Partnership Retirement Payments Satisfy SE Tax Exemption

XYZ is a professional limited liability partnership engaged in the practice of law. It is classified as a partnership for Federal income tax purposes and the members (partners) are treated as partners for Federal income tax purposes. The partners and partnership are calendar-year taxpayers.

XYZ maintains an unfunded retirement benefit program (retirement program) for partners that provides payments directly from XYZ to retired partners. The retirement program is set forth in the partnership agreement governing XYZs operations.

Under the retirement program, a partner may elect to retire any time after reaching age 60. If a partner retires before 60, benefits generally commence in the year the retired partner attains age 60. For a partner with 25 years of service, the earliest time benefits would commence is the year the partner attains age 55.

For purposes of the retirement program, XYZ partners are divided into two classes, general partners and special partners. Each retiring general partner is entitled to 150% of the partners highest annual calendar-year compensation during the final four years of service; each retiring special partner is entitled to 100% of the partners average annual calendar-year compensation during the final five calendar years. Payments are reduced if a partner does not reach a certain minimum number of years of service.

For a general partner, the payment commencement year is the later of the second calendar year following the calendar year in which his or her retirement date occurs, or the calendar year in which he or she attains age 60 (age 55 for 25 or more years of service). For a special partner, the payment commencement year is the later of the calendar year following the calendar year in which the special partners retirement date occurs, or the calendar year in which he or she attains age 60 (age 55, for partners with 25 years or more of service).

A retired partner receives all compensation due for the year he or she retires by March 15 of the following calendar year. The initial retirement payments are paid in five annual installments. After this series of annual payments is completed, and provided the retired partner is still living, he or she is entitled to $100 per month for the rest of his or her life.

In general, a partner will not render any services to XYZ following retirement. However, in rare cases a retired partner will enter into an of counsel relationship, under which he or she performs occasional services for compensation. In some cases, retiring partners may elect to continue to have an interest in the partnerships investment program after retirement.

Law

Sec. 1401 imposes a tax on the self-employment (SE) income of every individual. Sec. 1402(b) deines SE income as the net earnings from SE derived by the individual, subject to certain conditions and limits. Under Sec. 1402(a), net earnings from SE do not include retirement payments to a partner if Sec. 1402(a)(10) is met. Sec. 1402(a)(10) and Regs. Sec. 1.1402(a)-17 provide that such retirement payments are excluded from net earnings from SE if:

(1) the payments are made on a periodic basis by a partnership pursuant to a written plan that provides for payments on account of retirement to partners generally or to a class or classes of partners to continue at least until the partners death (to qualify as payments on account of retirement, the payments must constitute bona fide retirement income; generally, retirement benefits are measured by, and based on, such factors as years of service and compensation received);

(2) the retired partner to whom the payments are made rendered no service with respect to any trade or business carried on by the partnership (or its successors) during the taxable year of the partnership (or its successors), which ends within or with the taxable year of the partner and in which the payment was received;

(3) no obligation exists (as of the close of the partnership year referred to in (2) above) from the other partners to the retired partner except with respect to retirement payments under the plan or rights such as benefits payable on account of sickness, accident, hospitalization, medical expenses, or death; and

(4) the retired partners share of the capital of the partnership has been paid to him in full before the close of the partnerships taxable year referred to in (2) above.

On the basis of the facts presented, XYZs retirement program is a bona fide retirement plan within the meaning of Sec. 1402(a)(10). It provides for payment to each retiring partner on the basis of the partners age, physical condition and years of service, or a combination of age, physical condition and years of service. Although the payments are likely to be reduced after the initial annual payments, once the annual payments conclude, monthly payments that never fall below $100 per month will continue until the retired partners death.

Additionally, except for payments made to a partner providing services as of counsel and a partner electing to continue participation in the other investment arrangements, the payments to retired partners meet the conditions for exclusion under Regs. Sec. 1.1402(a)-17(c)(i) and (ii). The retired partner will withdraw his entire capital account by the end of the XYZ tax year in which the payments commence; XYZ will distribute the entire value of the retired partners interest in XYZs investment program by the end of the tax year. Thus, neither XYZ nor the other partners will have any obligations to the retired partner other than the retirement payments under the retirement program.

Thus, the retirement payments will be excluded from SE net earnings by Sec. 1402(a)(10), if (1) the retired partner renders no service during XYZs tax year that ends within or with the partners tax year in which the payment is received, (2) at the close of XYZs tax year, no obligation exists from the partners to the retired partner, except for retirement payments or rights such as benefits payable on account of sickness, accident, hospitalization, medical expenses or death; and (3) at the close of that tax year, the retired partners share of XYZs capital has been paid to him or her in full.

However, in any year in which a retired partner renders service to XYZ as of counsel and/or continues to participate in XYZs investment program, he or she will not satisfy Regs. Sec. 1.1402(a)-17(c), and all payments received during XYZs year ending within or with the retired partners tax year are not excludible SE net earnings under Sec. 1402(a)(10).

IRS Letter Ruling 200403056 (1/16/04)