SE Tax on LLC Distributable Income and Guaranteed Payments

The self-employment (SE) tax rules on distributable limited liability company (LLC) trade or business income and guaranteed payments are an everyday issue in tax practice, but there is little guidance on determining the income subject to SE tax.

The SE tax rate is 15.3%, of which 12.4% is Old Age, Survivors, and Disability Insurance (OASDI), and 2.9% is Medicare tax. The OASDI portion is subject to an $87,900 limit for 2004. The Medicare tax is not subject to an income limit and, thus, is paid on all SE net earnings. One-half of the SE tax can be deducted in arriving at adjusted gross income. Another deduction is allowed through the SE tax computation itself; SE income is reduced by 7.65% before calculating the tax.

Determining SE Taxable Income

Sec. 1402(a) defines net earnings from SE to include an individuals distributive share (whether or not distributed) of income or loss from any trade or business carried on by a partnership in which he or she is a member. A partners share of partnership dividends, interest and certain gains and losses are excluded by Sec. 1402(a)(2), even though they arise from the operation of a trade or business. Nontrade or business income (e.g., real estate rentals) is also excludible, via Sec. 1402(a)(1).

Sec. 1402(a)(13) excludes from SE income a limited partners distributive share of any income or loss, other than guaranteed payments received for services actually rendered. While a general partners distributive share of trade or business income is subject to SE tax, a limited partners share is not. However, if a limited partner receives a guaranteed payment for services actually rendered to or on the partnerships behalf, such payment is SE income; see Regs. Sec. 1.1402(a)-1(b).

While LLCs are subject to the partnership taxation rules under the default provisions of the check the box regulations, LLC members are not general partners; thus, trying to classify them as such for tax purposes can be confusing. As BNA Tax Management Portfolio 725-2d, Limited Liability Companies, p. A-31, succinctly states, [u]nfortunately, little guidance exists regarding classification of LLC members as general or limited partners. Due to the failure to address the treatment of members as limited or general partners, application of the Code to LLCs produces anomalous and uncertain results.

In 1994, Treasury issued proposed regulations (Prop. Regs. Sec. 1.1402(a)-18; EE-45-94, 12/28/94) dealing with the SE taxation of LLC members. An individual owning an LLC interest would be treated as a limited partner, based on (1) the management test (i.e., he or she lacked the authority to make management decisions) and (2) the limited partnership (LP) equivalence test (i.e., if the LLC could have been formed as an LP in the same jurisdiction).

Commentators were critical of the 1994 proposed regulations; as a result, Treasury withdrew them in 1997 and issued new proposed regulations (REG-209824-96, 1/13/97), which were complicated and also drew immediate criticism. Finalization was delayed until July 1, 1998, by Section 935 of the Tax Relief Act of 1997. To date, they have not been finalized; further, no relevant cases shed light on how the SE tax rules apply to LLCs.

The 1997 proposed regulations are particularly difficult to understand: Treasury is trying to fit the LLC laws into LP rules of SE taxation. Not withstanding the lack of a bright-line set of rules, the proposed regulations do offer insight into Treasurys view of SE taxation of LLC income. The examples in the regulations specifically address LLCs. Prop. Regs. Sec. 1.1402(a)-2(i) mentions limited partners, but the examples use an LLC and its members.

Example. (i): A, B and C form an LLC under state law to engage in a business that is not a service LLC. The LLC is classified as a partnership for Federal tax purposes and allocates all its items of income, deduction and credit to A, B and C in proportion to their ownership interests. All members contribute cash for their interests. A does not perform services for the LLC. B receives a guaranteed payment of $6x for 600 hours of service rendered to the LLC. C receives a guaranteed payment of $10x for 1,000 hours of service. C is also elected as the LLCs manager and has state law power to contract on the LLCs behalf.

Example. (i) states that As distributive share is not SE income. While Bs guaranteed payment is SE income, his distributive share is not SE income, even though B worked for the LLC. Cs guaranteed payment and his distributive share are SE income.

Summary: The proposed regulations can be summarized as follows:

1. Guaranteed payments to LLC members for services actually rendered to the entity are SE income; see Prop. Regs. Sec. 1.1402(a)-2(g);

2. Members of service LLCs (e.g., law, medicine, dentistry, engineering or accounting) cannot be treated as limited partners; as such, their allocable shares of income, as well as their guaranteed payments, are subject to SE tax; see Prop. Regs. Sec. 1.1402(a)-2(h)(5) and (6)(iii).

3. Members with the authority to contract on an LLCs behalf (e.g., managers) are not treated as limited partners; their distributive shares of income or loss, as well as their guaranteed payments, are SE income; see Prop. Regs. Sec. 1.1402(a)-2(i), Example. (iv).

4. If an individual has personal liability for an LLCs debts or claims, he or she will not be treated as a limited partner and his or her entire distributive share will be SE income; see Prop. Regs. Sec. 1.1402(a)-2(h)(2)(i).

5. Members who participate in an LLCs trade or business for more than 500 hours during a tax year are not treated as limited partners; as a result, their distributive shares of income or loss are subject to SE tax; see Prop. Regs. Sec. 1.1402(a)-2(h)(2)(iii).

However, if there is only one class of interest and other members do not work 500 hours but have the same ownership interest as the member who does, then their shares of income are not SE income; see Prop. Regs. Sec. 1.1402(a)-2(h)(4). The reasoning seems to be that if a nonactive member receives the same type of distribution as an active member, then active members would not be receiving their distribution for services; as a result, they should not be penalized with SE tax. This exception does not apply to members who can contract for the LLC or who are personally liable for debts or claims against the LLC; see Prop. Regs. Sec. 1.1402(a)-2(h)(2)(i) and (ii).

6. An exception occurs when an LLC has more than one class of interest and members with more than one class receive the same distributions as members of the same class who (1) have no personal liability for the LLCs debts, (2) have no authority to contract for the LLC or (3) participate in the LLCs business for less than 500 hours during the tax year. This bifurcation seems to avoid SE tax on a members distributive share of income, if the member receives the same allocable share of income as a passive member; see Prop. Regs. Sec. 1.1402(a)-2(h)(3).

Conclusion

As was discussed, the SE tax rules for LLC distributable income and guaranteed payments are confusing; no recent cases offer clarification. As a result, SE tax treatment of LLC income is open to broad interpretation. Clearly, guaranteed payments made to LLC members for services rendered are SE income. However, in following the proposed 1997 regulations, an LLC can be structured to mitigate SE income for managing members, through the creation of a second class of member units.

From Richard L. Hawkins, CPA, and Thomas Moe, CPA, Geffen, Mesher & Co., P.C., Portland, OR