LLC Members are Not Exempt from Self-Employment Tax
by Jack S. Johal
Limited partners and limited liability members often assume that they can escape self-employment tax, but the Internal Revenue Service ("IRS") may disagree.
The Past is Murky
Self-employment tax applies not only to income from a business that an individual takes as compensation, but it can also apply to an individual's partnership income. When an individual is a partner in a partnership, his or her share of partnership income flows through the partnership and is taxed on his or her personal tax return. Until the 1970s, all partnership income was subject to self-employment tax, but Congress changed the law to exclude earnings of "limited partners" from self-employment tax.
Typically, there are two kinds of partners under partnership law: (i) general partners; and (ii) limited partners. General partners participate in the management of the partnership, but do not enjoy limited liability protection. Limited partners have limited liability protection, but do not generally participate in management.
Congress stated that it wanted to exclude limited partners' earnings from self-employment tax, because those earnings are basically of an investment nature and not from providing services. But with the emergence of the limited liability company ("LLC"), which is taxed as a partnership, but provides limited liability protection to all members, the situation became murky. Prior to the existence of the LLC, the Uniform Limited Partnership Act specified that a partner would never have both limited liability and the ability to participate in the business; participating in the business would cause a limited partner to lose his or her limited liability protection. Yet, all LLC members enjoy both limited liability and the ability to participate in the management of the business.
Can an LLC member be a "limited partner" who does not pay self-employment tax on his distributive share if his interest is in the nature of an investment? The answer is commonly "yes," but there is very little guidance on this issue. The Internal Revenue Code ("IRC") does not define "limited partner," so the IRS and taxpayers have argued about this term for years.
In 1997, the IRS issued proposed regulations that would have offered some clarification. These proposed regulations specified that an LLC member's partnership income would not be subject to self-employment tax, unless the member had: (i) personal liability for LLC debts; (ii) authority to contract for the LLC; or (iii) participated in the LLC's business for more than 500 hours per year. For various political reasons, these proposed regulations were never finalized and practitioners tend not to rely on them.
This same issue has been brought before the courts on several occasions. In one case, the tax court ruled that the partners in a law firm that was organized as a limited liability partnership (similar to an LLC except it is for professional services firms) were all subject to self-employment tax on their earnings because they were actively performing services, rather than making investments. The issue remains open and is a continual source of confusion.
New Guidance from the IRS
The recently issued IRS legal memorandum 201436049 from the Office of Chief Counsel ("Memo") has received a great deal of attention due to the scant authority in this area. In the Memo, the IRS concludes that LLC Members who actively provide services to their business are subject to self-employment tax. What is an IRS legal memorandum? An IRS legal memorandum is internal legal advice issued by the IRS Chief Counsel's Office to IRS agents and employees who have questions of law during an audit.
This Memo involves an LLC taxed as a partnership for federal tax purposes. The LLC was a general partner in an investment fund limited partnership, serving as its fund manager. The LLC's member activities included investment and portfolio management services, legal services, and all other management services. Pursuant to the LLC's operating agreement, the members were to receive income from the LLC based on their distributive shares. The limited partnership paid management fees to the LLC, which was treated as ordinary income. The LLC treated all of its members as limited partners and reported only the member's guaranteed payments as subject to self-employment tax. The IRS concluded that the LLC members were subject to self-employment tax, because the income from the LLC was derived from its services in managing the funds of the investment fund limited partnership, and not from its investments.
This Memo reflects the IRS' current position that the distributive share of partnership income allocated to members of an LLC who provide services to their business, will be subject to self-employment tax. This position does little to address the outstanding issues regarding the proper definition of a limited partner and the appropriate status of LLC members.
On the positive side, the White House's 2015 budget proposal proposes equalizing the self-employment tax rules for all types of professional services entities, including S Corporations, limited partnerships, general partnerships, and LLCs taxed as partnerships. Members who materially participate would be subject to the self-employment tax only on their "reasonable compensation" for the services they provide to the business.
In addition, the House of Ways and Means Committee Chairman, Dave Camp, has put forth a proposal that provides a partial exemption from self-employment tax to partners in partnerships, including management companies. Mr. Camp's proposal would apply the self-employment tax to only 70% of limited partnership income for limited partners who materially participate in the business. The remaining 30% would be exempt from the tax.
The laws that affect taxes and businesses are complex and perpetually in flux, which is why it is so important for current and potential business owners to consult with competent legal experts before choosing an entity structure. This is especially true in complex situations involving multiple parties and entities.
Please contact me if you have any additional questions.
DISCLAIMER: This publication does not constitute legal advice. Readers should consult with their own legal counsel for the most current information and to obtain professional advice before acting on any of the information presented.
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