06 Feb LLC Income is INDEED Subject to Self Employment Tax: IRS Chief Counsel Advice 201436049
In 1997, the IRS issued proposed regulations governing when the distributive share of partnership income for Limited Liability Company (LLC) members was to be included in self-employment income. It basically advised that an LLC member would be treated as a limited partner â€” and thus the distributive share would NOT be self-employment incomeâ€“ unless the LLC member either:
- had personal liability for the debts of the LLC under state law (this would be pretty rare)
- had authority under state law to contract on behalf of the LLC, or
- participated in the trade or business of the LLC for more than 500 hours during the year.
This is significant because the treatment of an LLC memberâ€™s distributive share of income for purposes of self-employment taxation was varying and random from taxpayer to taxpayer due to different opinions and interpretations of the Internal Revenue Code as well as prevailing Court Cases.
There were up until most recently no final governing regulations setting the record straight and as a result tax payers have been all over the map reporting their income in these regards.
So what does a tax geek do that can’t seem to shake that feeling of jaded frustration after digesting the relevant Court cases? Review the legislative history ofÂ IRC Section 1402(a)(13)Â – Net Earnings from Self Employment – of COURSE!
Turns out it was not Congress’ intention to exempt partners who performed services for a partnership from self-employment income on their distributive share of profits from the partnership.Â The exclusion from self-employment income for limited partners was intended to protect partners whose interest in the partnership represented merely a passive investment. Duh!
According toÂ IRC Section 1402, self-employment income is generally gross income made by an individual from any trade or business carried on by the individual. Because of the pass-through nature of partnerships, partners are generally considered to be conducting the business of the partnership. In other words by definition self-employment income is a partnerâ€™s distributive share of income from any trade or business carried on by a partnership.
WHAT ON GOD’S GREEN EARTH DOES THIS MEAN?
Basically as a partner of a partnership generally speaking your pass through profits reported via IRS Form 1065 Schedule K1 are subject to both Income Tax AND Self Employment Tax. Â So don’t go thinking you can avoid tax obligations by forming a partnership as per recently released IRS Chief Counsel AdviceÂ CCA 201436049.
Accordingly in this CCA the distributive share of partnership income allocated to members of a management group structured as Limited Liability Company (LLC) is subject to both self-employment tax as well as income tax. Â Thank you baby Jesus for the clarification.
Interestingly enough Â however for those of you who follow my mussing regularly on the other end of the spectrum, aÂ shareholderâ€™s distributive share of the S corporationâ€™s income is not subject to self-employment income, regardless of the shareholderâ€™s level of participation or services rendered.
WHERE ON GOD’S GREEN EARTH IS THE MIDDLE GROUND?
if you are a > 2% shareholder of an S corporation you are essentially required to pay yourself â€œreasonable compensation.â€ Any amounts above this nebulous “reasonable compensation” passes through to you as a distributive share of profits free from self-employment tax. Â
This is where life turns into a Mexican soap opera of sorts.Â WHY?Â
BECAUSE SELF EMPLOYMENT TAX IS EXPENSIVE AND EVERYONE IT SEEMS WANTS TO AVOID IT LIKE A DISGRUNTLED LOVER CAUSING SOME AMAZING DRAMA. SPECIFICALLY THIS IS HOW:
12.4% goes to the Old-Age, Survivors, and Disability Insurance tax
2.9% earmarked for the Hospital Insurance of medicare tax. In addition, beginning January 1, 2013, an extra
15.3% sub total
0.9% tax is tacked on to a taxpayerâ€™s self-employment income in excess of $250,000 (if married filing jointly, $200,000 if single)
16.2 cents on your dollar!!!! Â That is a lot of $$ people!!!
In the interest of fairness one-half of the self-employment tax (not including the new 0.9% surtax) is credited back as per IRC Section 164(f)Â above the line on IRS Form 1040.
If you’ve made it this far in the post, may your God bless you. Â HERE’S THE 10 POINT TAKE AWAY.
- A partner rendering services to the partnership is not an an employee of the partnership FOR FEDERAL INCOME TAX PURPOSES.
- The proper way to record a payment to a partner for services rendered to a partnership is to pay them a â€œguaranteed paymentâ€ that unfortunately is subject to self-employment tax as perÂ IRC Section 707. Any ordinary business income of the partnership afterÂ guaranteed payments are made is divided among the partnersÂ becoming theÂ â€œdistributive shareâ€ under IRC Section 702.
- IRC Section 1402 states that all trade or business income, including a partnerâ€™s distributive share of partnership income, is included in self-employment income. Of course there are exceptions worth understanding.
- In a limited partnership, there are two types of partners under MOST state law: general partners and limited partners. General partners are free to manage and control the business; the price they pay for that control, however, is that they have unlimited legal liability. If a creditor cannot be repaid from the partnership, they can pursue the assets of the general partner.
- A limited partner has only limited legal liability which basically means that fundamentally in theory anyhow a creditor can only take that partnerâ€™s investment in the limited partnership.
- The limited partnerâ€™s personal assets then are protected. In exchange under the Revised Uniform Limited Partnership Act of 1976, the limited partner could not take part in control of the partnership.
- Because a limited partner could NOT participate in any management of the partnership, the limited partnerâ€™s involvement was essentially limited to his cash investment in the partnership. As suchÂ the limited partnerâ€™s pass through income from the partnershipÂ was considered a passive income and NOTÂ self-employment income. Guaranteed payments REMEMBER are considered self-employment income.
- Do NOT play games here the ramifications are profound.
- In an LLC, unlike a general or limited partnership, ALL of the members of the partnership have limited legal liability meaning essentially that ALL of the members of the LLC are limited partners. As opposed to limited partners, however, LLC members are permitted to some degree to participate in the management of the LLC with varying degrees of control dictated by state statute.
- By default the distributive share of an LLC members pass through income is subject to self employment tax.