Payments made to liquidate a retired partner’s ownership interest in the partnership (other than payments for his or her share of certain partnership assets) are usually subject to the federal self-employment tax (also known as SE tax). That can amount to a large tax bite.
Fortunately, there is a taxpayer-friendly exception. When it applies, this exception can exempt partner retirement payments from SE tax. If the retirement plan is properly structured, even large payments made in the years just after a partner retires can avoid this tax.
Here’s an important distinction to remember: The payments that qualify for this exception do not come from the partnership’s or LLC’s qualified retirement plan. They involve money paid directly to retired partners under an unqualified written plan often set up by law firms that provide specifically for the payments.
A Well-Structured Plan
Payments received under a written partner retirement plan are generally exempt from SE tax if the following requirements are met:
- The plan must provide for bona fide retirement payments on a periodic basis to partners.
- The payments must continue at least until the retired partner’s death.
- The retired partner cannot render services to the partnership during the partnership tax year that ends with or within the partner’s tax year in which the payments are received.
- At the end of the partnership tax year referred to in requirement 3 above, the partnership cannot have any obligations to the retired partner except the obligation to make payments under the retirement plan or the obligation (if any) to make benefit payments on account of sickness, accident, hospitalization, medical expenses or death.
- The retired partner’s share (if any) of partnership capital must be paid to him or her in full before the end of the partnership tax year referred to in requirement 3 above.
Front-Loaded Payments
In one Private Letter Ruling, the IRS looked at a law firm’s unfunded written partner retirement plan. For purposes of the plan, partners of the firm were divided into two classes:
- General partners, who had an interest in the net earnings of the firm and were eligible for additional amounts awarded at the discretion of the firm. Each retired general partner was entitled to a receive an amount equal to 150% of his or her highest annual compensation in the last four years of service.
- Special partners, who received a guaranteed payment and were eligible for additional compensation awarded at the discretion of the Firm. Each retired special partner was entitled to 100% of his or her average annual compensation during the last five years of service.
Under the plan, after the initial five installments were paid out, the retired partner collected additional payments of only $100 per month until death. As you can see, the payments under this plan were heavily front-loaded. After the initial five installments were received, the retired partner’s maximum annual benefit was only $1,200 (12 months times $100 per month).
Nevertheless, the IRS ruled that this arrangement was a bona fide partner retirement plan that qualified for the SE tax exemption. Reasons: The plan provided for payment to each retiree on the basis of the partner’s age, physical condition and years of service; or a combination of those factors. And even though the plan’s payments were drastically reduced (to only $100 per month) after the first five annual installments, the payments continued until the retired partner’s death.
However, any money received by a retired partner during a year in which he or she provided “of counsel” services to the partnership was subject to SE tax. (IRS PLR 200403056)
Important tax planning point: If properly structured, partner retirement payments can be heavily front-loaded without losing the valuable SE tax exemption. In other words, to qualify for the exemption, retirement payments do not have to resemble fixed annuity payments.
When partners retire, there are other important tax implications for both the retiring partner and for the partnership. Careful planning is needed to achieve the best tax results.
Please contact Winnie Yang via our online contact form for more information.
Councilor, Buchanan & Mitchell (CBM) is a professional services firm delivering tax, accounting and business advisory expertise throughout the Mid-Atlantic region from offices in Bethesda, MD and Washington, DC.
