Ambiguity in the tax code and regulations has led many limited liability company (LLC) members to take an aggressive position regarding self-employment (SE) tax. They claim that their distributive shares of LLC income — after deducting compensation for services in the form of guaranteed payments — aren’t subject to the tax.
Recently, however, the IRS has been cracking down on LLC members it claims have underreported SE taxes, seeking back taxes and penalties, with some success in court. Considering these developments, it’s a good idea for LLC members to review their treatment of SE tax. (For the purposes of this article, LLCs also refer to limited liability partnerships and professional limited liability companies.)
SE tax refresher
The SE tax is designed to ensure that self-employed individuals pay the Social Security and Medicare taxes (payroll taxes) that would otherwise be withheld by an employer. Generally, employer and employee each pay a 6.2% Social Security tax on wages up to a wage base ($128,400 in 2018) and a 1.45% Medicare tax on all wages. Thus, self-employment income is subject to a 12.4% Social Security tax (up to the wage base) and a 2.9% Medicare tax. The “employer half” is deductible as a business expense.
Generally, you’re considered self-employed if you conduct a trade or business as a sole proprietor or you’re a member of a partnership (including an LLC taxed as a partnership) that conducts a trade or business. General partners pay SE tax on all their business income from the partnership, whether it’s distributed or not.
Limited partners are treated differently. Under the tax code, they’re subject to SE tax on guaranteed payments for services they provide to the partnership. But they’re otherwise exempt from SE taxes on their distributive shares of partnership income. The rationale for this provision is that limited partners, who have no management authority, are more akin to passive investors than active business participants.
S corporation shareholders who perform services for the business are subject to payroll taxes on their salaries. But so long as their compensation is reasonable, they escape SE tax on their distributive shares.
The LLC conundrum
Why all the confusion about the treatment of LLCs? Internal Revenue Code Section 1402(a)(13) was added to the tax code before the advent of the LLC. (The first LLC statute was enacted in 1977.) As the LLC form caught on, many LLC members took the position that they were equivalent to limited partners and, therefore, exempt from SE tax (except on guaranteed payments for services). But there’s a big difference between limited partners and LLC members. Both enjoy limited personal liability, but, unlike limited partners, LLC members can actively participate in management without jeopardizing their liability protection.
Arguably, LLC members who are active in management or perform substantial services related to the LLC’s business are subject to SE tax, while those who more closely resemble passive investors should be treated like limited partners. Unfortunately, guidance on this subject has been scarce. The IRS issued proposed regulations in 1997, but to this day hasn’t finalized them (although it follows them as a matter of internal policy).
Under the proposed regulations, an LLC member’s distributive share is exempt from SE tax unless the member:
- Is personally liable for the LLC’s debts,
- Has authority to contract for the LLC, or
- Participates in the LLC’s business for more than 500 hours per year.
There’s a special rule, however, for “service partners” in service partnerships, such as law and accounting firms, medical practices, and architecture and engineering firms. Generally, they may not claim limited partner status regardless of their level of participation.
Some LLC members have argued that the IRS’s failure to finalize the regulations supports the claim that their distributive shares aren’t subject to SE tax. But the IRS routinely rejects this argument and, in recent years, has successfully litigated its position. The courts have imposed SE tax on LLC members unless, like traditional limited partners, they lack management authority and don’t provide significant services to the business. And some courts have ruled that mere management control, by itself, is enough to defeat limited partner status, regardless of whether that control is exercised.
Review your options
The law in this area remains uncertain, particularly with regard to capital-intensive businesses. (See “Capital matters.”) But given the IRS’s aggressiveness in collecting SE taxes from LLCs, LLC members should review their treatment of SE taxes. Those who wish to avoid or reduce these taxes may have some options, including converting to an S corporation or limited partnership, or restructuring their ownership interests. When evaluating these strategies, bear in mind that there are other issues to consider besides taxes.
The IRS has taken the position that limited liability company (LLC) members who participate in management or provide significant services are subject to self-employment (SE) tax on their distributive shares, even if a substantial portion of that income is attributable to returns on invested capital. It’s uncertain, however, how this approach would be greeted in the courts.
Proposed regulations contemplate situations in which an active LLC member can exclude amounts from self-employment income that are “demonstrably returns on capital invested in the partnership.” For example, they provide that under certain circumstances LLC members may be able to segregate SE income from investment income by holding separate management and investor classes of interests, much like general partners can also hold limited partnership interests. If you would like assistance in determining your tax situation, contact us.