On January 17th, the Tax Court issued an interesting memorandum decision addressing self-employment tax liability. Hardy v. Comm’r, T.C. Memo 2017-16, 2017 Tax Ct. Memo LEXIS 17 (Jan. 17, 2016). In Hardy, a clever structure limited the self-employment tax exposure of a plastic surgeon.
Dr. Hardy operated his practice through a single-member professional limited liability company managed by his wife. Hardy, 2017 Tax Ct. Memo LEXIS 17 at **3. Some of Dr. Hardy’s surgeries were conducted at a facility known as the Missoula Bone & Joint Surgery Center (“MBJ”). Id. at **1. MBJ was a limited liability company organized by a group of physicians to own and operate a surgery center; it was treated as a partnership for federal income tax purposes. Id. at **5. In 2006, Dr. Hardy purchased a 12.5% interest in MBJ for $163,974. Id. at **6.
MBJ was professionally managed and had its own staff that did not overlap with the staff of Dr. Hardy’s practice. Id. MBJ charged patients a fee for the use of the facility, and the net earnings from those fees flowed through to the partners. Id. Dr. Hardy’s distributions from MBJ were not tied to the volume of the surgeries he performed there. Id. at **7. Dr. Hardy had no involvement in the management of MBJ. Id.
After two years of treating the income received from MBJ as nonpassive income and paying employment tax on it, the Hardys’ accountant concluded that the income from MBJ was passive income, in contrast to the income Dr. Hardy earned through his medical practice for the surgeries he performed. Consequently, the couple’s 2008 return and their subsequent returns only reflected self-employment tax associated with Dr. Hardy’s earnings from his medical practice. Id. at **9-**10. The shift in tax treatment ultimately triggered an audit.
After dealing with a fairly complex issue concerning passive activity losses, the Tax Court turned to the employment tax issue. Section 1401 of the Internal Revenue Code imposes taxes on income earned by those who are self-employed that mirror FICA. See I.R.C. § 1401(a), (b). The income subject to self-employment tax is defined as gross income from a taxpayer’s trade or business, less allowable deductions “plus his distributive share (whether or not distributed) of income or loss described in section 702(a)(8) from any trade or business carried on by a partnership of which he is a member.” I.R.C. § 1402(a). Section 1402(a) of the Code excludes certain categories of income from self-employment tax, including “the distributive share of any item of income or loss of a limited partner, as such,” so long as that distributive share does not consist of guaranteed payments made to the partner to compensate her for services rendered either to the partnership or on its behalf. I.R.C. § 1402(a)(13).
In Hardy, the IRS took the position that Dr. Hardy did not fall within the scope of the exclusion because he was performing surgery at MBJ. Id. at **29. The Tax Court disagreed, holding that Dr. Hardy’s role as a passive investor meant that the income distributed to him from MBJ was not subject to employment tax, emphasizing that Dr. Hardy was paid separately by his patients for his surgical services. Id. at **31.
Ironically, Dr. Hardy had originally contemplated building his own surgical center, but concluded that the investment in MBJ was less risky. Id. at **5. That decision saved him a significant amount of tax liability, as the earnings from a surgical center he controlled and operated would almost certainly have been treated as self-employment income. The impact was significant: The base rate for self-employment tax is 15.3%, and self-employment tax (unlike FICA) is not capped.
Efforts to plan around self-employment tax should, however, be approached with caution. The Tax Court in Hardy carefully distinguished a case involving a group of tax lawyers who were too aggressive; the law firm received revenue from the partners’ fees but did not report the income as earnings from self-employment. Id. at **29. (discussing Renkemeyer, Campbell & Weaver, LLP v. Comm’r, 136 T.C. 137 (2011)). The tax lawyers lost because their law firm derived its revenues from their work, and the work was performed in their capacities as partners in the firm, not in their capacities as investors. Id. at **30.
Another way that professionals can reduce their exposure to self-employment tax is to elect to be taxed as an S Corporation. The income of an S Corporation is not subject to self-employment tax. Rev. Ruling 59-221, 1959-1 Cum. Bull. 225. But again, caution is in order: Income paid to a shareholder who performs services through the S Corporation will be treated as wages subject to self-employment tax if his compensation is set too low. Veterinary Surgical Consultants, P.C. v. Comm’r, 117 T.C. 141 (2001), aff’d sub nom. Yeagle Dry Wall v. Comm’r, 54 Fed. Appx. 100 (2002).
So while it is good to plan, remember that greedy taxpayers rarely prevail.