A Legal Times report notes that one proposal for making up the revenue shortfall that would accompany partial privatization of Social Security is to require limited partners, shareholders in LLC’s, and subchaper S corporations to pay employment taxes. Because of the increasing popularity of limited-liability entities this change would be felt by many law firms. While there is no rule expressly prohibiting a law firm organized as an LLP from not treating "limited partners" as general partners for the purposes of employment taxes, it should be clear to any fair-minded lawyer that compensation paid to these partners should be treated as subject to employment taxes.
This is the classic structure of a loophole: The formal rule does not expressly subject compensation of limited partners in professional service firms to employment taxes, but that treatment would be "contrary to the spirit and intent of the employment tax rules." As a matter of legal ethics, I think lawyers must advise clients, and take positions before the IRS, on the basis of "spirit and intent," not simply the form of legal rules. (Long jurisprudential argument omitted, but interested readers can find it here.) Apparently taxpayers and their lawyers think otherwise, to the tune of $6 billion in unpaid employment taxes. But the interesting thing about the article is the statement that lawyers have by and large avoided exploiting loopholes created by the rules on taxation of these entities. "Any analysis by a tax lawyer or accountant will conclude that in a professional services firm, all or virtually all compensation is subject to [employment taxes]." When applying the law to themselves, lawyers apparently adhere to its spirit and purpose, but are more willing to exploit loopholes on behalf of their clients.
The old saying goes that a lawyer who represents herself has a fool for a client. This case suggests the opposite conclusion, that lawyers take care not to subject themselves to potential liability for underreporting taxes, but are willing to let clients roll the dice. As some of the late 1990's tax shelters continue to unravel, creating huge liabilities for firms and their clients, maybe clients will start to ask lawyers what they would do if they were in the position of the taxpayer.