Navigating Self-Employment Taxes: S Corporations vs. Partnerships

Self-employment taxes are substantial, and most people want to minimize them. Self-employed taxpayers often avoid self-employment taxes by operating as an S corporation.

The distributions from the S corporation are not subject to self-employment tax. But Social Security and Medicare tax must be paid on the shareholders’ employee compensation (which must be reasonable based on the services they provide). S corporations are also subject to various legal restrictions that can be inconvenient.

Exploring Partnerships as an Alternative

When considering partnerships as an alternative, general partnerships fall short since general partners must pay self-employment taxes on their distributive share of the ordinary income from the partnership’s business. But what about limited partnerships?

Limited partnerships have two types of partners:

1. General partners - who are personally liable for partnership debts and manage the business.

2. Limited partners - whose liability is limited to their contributions and who do not manage the business.

Tax law provides that limited partners do not have to pay self-employment tax on their distributive share of partnership income. Moreover, in about half the states, laws have been revised to allow limited partners to work for the partnership without losing their limited liability. This raises the question: Can limited partners in these states work for the partnership and avoid paying self-employment tax on their share of the income?

The Impact of the Soroban Case

High-earning limited partners, such as hedge fund managers, could save substantial amounts in taxes if this were the case. Unfortunately, a recent U.S. Tax Court decision in the Soroban case provides a clear answer: no. The court ruled that the limited partner exception to self-employment taxes applies only to passive investors, not to those actively involved in the partnership’s business.

Soroban is part of a series of cases where the IRS has prevailed in matters involving self-employment taxes for partnership-like entities. Other cases involved active participants in state limited liability partnerships, limited liability companies taxed as partnerships, and professional limited liability companies. The consistent ruling is that only passive investors in these entities can avoid self-employment tax.

Looking Ahead: Increased IRS Scrutiny

Encouraged by these victories, the IRS is drafting regulations that require a functional analysis to determine if someone is a limited partner. We can also expect an increase in self-employment tax audits of limited partnerships.

Conclusion

While operating as an S corporation remains a viable strategy for minimizing self-employment taxes, it is essential to navigate the associated legal restrictions carefully. For those considering limited partnerships, the recent legal precedents underscore the importance of distinguishing between passive investors and active participants. As the IRS ramps up its scrutiny, staying informed and compliant with tax laws will be crucial for self-employed individuals seeking to optimize their tax strategies.

If you have any questions or need further guidance on this topic, please reach out for personalized advice tailored to your specific situation.