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Do you think physics is hard? Test the tax liability of the self-employed

Albert Einstein was, as we all know, a brilliant theoretical physicist. His fame probably comes from his ability to look at problems in ways that others simply cannot.

Richard Feynmann won the 1965 Nobel Prize in Physics for his work on electrodynamics. His introduction to the field occurred while he was a doctoral student at Princeton in the early 1940s.

Feynmann’s first lecture at Princeton was in 1940, when he was 22 years old. Among the audience were famous physicists, including Wolfgang Pauli and Einstein himself.

Pauli challenged Feynmann during his speech. Pauli then asked Einstein what his thoughts were. Feynmann credited Einstein’s response, as well as post-lecture discussions with Pauli, with later work that won him the Nobel.

Einstein’s talent was to reason through physics. Feynmann was more the mathematician. Late in life Einstein spoke of how relativity and quantum mechanics had been taken over by mathematics.

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Tax professionals are unlikely to be confused with Einstein. Yet there are areas of tax practice that are moving from the intuitive to the concrete.

If you are self-employed (SE), you pay a 12.4% tax on the first $160,200 of your 2023 SE income. You pay an additional 2.9% on all of your SE income.

If you earn enough to pay the Medicare surcharge, you can pay another 0.9%. All of this is before your income tax liability.

You have reasons to try to avoid this tax. Partners are generally considered to be in the business of their partnership. Then this SE tax can be applied to your share of the partnership income.

If you are a limited partner, the law generally exempts you from SE tax on your share of the partnership income. This seems very clear.

What is not clear is the result if you are a member of a limited liability company (LLC). Members of the LLC can participate in the management and can bind the entity. Limited partners cannot.

But both limited partners and LLC members have limited liability. LLC members have characteristics of both limited partners and general partners.

The tax issue, then, is that LLC members get the SE tax advantage of the limited partner treatment? Nobody really knows. Hence, tax professionals have had to adopt intuitive, Einstein-like solutions.

In 2011 the IRS won a tax court case involving a Kansas law firm. The firm was organized as a limited liability company (LLP) in Kansas.

A Kansas LLP is effectively a general partnership that files a separate form with the state to obtain limited liability. The law firm filed this form.

The legal partners claimed limited partner status for the SE tax. The court disagreed. The income was earned by the efforts of the associates. The court said the limited partner’s objection cannot apply to this special status entity.

Four years later the Tax Court was faced with a factual picture involving an LLC that managed investments. The LLC was owned by two members: 99.32% by a limited partnership and 0.68% by a trust that managed the LLC.

A Mr. Sands was paid $6.5 million by the LLC on a W-2. He also reported SE income for the small income from the trust, but no SE income for the major portion from the limited partnership.

Mr. Sands was not found liable to SE tax on his limited partner’s income. This decision suggested a way to avoid the SE tax for a large portion of the LLC’s income ($18 million in this case).

There is a new case registered in the tax court which could lead tax professionals away from the old intuitive way of dealing with SE tax.

The new case involves a limited partnership (LP). The general partner (GP) manages the entity. The three limited partners are paid by the GP for the management work.

Partners reported no SE income for the large share of income from the LP. They have paid the SE tax on the fee received from the general practitioner for the services provided.

This new case is under observation because it is “purer” than LLC structures. This entity is an LP. It may therefore present less confusion about how to apply the SE tax.

The name of the case is Soroban. It could move us from Einstein’s intuitive approach to Feynmann’s concrete approach. Moving can be stressful.

Jim Hamill is the director of tax practice at Reynolds, Hix & Co. in Albuquerque. He can be reached at [email protected].

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