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.
Payments received under a written partner retirement plan are generally exempt from SE tax if the following requirements are met:
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:
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.