If you have an LLC do you know how much your member’s shares are when it comes to self-employment tax?
It’s a complicated matter because the IRS code and regulations do not provide any guidance on how to treat an LLC member in that regard. However, the agency has just provided a form that details how aggressive it will be in going after self-employment taxes from certain LLC members and it’s something to be aware of. Kevin Thompson, CPA says “this is another example of a complex set of laws biting taxpayers when they try and do the right thing.”
Before anything else, it’s important to understand why this is an issue, who is subject to SE tax, and why the authority doesn’t exist.
Self-employment income is taxed at 15.3%. 12.4% goes to old-age survivors and disability insurance tax. The remaining 2.9% is designated toward hospital insurance tax. Another 0.9% has been tacked on to a taxpayer’s self-employment if their income is over $250,000 married – filing jointly, and $200,000 if single. In total, the self-employment tax burden, under the current law, can be as high as 16.2%, before considering the deduction for one-half of the self-employment tax that doesn’t include the 0.9% surtax.
What exactly is self-employment income?
It is the gross income derived by an individual from any trade or business carried on by the individual less deductions allocated to the business.
How it affects partnerships
Partners can receive income in 3 ways.
For services to the partnership – Some partners in an LLC are paid wages and receive a W-2, like an employee. Even though this is popular it’s wrong because members who are partners are not employees of the partnership.
Instead, the proper way to compensate partners is to pay them a “guaranteed payment” which is subject to self-employment tax.
The third way is when any net income the partnership generates that is not paid out as guaranteed payments is later divided among the partners, with each including his or her allocable share of the partnership’s net income (or loss) in taxable income. This is whether or not the partnership actually distributes the income to the partner. It’s known as the partner’s “distributive share.” Thompson says “I am a CPA, practicing near 40 years and my eyes rolled in my head like a slot machine when I read this. Why does this have to be so complicated?”
It gets tricky because the distributive share of partnership income of a “limited partner” – other than guaranteed payments – is not included in self-employment income.
In limited partnerships, there are two types of partners under the state law.
- General partners
- Limited partners
General partners are able to manage and control the business but have unlimited legal liability.
A creditor can only take a limited partner’s share of what they invested in the company and cannot pursue their personal assets.
A limited partner cannot take control of the partnership.
Congress has excluded the distributive share of limited partners from self-employment income. And because a limited partner can’t participate in the management of the partnership, their involvement is limited to their cash investment. It would appear that the limited partner’s distributive share was the same as earnings on a passive investment. Because of this, the Congress has decided it shouldn’t be included in self-employment income. However, if a limited partner performed services for the partnership and was paid a guaranteed payment, that payment would be included in their self-employment income. Thompson says “Congress has already ruled on this so this is pretty well defined. But, I do believe if there is a way for the IRS to squeeze one more drop of blood from this they will try.”
Limited Liability Companies (LLC’s) are different than general or limited partnerships. In an LLC, ALL the members of the partnership have limited legal liability. But unlike limited partners, LLC members are able to participate in the management of the organization to some degree. This poses a problem for tax law.
The IRS proposed regulations to govern whether the distributive share of partnership income of members of an LLC should be included in self-employment income. The LLC partner would then be treated like a limited partner and the distributive share would not be self-employment income unless the member had personal liability for the debts of the LLC under law. The problem is, the regulations were never finalized. “And this, in theory,” says Thompson “is another example of the challenges facing both sides. We realize this is a problem; Congress starts to fix it but then special interests kill it.”
The Congress went ballistic about the idea of a “hidden tax increase” and squelched it. In theory, you can exclude the distributive income of an LLC member from SE income but that doesn’t mean the IRS will not argue that you should. Several arguments have ended up in the courts.
You can read examples of these arguments and other details here.
Self-employment tax for LLC’s in summary:
The IRS says that if an LLC member provides significant services to a service LLC, then the member is not a limited partner because the income of the LLC is attributable to the services rendered by its members. It has determined that even when the LLC is not a service partnership, but instead sells a product, it doesn’t matter. If the LLC member manages the LLC, all the income attributable to the member is subject to SE tax, even if a portion of that income could reasonably be argued to represent a return of the LLC member’s capital investment to the LLC. If the LLC member is involved in the management of the LLC, the income needs to be subject to SE tax.
Contact Kevin Thompson CPA
firstname.lastname@example.org or call him @ (310) 450-4625 x102