Applying the SE Tax Rules to LLC Members

According to an IRS official and a national issue specialist in its Examination Specialization Program, until the Service issues further guidance, it will not challenge limited liability company (LLC) members on self-employment (SE) tax if the member and the LLC conform to the most recent (1997) proposed regulations (REG-209824-96). These regulations, however, need clarification now on the definition of limited partner (LP).

General Rules

Under Prop. Regs. Sec. 1.1402(a)-2(h)(5), if substantially all of a partnerships trade or business activities involve the performance of services (i.e., consulting), any individual who provides such services as part of that trade or business will be a general partner (GP) for SE tax purposes.

In a nonservice partnership, Prop. Regs. Sec. 1.1402(a)-2(h)(2) treats a partner as an LP for SE tax purposes, unless he or she:

1. Has personal liability for the partnerships debts by reason of being a partner;

2. Has the authority to contract on the partnerships behalf; or

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

Even if a member does not meet the hours test or is not personally liable for a partnerships debts, an individual serving as a manager in a member-managed LLC would be subject to SE tax. If the LLC agreement does not precisely give the managing rights to a specific individual, all members would be subject to SE tax.

Exceptions and Clarifications

In general, under Sec. 1402(a), net earnings from SE include the gross income derived from any trade or business carried on by an individual, less any allowable deductions attributable to such trade or business, plus his or her distributive share of income or loss from any trade or business carried on by a partnership of which he or she is a member.

Under Regs. Sec. 1.1402(a)-2(f), a partnership includes a syndicate, group, pool, joint venture or other unincorporated organization that carries on a trade or business, but is not a trust, estate or corporation.

For this purpose, gross income includes payments received by a partner from the partnership for services rendered to the partnership or for the use of capital by the partnership (guaranteed payments). However, Sec. 1402(a) provides a number of specific exceptions from SE earnings, such as (1) rental income or loss from real and personal property, (2) interest and dividend income, (3) gains or losses from sales or exchanges of capital assets and (4) payments received from a partnership not engaged in a trade or business within the meaning of Sec. 1402(c) and Regs. Sec. 1.1402(c)-1.

Sec. 1402(a)(13) excludes an LPs distributive share of any item of income or loss received as remuneration (other than guaranteed payments described in Sec. 707(c) for services rendered to the partnership or on its behalf). However, further clarification is needed in applying this exception to LLC members.

Legislative History

In December 1994, proposed regulations were issued, specifically addressing which LLC members were to be included in the definition of LP. Under those rules, an individual owning an LLC interest was treated as an LP if (1) he or she lacked the authority to make management decisions needed to conduct the LLCs business and (2) the LLC could have been formed as a limited partnership rather than an LLC in the same jurisdiction, and the member could have qualified as an LP in that partnership under applicable law. Because such an assessment would have been difficult to make with certainty, and because this rule could have led to inconsistent LLC-member treatment, the Service withdrew the proposed regulations.

Revised proposed regulations were issued in 1997, defining which partners were to be considered LPs for Sec. 1402(a)(13) purposes. These regulations intended to exclude from SE tax an individuals net earnings that were demonstrably returns on a capital investment in the partnership. However, if these rules are applied literally, numerous partners would be reclassified as GPs (even though they might not function as such), subjecting their investment income to SE taxes.

Because of criticism on this matter, Congress added Section 935 to the Taxpayer Relief Act of 1997, preventing the IRS from finalizing these regulations before July 1, 1998. However, to date, the Service has not finalized, withdrawn or modified them. Although the proposed regulations do not have the same judicial weight as final regulations, they represent Treasurys position on this matter.

Possible Alternatives

A taxpayer has other options in dealing with the SE tax, rather than following the proposed regulations, but these bear various risks. One alternative is to adopt the position that all the LLCs members are LPs, which would eliminate the SE tax for all of them. Unfortunately, this position has limited legal support. Letter Ruling 9452024 held that even though members were not classified as LPs per se, they could be treated as such for some Code purposes. However, for a member who participates in the daily operations of an LLCs business, this argument would be fairly weak. Further, under the Revised Uniform Limited Partnership Act, an LP who participates in a partnerships activity risks losing his or her limited liability protection and effectively reverting to GP status if he or she participates in the control of the partnership.

An LLC member could take the position that his or her portion of earnings is a return on capital invested in the LLC, which arguably matches the 1997 proposed regulations intent. A percentage could be determined by paralleling a similar investment (such as a return on small publicly traded stocks), with an adjustment for the increased risk of a nonpublicly held company. However, there is neither Code nor IRS guidance on this position; thus, if taken, it should be disclosed on the members return to avoid a penalty.

A variation would be for the LLC member to adopt a position that only reasonable compensation is subject to the SE tax. However, this would most likely be even riskier, resulting in an ever-larger exclusion. Again, this position lacks Code and IRS guidance and, so, should be properly disclosed.

Proper planning can minimize SE tax on LLC members. An LLC manager can be a 1% member, which could eliminate the tax on the remaining 99% of income. An S corporation can be the manager, which could potentially remove all members from the tax.

Conclusion

The proposed regulations represent the Treasurys position on this matter; taxpayers can rely on them until further notice.

From Sharon L. Cook, CPA, South Bend, IN