The Tax Court has held that disbursements from a limited liability company, which was engaged in consulting and taxed as a partnership, to its primary owner who performed all of its services were guaranteed payments. As a result, in a separate partner-level proceeding, IRS will be able to assert that the payments are subject to self-employment tax. Seismic Support Services, LLC, Scott A. Whittington, Tax Matters Partner, TC Memo 2014-78


Background. IRS audits and related activities involving the tax treatment of partnership items and affected items generally are done at the partnership level under the "unified partnership audit procedures." (Code Sec. 6221 through Code Sec. 6234) Congress enacted the unified partnership audit and litigation procedures as part of the Tax Equity and Fiscal Responsibility Act of '82 (TEFRA, P.L. 97-248).


Under the TEFRA procedures, the tax treatment of any partnership item, and the applicability of any penalty, addition to tax, or additional amount that relates to an adjustment to a partnership item, must be determined at the partnership level. A partner's treatment of partnership items may not be changed except as provided under those procedures. (Code Sec. 6221, Reg. § 301.6221-1) Whether a payment is a guaranteed payment is such a partnership item. (Reg. § 301.6231(a)(3)-1(a)(2))


A guaranteed payment is a payment from a partnership to a partner for services or use of capital that does not represent a distribution and is determined without regard to the partnership's income. (Code Sec. 707(c)).


Facts. Scott A. Whittington was employed as a seismic design consultant. He formulated a scheme to alter his status as an employee to reduce his tax obligations. He first requested that his employer treat him as an independent contractor. His employer refused, so he resigned that position. He then decided to form an LLC through which he could provide services as a subcontractor. To that end, he organized Seismic Support Services, LLC (Seismic) under Delaware law. Scott owned 95% of Seismic, and Management Partners, LLC, owned the rest.


Seismic provided consultation services as a subcontractor during the years at issue (2007, 2008 and 2009). Scott performed all services on Seismic's behalf. Seismic received all compensation for those services. Seismic paid Scott $131,690 in 2007, $168,300 in 2008, and $142,600 in 2009 (payments). Seismic labeled the payments "distributions" on each bank draft.


Seismic filed partnership returns and reported gross income of $157,267 for 2007, $178,302 for 2008 and $166,592 for 2009. It claimed management fee deductions of $141,400, $161,800 and $150,000 for these years. Seismic did not have any employees or file employment tax returns.


IRS issued the final partnership administrative adjustment (FPAAs) determining that the payments were guaranteed payments under Code Sec. 707(c). According to the FPAAs, the payments are still fully deductible by Seismic, but by recharacterizing the payments as guaranteed payments, IRS will be able to assert, in a subsequent partner-level proceeding, that Scott is personally liable for self-employment tax. IRS disallowed the corresponding management fee deductions.


Parties' arguments. IRS contended the payments were guaranteed payments for services Scott performed. On the other hand, Scott contended that the payments were for the use of capital rather than services.


Payments were guaranteed payments. The Tax Court concluded that Seismic made payments to Scott for services that were determined without regard to Seismic's income. The Court stressed that Scott performed all services on behalf of Seismic. It also pointed out that there was no basis in the record to conclude the payments were for the use of capital. Accordingly, it held that the payments were guaranteed payments.


M&Q observation: IRS is now in a position to assert in a separate partner-level proceeding that the guaranteed payments to Scott constitute net earnings from self-employment tax under Code Sec. 1402(a) and Reg. § 1.1402(a)-1(b) and hence are subject to self-employment tax under Code Sec. 1401.


For more information regarding partnership audits or guaranteed payments, contact the tax attorneys at McLaughlin & Quinn, LLC at 401-421-5115 or visit our website at