By: Ralph Levy, Jr.
In a recent Chief Counsel Advice (CCA 201640014, issued 9/30/2016), the Office of Chief Counsel (“OCC”) of the Internal Revenue Service found that all of a franchisee’s share of earnings from a partnership that operating several restaurants is subject to self-employment taxes when the franchisee, an individual, served as the manager, President and CEO of the partnership. In reaching this conclusion, the OCC overruled the argument of the franchisee that the income derived from the partnership should be divided into two components, one that represented an investment return on contributed capital (exempt from self-employment tax) and another as compensation for services rendered by the individual to the partnership (subject to self-employment tax).
By asserting the argument that the franchisee’s income from the partnership should be “split” into two streams (one subject to self-employment tax and another not subject to self-employment tax), the individual tried to distinguish the activities of the restaurant partnership from Renkemeyer, Campbell & Weaver, LLP, a 2011 Tax Court case in which the Tax Court determined that even though the attorneys who provided legal services for a law firm that was operated as a partnership were limited partners of the law firm partnership, their income from the partnership was subject to self-employment tax.
The CCA found that for the same reasons adopted in the Renkemeyer case, all of the individual franchisee’s income from the restaurant partnership was subject to self-employment income and not just the guaranteed payments made by the partnership to the individual who was the principal owner of the partnership.
Despite the franchisee’s delegation of a portion of the services required by the partnership to operate the franchised restaurants to an executive management team, the individual’s entire distributive share of the partnership income should be treated as compensation for services rendered by the individual as president, chief executive officer and manager of the partnership. As a result, the income paid to the individual was not exempt from self-employment income tax under IRC §1402(a)(13) (exemption of limited partner’s distributive share of income).
The main lesson to be learned from the CCA is that with proper planning, a portion of the franchisee’s income could have been structured so as to be exempt from self-employment taxes. For example, in the CCA, the franchisee had acquired the restaurants from a third party owner and then contributed the assets to the partnership. If the purchase transaction had been structured as a direct purchase by the partnership using a combination of funds contributed by the franchisee as paid-in capital and a loan by the franchisee to the partnership, the interest and principal payments on the partnership loan would not be subject to self-employment income taxes.
For more information, please contact Ralph Levy in the Nashville, Tennessee office at 615-620-1733.