LLC Members Self Employment Tax
October 21, 2014 — Many tax professionals are changing their stance on how to treat business income allocated to LLC Members for Self Employment Tax (SET) purposes.
In general, per Internal Revenue Code Section (IRC) 1402(a), taxpayers who are allocated business income from an entity taxed as a partnership (e.g., general partnership, limited partnership, LLCs) are subject to SET on such income. However, an exception applies for income allocated to Limited Partners (IRC section 1402(a)13). This exception does not apply to payments for services to such partners as "guaranteed payments."
That being said, the treatment of LLC members has been somewhat controversial. Are they Limited Partners for purposes of these rules? The IRS has attempted to issue regulations twice, but has never finalized them. The IRS has provided very little guidance on this matter. There have been some recent court cases and a new Chief Council Advice (201436049) that address specific taxpayers’ situations.
It appears that both the courts and the IRS are looking at the type of business income as well as the taxpayers’ role (active vs investor), but not their status as a limited partner under state law. In essence, the IRS and certain courts are applying a special definition of "Limited Partner" under section 1402(a)(13), based on the intent of the law, not their status under State law.
So what do we do?
Many professionals are treating all Limited Liability Company members’ business income as exempt from SET. Some treat only business service income as subject to SET and some treat all business income as subject to SET.
I believe each situation needs to be reviewed to determine the best position to take. Whether the income is a return on investment or a result of the owner’s services is a key factor. The type of income also matters (service vs. other.) There is no specific rule here. One might want to look at the passive loss rules and apply the material participation test. This type of concept is in the proposed regulation issued by the IRS that was never finalized.
At a minimum, make sure owners who are providing services to the entity are paid a reasonable "guaranteed payment" for such service.
Some advisors recommend using S-Corporations to minimize the SET. Subject to a requirement to pay reasonable compensation, S-Corporation income is not subject to SET. However, the partnership tax rules are generally much better and more flexible compared to the S-Corporation rules. When all else is equal, I always recommend creating entities that can use the partnership tax rules.
One may consider setting up separate S-Corporations for each LLC member to hold their LLC units. This should help avoid the Self Employment Tax on the LLC income and also allow the LLC to treat its taxpayers as employees.
This issue should be part of year-end planning discussions.
There’s been lots going on lately. Our Stillwater Condo overlooking the St. Croix River has been expanded by adjoining the small one next door. What a project that was - Jan blew my budget away. Fall has arrived and the boat in Minnesota is put away for the year, but the one in Florida is all ready to go! Our Grandkid’s dancing and hockey activities are in full swing now, lots of fun spectating to look forward to there.
And of course, I’m still reading tax articles daily. Life is good!!