When Is LLC Income SE Earnings?

The treatment of limited liability company (LLC) income for self-employment (SE) tax purposes is not new, but continues to generate controversy. The LLC has become the entity of choice for many businesses; LLCs are generally treated as partnerships for Federal income tax purposes, unless an election is made to be treated as an association taxable as a corporation. LLCs combine the S corporation benefits of flowthrough taxation and limited liability with partnership-type flexibility of distributions and ownership.

Overview

One of the disadvantages of operating as a partnership and/or LLC, rather than as an S corporation, involves SE tax. SE tax is the Social Security tax that a self-employed individual pays, and includes both the employer and employees portion of the tax. In 2004, the SE tax rate is 15.3%, 12.4% of which is applied against the first $87,900 of earnings. The 2.9% Medicare tax rate applies to all of the taxpayers SE income, without limit.

The SE tax applies to trade or business income of sole proprietors, independent contractors and some partners. In general, LLC members are treated as partners and are subject to SE tax. According to Sec. 1402(a), net earnings from SE include a partners distributive share of income or loss described in section 702(a)(8) from any trade or business carried on by a partnership of which he is a member. Partnership guaranteed payments are also treated as net earnings from SE, under Regs. Sec. 1402(a)-1(b).

Certain items are statutorily excluded in determining SE net earnings, including, under Sec. 1402(a),  real estate rentals, dividends and interest, certain gains and losses from property dispositions, partnership retirement benefits and limited partners distributive shares.

The exclusion of limited partners earnings applies as defined in the regulations, not under state law. The IRS issued proposed regulations in January 1997 to replace 1994 proposed regulations (Prop. Regs. Sec. 1.1402(a)-18) withdrawn partially due to disparate treatment that would have resulted for LLC members with identical rights in different states. The proposed regulations are not effective until finalized. Because there is no definitive IRS guidance, the application of the SE income tax rules has created uncertainty and flexibility for taxpayers. However, because the proposed regulations are the most definitive guidance to date, many taxpayers and tax advisers have applied their definition of a limited partner to LLC members.

Prop. Regs.

Prop. Regs. Sec. 1.1402(a)-2 addresses whether an LLC member resembles a general partner or a limited partner in a limited partnership. Under the proposed regulations, the characterization of a limited partner is not determined by state law, but instead by the relationship between the partner, the nature of the business and the partnership. Under Prop. Regs. Sec. 1.1402(a)-2(h), an individual is treated as a limited partner unless he or she:

1. Has personal liability for the debts of, or claims against, the partnership by reason of being a partner;

2. Has authority to contract on behalf of the partnership under the law of the jurisdiction in which the partnership is organized; or

3. Participates in the partnerships trade or business for more than 500 hours during the partnerships tax year.

Prop. Regs. Sec. 1.1402(a)-2(h)(5) and -(2)(h)(6)(iii) provide that if substantially all of a partnerships activities involve the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science or consulting, then all individuals who provided services as part of the trade or business will not be considered limited partners.

Under Prop. Regs. Sec. 1.1402(a)-2(h), an individual who fails the three limited partner general tests can still qualify as a limited partner, under one of two exceptions. The first applies to an individual who fails the tests solely because he or she lacks 500 hours of participation. Under the exception, an individual may be treated as a limited partner if other individuals treated as limited partners under the general rules own a substantial, continuing interest in that specific class of partnership interest and the individuals rights and obligations in such class of ownership are identical to those of the other limited partners.

The second exception applies to an individual who owns more than one class of ownership in the LLC. The individual may be treated as a limited partner with respect to a certain class of ownership if other individuals treated as limited partners under the general rules own a substantial, continuing interest in such class of ownership and the individuals rights and obligations as to that class of ownership are identical to those held by the other limited partners.

Planning

With no formal guidance, how should practitioners advise taxpayers operating as LLCs? The proposed regulations offer opportunities for structuring LLCs to minimize SE tax for members; although the regulations are not binding, they represent the most definitive guidance now available. One recommendation is a segregation of business activities into separate LLCs. If members provide less than 500 hours of service to each separate LLC and are nonmanager members, they will likely meet the limited partner tests and their income will not be subject to SE tax. Because the limited partner tests are not aggregated and are applied on an entity-by-entity basis, this structure should eliminate the SE tax for nonmanaging members.

Another recommended structure involves forming an S corporation to hold a members LLC interest, with the S corporation leasing the member (an employee of the S corporation) to the LLC. Any salary paid to the individual by the S corporation is subject to SE tax, but neither the distributive share of the LLC to the S corporation, nor the distributive share of the S corporation to the individual, is subject to SE tax. The IRS may raise reasonable compensation issues as to the salary paid from the S corporation, or may collapse the structure entirely and argue the S corporation is not truly a separate entity.

Conclusion

In general, an individual who is an active LLC member will be subject to SE tax on income received from a trade or business, including a distributive share of the LLCs income and guaranteed payments received for services rendered or use of capital. However, with guidance from the Sec. 1402 proposed regulations, an LLC can be structured to meet the limited partner exception and minimize SE tax liability.

From Shannon E. Lynch, CPA, MST, Quincy, MA