The Fifth Circuit Court of Appeals has taken a hard look at how the Tax Court has construed how the Tax Code defines “Limited Partner” under 26 USC Section 1402(a)(13), and rejects this notion that the term refers only to passive investors in a limited partnership. In the case,a limited liability limited partnership formed under Delaware law was operating out of Texas as a business-consulting firm with additional offices in London, England. The general partner was Sirius Solutions GP, LLC, also formed under Delaware law. The tax returns at issue in the dispute were the Form 1065 returns from 2014, 2015, and 2016. In the 2014 year, the LLLP was owned by 9 limited partners and the GP LLC entity held a .6457% interest. 4 limited partners then sold their interests in 2014, meaning that there were only 5 partners in 2015 and 2016, along side the GP LLC entity, such that during those second 2 years, the GP LLC entity held a .7529% interest in the LLLP. When the LLLP had ordinary business income of $5.8M in 2014, $7.2M in 2015 and -$490K in 2016, and then allocated ALL of that income to its limited partners, and yet excluded the distributive shares of income from the calculation of net earnings from self-employment (-0-), the IRS said not so fast, and redetermined ALL of the income as net earnings from self-employment. The LLLP took the adjustment to Tax Court, seeking “readjustment” under the old TEFRA rules. The Tax Court agreed with the IRS, viewing the “limited partner exception” under IRC Section 1402(a)(13) as only applying to “passive investors.” This was viewed by the 5th Circuit as simply wrong and they literally say so in the decision. In other words, it refers to someone with limited liability. Of course, the court is careful to say that it is only as to “limited partners” in a state law limited partnership that is afforded limited liability.
The dissenting opinion noted that a “functions and roles analysis” is important, and noted that it has been applied in a number of Tax Court cases such as Renkemeyer, Hardy, and Denham Capital. The individual “limited partners” were viewed as engaged in all aspects of the operating business, and agreed to covenant not to competes, devoting large amounts of time and performing services.
