Properly Structured Retirement Payout Avoids SE Tax

At long last, a letter ruling approves a retirement payout strategy used by many personal service firms, so that the recipient avoids self-employment (SE) tax. It identified a specific set of facts under which payments to retired partners of a professional limited liability partnership met Sec. 1402(a)(10) requirements and, thus, were not subject to SE tax.

Facts

In Letter Ruling 200403056, a partner, who meets all of the firms requirements for retirement payments, would receive five annual payments, based on a written formula. After that, the partner would receive $100 per month for life. All of the partners capital would be paid out by the end of the partnerships year in which retirement payments begin. The partner would render no services to the firm during that year.

Analysis

Sec. 1402(a)(10) specifically ex-cludes payments to partners on account of retirement from the definition of net earnings from self employment, as long as the sections requirements are met. Under Sec. 1402(a)(10) and Regs. Sec. 1.1402(a)-17, all of the following criteria have to be met to exclude retirement payments from the
definition:

• The payments to the retiring partner must be made pursuant to a written plan that sets forth the terms and conditions for making retirement payments.

• The plan must provide for retirement payments to partners in general, or to a class or classes of partners.

• The payments must be made on a periodic basis and continue at least until the partners death. For this purpose, payments must be made at least annually.

• Under the plan, the payments must constitute bona fide retirement payments. Thus, plan benefits not customarily included in a pension or retirement plan (e.g., layoff or severance benefits) do not qualify. Regs. Sec. 1.1402(a)-17(b)(1) points out that retirement benefits are generally measured by, and based on, years of service. Formulas reflected in public or broad-based private pension plans would be acceptable in determining if a plan is providing retirement benefits. However, the regulation does not overtly exclude plans in which benefits are based on something other than years of service.

• The plan must establish criteria for retirement on the basis of age, physical condition, years of service or a combination of these.

Assuming a partnership makes retirement payments under a plan that meets the above requirements, three additional continuing annual criteria have to be met, for the partner to exclude the payments from SE income, under Sec. 1402(a)(10):

1. The partner receiving such payments must not render any services for a trade or business carried on by the partnership (or its successors).

2. The partnership (or any of its partners) making such payments must not have any obligations to the retired partner, except for those related to retirement payments or health-related benefits.

3. The retired partners capital must be paid out in full in a year before the year in which the retirement payments are made. In other words, the partner cannot have a continuing economic interest in the partnership from which he or she retired.

According to Regs. Sec. 1.1402(a)-17, this is an annual all-or-nothing test, measured by the firms year, not the recipients year. Thus, a fiscal-year partnership could taint payments made to a retiring partner, before and after the year closes.

Significantly, according to Letter Ruling 200403056, annual retirement payments need not be equal. Front-loading is allowed, apparently without limit, as long as continuing payments are at least $100 per month for the remainder of the retired partners life. The ruling is not clear whether payments of less than $100 per month for life would also meet the requirements.

In the ruling, the retiring partner was 60 years oldnot an unusual age for partners to retire from professional service firms. He would receive a fixed payout for five yearspresumably a relatively large amount of moneyand then receive $100 per month for life. The for life provision allows the five-year payout to avoid SE tax.

Limits: Many professional services firms usually want a retired partner to perform some services (usually to retain clients), for a period of time, ranging from a few months to a year or more. The price for such services is SE tax for the retired partner. However, this would taint the entire years retirement payments. In addition, the regulations do not require the retiring partner to be compensated for the services; any services, whether or not compensated, taint the retirement payments.

Capital payments are another major stumbling block. The larger the firm, the easier it is to pay out capital quickly. However, many small or medium-sized firms have some dominant partners whose capital account repayments, if required to be paid out in one year or so, could harm the financial health of the firm and its remaining partners. One solution would be to defer paying retirement benefits until the year after the partners capital has been paid out. An increase in the retirement benefits by an interest factor should not violate the normal retirement benefits provision.

Firms that typically pay retirement payouts for a short period (e.g., three to five years) will not likely change the payout for life, even if the back-loaded amounts are minor. Firms that pay out over 10 or more years might consider a life payout if the total additional burden is not significant. An obvious solution would be to scale back the final payment and use the funds to purchase a $100 lifetime monthly annuity for the retirement payment, which the partnership could use to fund the continuing obligation. Depending on the retiring partners age, the annuitys cost could be minor, compared to the overall payments due under a typical retirement arrangement.

Conclusion

Clearly, every retiring partner would want to avoid the SE tax, if possible. However, to do that, remaining partners might have to pay more than they would pay otherwise, or the retiring partner might have to reduce (or risk reduction of) the payments he or she would otherwise receive.

From Valerie C. Robbins, CPA, MBA, Beers & Cutler PLLC, Washington, DC