IRIS LAWS
So, we have our listeners who are, you know, owners or partners in these partnerships, LLCs, whatnot. Should they be thinking about filing amended returns at this point or, you know, filing for refund? Like, what’s the next step for realistically, for our listeners who are partners at this point, if any, right? Or are we just waiting basically?
CRAIG KUECHENBERG
I think right now it’s kind of a wait-and-see approach because, you know, we want to understand like because in the Fifth Circuit, they’ve sent it back to the U.S. Tax Court to decide under these rules of control and level of management of the business, you know, are the taxpayers in that Sirius case, are they limited partners or not?
So, until we kind of have an idea of what that test looks like, you may not want to be making significant structural changes to your organizational structure. Or it could be something, as we get more information, you can possibly just change your operating agreement and some of the terms in the operating agreement to meet the control exceptions and that sort of thing.
So, we still have the First and Second circuit to rule. And if the circuits ultimately don’t agree in their rulings, that could then bring the cases to the Supreme Court to decide. You know, we, for decades we’ve been hoping that Congress would fix the statute or clarify the statute, or the IRS would issue regs to better help taxpayers navigate this. But at this point, there doesn’t seem to be a lot of momentum for changes in in Congress at this point.
So, I think it’d be a recommendation, just kind of wait and see how these other two circuits decide. And then if we can get some more clarification on, you know, this control test or this passive investor test.
IRIS LAWS
Sure. But what you’re mentioning is like there might be some recourse for, depending on how they rule, right, to adjust things within the partnership structure itself to accommodate for this, you’re not going to all of a sudden have everyone switching to Corp’s or something like that, or is that possible?
CRAIG KUECHENBERG
I don’t know that everyone would want to switch to a corp, just because of the other, now you’ve brought other, you know, maybe negative tax consequences through double taxation or how you share in profits amongst the owners. But I would just say, you know, in January, based on the Sirius ruling that was vacated, it was more of a, they were relying moreso on the state law classification.
So, if somebody, you know, really acted quickly, converted their LLC to a limited partnership, if they’re in those states in that circuit, now they can’t rely on that anymore because that rule is vacated. And so, now they’ve moved to be a limited partnership when that’s really not going to help them at this point. So, I think kind of a wait and see approach makes some sense.
IRIS LAWS
I think that’s great advice. And I think, you know, this could be really impactful for our listeners just depending if they are partnership and if they’re, you know, their company is organized as a partnership and they are partners in it. And self-employment tax can be pretty impactful just from their tax, ultimately, that they’re paying.
So, a really good analysis. If we get this further along in the courts and hear more developments we will have you back on, Craig.
CRAIG KUECHENBERG
Well, thank you so much, Iris.
IRIS LAWS
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