Incorporator The Journal of U.S. Formation
Start Free Quiz
Editorial 10 MIN READ

LLPs and LLLPs, 20 months later: the form the tax law turned against

Section 199A kicked most LLP-adopting professions out of the pass-through deduction, the BBA audit regime is live, and Renkemeyer still controls the self-employment question

The Editors
Staff, Incorporator.org
10 min read Updated
Contents 6 sections
  1. What §199A did to the LLP's user base
  2. What the election still buys, and what it now costs
  3. The BBA audit regime is live
  4. Renkemeyer is still the authority that matters
  5. The net position for a partnership considering an LLP election in late 2018
  6. Sources

he LLP has been the default wrapper for American law and accounting firms for a quarter century. In the 11 months since the Tax Cuts and Jobs Act was signed, the federal code has done more to that wrapper than any state legislature has in a decade, and none of it is good for the firms that use it.

This is an update to our March 2017 LLP and LLLP piece. The formation mechanics have not moved. The tax environment has.

What §199A did to the LLP's user base

Section 199A, enacted in December 2017 and codified at IRC § 199A, gives most non-corporate owners of qualified trades or businesses a deduction of up to 20% of qualified business income. It is the headline reason pass-through owners tolerated the rest of the TCJA. It is also, by design, unavailable above specified income thresholds to owners of a specified service trade or business.

Section 199A(d)(2) defines SSTB by reference to §1202(e)(3)(A) and adds one category of its own. The enumerated fields are health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, any trade or business where the principal asset is the reputation or skill of one or more employees or owners, and (per the §199A-specific add) investing and investment management, trading, or dealing in securities, partnership interests, or commodities.

Read that list against the population of LLPs. The partial-shield statute enacted in Texas in 1991 was written for law and accounting firms. The full-shield version the Uniform Law Commissioners added to RUPA in 1996 spread through the mid-1990s on the same constituency. Today, a majority of registered LLPs in every large state are law firms, accounting firms, consulting firms, or investment-management partnerships. Every one of those fields is an SSTB.

The operational consequence: above the §199A(e) thresholds ($157,500 taxable income for single filers and $315,000 for joint filers, indexed for 2018), the §199A deduction phases out over a $50,000 single / $100,000 joint band and then disappears entirely for SSTB owners. A senior partner in a New York or DC LLP almost always clears the joint threshold by a comfortable margin on their K-1 alone. The §199A deduction, for that partner, is zero.

The proposed regulations that landed in August tightened the definitions rather than loosening them. Our piece on what REG-107892-18 actually says walks through the SSTB definitions at Prop. Reg. § 1.199A-5(b)(2); what matters here is that "law," "accounting," "consulting," and "investment management" each got read close to the way working practitioners would read them, with the narrow reputation-or-skill clause the only category Treasury actually took a pair of scissors to. Law firm and accounting firm partners do not have a reasonable argument that they are outside the enumerated categories.

A handful of LLP-heavy fields escape. Engineering and architecture were deliberately omitted from the §1202(e)(3)(A) cross-reference and are not SSTBs; the statute and Prop. Reg. § 1.199A-5(b)(2) both read this way, and Treasury confirmed the omission was intentional in the preamble to the proposed regs. Land surveying, though not expressly called out, fits the same pattern and is not enumerated. The five licensed professions that California funnels into the LLP under Corp. Code § 16101, architecture, public accountancy, engineering, land surveying, and law, split cleanly for §199A purposes: the accountants and lawyers are out of the deduction, the engineers, architects, and surveyors are in it.

For partnerships where some partners do SSTB work and some do not, the de minimis rule at Prop. Reg. § 1.199A-5(c)(1) lets a trade or business with 10% or less of gross receipts from SSTB activity (5% for gross receipts over $25 million) ignore the SSTB taint. That is not a rule an 80-lawyer firm with a legal-tech product on the side will benefit from. The SSTB taint runs at the trade-or-business level, and a law firm is a law firm.

What the election still buys, and what it now costs

The §306(c) shield is unchanged. The filing mechanics are unchanged. The fee math our earlier piece laid out for Texas ($200 per general partner, annually, under Tex. Bus. Orgs. Code § 152.806) and Delaware ($200 to file the §15-1001 statement, plus a per-partner LLP tax and the $300 flat alternative-entity tax, June 1 deadline) is the same math partnerships paid in 2017. California's $800 franchise tax under Form 565 has not moved. California's § 16101 licensing restriction has not moved, and § 17701.04(b)'s bar on LLCs for licensed professionals has not moved; California lawyers and accountants are still pushed into the LLP because it is the only entity available to them.

What changed is the ratio. In 2017, a senior partner in a law or accounting LLP paid federal ordinary rates on K-1 ordinary income plus self-employment tax on the same base, with the partial SE offset from §164(f). In 2018 the top ordinary rate dropped from 39.6% to 37% under TCJA § 11001. For a senior partner at a law firm the §199A deduction is worth zero. For an identically situated engineering partner, it is worth 20% of QBI up to the §199A(b)(2) wage-and-capital cap. The same two partners, running parallel partnerships, with the same $600,000 of K-1 ordinary income, now face marginal federal rates roughly seven percentage points apart on that income.

This is the arithmetic that is going to push the marginal investment- management partnership toward a C-corp conversion analysis in 2019. A 21% corporate rate under IRC § 11 plus a qualified-dividend rate on distributions is, for some cash-generating service firms that do not distribute all earnings, a lower all-in rate than 37% ordinary with no §199A deduction. It was not a viable analysis at 35%. It is a real one at 21%. The LLP wrapper does not block the analysis; a partnership can check the box to be taxed as a corporation under Treas. Reg. § 301.7701-3(c). But the analysis exists for the first time in a generation, and it is one of the reasons a law firm considering moving its capital partners into a PC holding structure will get a better audience in 2019 than in 2016.

The BBA audit regime is live

The Bipartisan Budget Act of 2015 rewrote the partnership audit rules at IRC §§ 6221 through 6241, replacing the 1982 TEFRA regime with a centralized audit at the partnership level. The new rules apply to partnership tax years beginning after December 31, 2017. Our earlier explainer covered the mechanics in detail; the relevant point here is that for every LLP and LLLP filing a Form 1065 for 2018, BBA is the live regime.

Two operational consequences for LLPs specifically.

First, the partnership now needs a partnership representative under § 6223, replacing the TEFRA tax-matters partner. The PR has sole authority to bind the partnership in an audit, and its decisions bind every partner, current and former, without the dissent-and-notice rights TEFRA provided. Most LLP agreements drafted before 2018 designate a tax-matters partner. The agreement needs to be amended to appoint a PR and, in a multi-office firm, usually to specify that the PR's authority is subject to management-committee oversight. Firms that punt on this get a default PR assignment by the IRS under Reg. § 301.6223-1(f), which is not where counsel wants to end up.

Second, § 6226 lets the partnership elect to push any audit adjustment out to the partners who held interests in the reviewed year, rather than have the partnership pay the imputed underpayment at the top rate at the adjustment year. For an LLP with significant partner turnover, the push-out election is usually correct; the partnership-level default forces current partners to economically bear an adjustment generated by departed partners' K-1 positions, which is a bar fight waiting to happen. The election is made on Form 8988 within 45 days of the notice of final partnership adjustment. The partnership agreement should pre-authorize it. Many do not.

Eligible small partnerships can still elect out of BBA under § 6221(b), but the election is narrow: 100 or fewer partners, each of whom is an individual, a C corp, an S corp, a foreign entity that would be a C corp if domestic, or an estate of a deceased partner. A partnership with another partnership as a partner is not eligible. A service firm with a professional-corporation partner is fine; a real-estate LLLP owned through a tiering structure is usually not.

Renkemeyer is still the authority that matters

§ 1402(a)(13) carves limited partners out of self-employment tax on their distributive shares of partnership income, other than guaranteed payments for services. The question LLP partners keep asking, whether their distributive share qualifies for that carve-out, has had the same answer since 2011, and nothing since has moved it.

Renkemeyer, Campbell & Weaver, LLP v. Commissioner, 136 T.C. 137 (2011), held that three Kansas LLP partners who performed substantially all the services of the law firm were not "limited partners" within § 1402(a)(13) and owed SE tax on their full distributive shares. The court read the statutory term functionally: Congress used "limited partner" to describe a partner whose role was that of an investor, passive and capped by a capital commitment, not whoever a state-law statute happened to label "limited." The LLP label did not insulate the partners from SE tax because their role in the firm did not fit the functional definition.

In the seven years since, the IRS has litigated the issue consistently on that authority. There has been no contrary Tax Court decision, no circuit split worth the name, and no regulatory project that has reached proposed regs; the proposed regulations Treasury issued in 1997 under § 1.1402(a)-2 were never finalized. The agency's position, stated in CCA 201436049 and restated in several later field advice memoranda, is that a service partner's distributive share is SE income, period. The practical result for an LLP service partner: pay SE tax on the full distributive share, take the above-the-line deduction for half of SE tax under § 164(f), and move on. For LLLP general partners, the analysis is easier; the § 306(c) shield plus the general-partner role means the position on SE income has always been clear.

The live question, which Renkemeyer did not fully answer, is how to treat a partner who holds both a capital interest and a service role, particularly in an LLLP or in a Delaware LLC classified as a partnership where state law distinguishes "limited" and "general" partners. The majority approach in the commentary is to bifurcate: a return on capital reasonably allocable to the partner's capital contribution can qualify under § 1402(a)(13), the service component cannot. The IRS has not endorsed a bifurcation method in guidance, and the tax bar should not expect one. Until a court issues a contrary holding, assume service-partner income is SE income.

The net position for a partnership considering an LLP election in late 2018

If the firm is engineering, architecture, land surveying, or another non-enumerated profession, the LLP analysis is close to the 2017 analysis our earlier piece described, with the §199A deduction materially improving the after-tax position of the partners. File the election, amend the partnership agreement to designate a BBA partnership representative, pre-authorize the § 6226 push-out, and calendar the June 1 Delaware or annual Texas renewal.

If the firm is law, accounting, consulting, or investment management, the § 306(c) shield is still worth having and the LLP is still the right default wrapper; above the income threshold the §199A deduction is not available, and the 2019 tax modeling will include a C-corp conversion line item that did not exist two years ago. Do the BBA paperwork either way. Whether to actually convert is an advice conversation that should be had with real numbers, not a rule of thumb.

And if the entity is a California partnership whose partners are not all licensed in the five § 16101 professions, the LLP is still closed and the LLC is still closed, and the client still needs a different conversation than the one about entity choice.

Sources

Keep reading

More from the journal.