* a disregard entity if it is owned by a sole member;
* a partnership if it is owned by two or more entities;
* a “S” corporation; or
* a “C” corporation.
For federal tax purposes, if an LLC has two or more members, it is taxed as a partnership unless it makes an election to be taxed as an S corp. or a C corp. Most business owners do not elect to have the LLC taxed as a C corp. There are a number of advisors that recommend that an LLC elect to be taxed as an S corp., but we will deal with that alternative in another article. Most multi-member LLC’s are taxed as a partnership under the default provision of the IRS.
One of the uncertainties in the tax consequences of multi-member LLC’s has been the issue of Self-Employment taxes. The self-employment tax actually consists of two taxes: (i) a 12.40% tax for social security (old-age, survivor and disability insurance); and (ii) a 2.9% tax for Medicare (hospital insurance).
In general, under § 1402(a) of the Internal Revenue Code (the “Code”), “net earnings from self-employment” includes the gross income derived from any trade or business carried on by a sole proprietor or partner in a partnership, less applicable deductions. In addition, any partner’s distributive share of income or loss from any trade or business carried on by a partnership is also, subject to certain exceptions, considered as net earnings from self-employment. The self-employment tax rules provide for a number of specific exceptions to the definition of includible self-employment earnings. These exceptions generally include: (i) rentals from real and personal property; (ii) interest and dividends; (iii) gains or losses from sales or exchanges of capital assets; and (iv) income or loss distributive share of limited partners.
Alright, so now we know that a limited partner’s distributive share of income or loss is excluded from self-employment net earnings (unless a limited partner’s guaranteed payments under § 707(c) of the Code in return for services are subject to the self-employment tax rules). If a partner is both a general and a limited partner, only the income and loss allocable to the general partnership interest is subject to self-employment tax.
Differences Between General Partner and Limited Partner Self-Employment Tax Treatment
The difference of whether you are treated as a general partner compared to a limited partner is significant for purposes of self-employment taxes. As stated above, if you, as a member of an LLC are treated as a limited partner, there is no self-employment tax on your share of LLC income (except for guaranteed payments). If you are considered a general partner, you must pay Self-Employment taxes on your LLC income.
Is a Member of an LLC a General Partner or a Limited Partner?
It has been difficult to determine with certainty the IRS’s position as to whether an LLC member is a general partner or a limited partner for purposes of self-employment taxes. What makes a member of an LLC a general partner for self-employment tax purposes as opposed to a limited partner? In December 1994, the IRS issued proposed regulations (the “1994 Proposed Regs”) attempting to provide guidance as to who is treated as a general partner and who is treated as a limited partner for purposes of self-employment taxes. After the 1994 Proposed Regs were published there were lot of negative comments and controversy. As a result of these negative comments, and further IRS analysis, in January 1997, the IRS withdrew the 1994 Proposed Regs and issued new proposed regulations (the “1997 Proposed Regs”).
1997 Proposed Regs
The 1997 Proposed Regs are intended to define which partners are considered limited partners for purposes of self-employment tax issues. The 1997 Proposed Regs are proposed to apply to all entities classified as a partnership for federal tax purposes (e.g. limited partnerships, LLC’s or other entities). Under the 1997 Proposed Regs, the analysis for determining who is a limited partner involves the relation-ship between the partner, the partnership, and the partnership’s business. (As used in this discussion, partner is synonymous with the term “member of an LLC.”)
Under the 1997 Proposed Regs, an individual is by default treated as a limited partner unless the individual:
* has personal liability for the debts of, or claims against, the partnership by reason of being a partner;
* has authority to contract on behalf of the partnership under the state entity statute pursuant to which the partnership is organized (such as the Utah Revised Limited Liability Company Act); or
* participates in the partnership’s trade or business for more than 500 hours during the taxable year.
Accordingly, if an LLC member is not personally liable for debts, does not have the power to bind the LLC to a contract and does not provide more than 500 hours of service per year to the LLC, the member will be taxed as limited partner and will not have self-employment tax obligations on his or her LLC income allocations. If an LLC member is personally liable for debts, does have the power to bind the LLC to a contract or does provide more than 500 hours of service per year to the LLC, the member will be taxed as a general partner and will have self-employment tax obligations on his or her LLC income allocations.
Notwithstanding the above bullet points, if substantially all of the activities of a partnership (or LLC) involve the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, or consulting, the 1997 Proposed Regs provide that any individual who provides services as part of that trade or business is not considered a limited partner.
What if a person is a General Partner and a Limited Partner?
It is possible that the entity, a partnership or an LLC, will have two classes of interests, one of which is treated as a general partnership interest and one of which is treated as a limited partner interest. If a partner or a member owns interests of both classes, then such partner or member will be able to allocate his or her income allocations between the two classes and will be required to pay self-employment taxes on the general partner portion and but will not be required to pay self-employment taxes on the limited partner portion.
Status of 1997 Proposed Regs
The 1997 Proposed Regs have never officially been adopted by the IRS but have been relied on by many tax payers. On January 25, 2010, I received an email from nationally recognized LLC taxation experts Charles R. Levun and Michael J. Cohen that read as follows:
“Earlier this month, an IRS representative stated at a DC Bar Taxation Section meeting that taxpayers can rely on the 1997 Proposed Regs (but not the 1994 Proposed Regs). Specifically, the IRS representative stated that if a transaction is structured within the “four corners” of the proposed regulations, the IRS would not challenge the reporting of the transaction for self-employment tax purposes.”
This is welcome information to provide some additional certainty in the LLC Self-Employment tax arena.
Contact A.O. “Bud” Headman at firstname.lastname@example.org for more information.
- On November 19, 2012