When is Self-Employment Tax Required for LLC Members?
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It is common for limited liability company (LLC) members to claim that their distributive shares, after deducting compensation for services in the form of guaranteed payments, of LLC income are not subject to self-employment (SE) tax. Recently the IRS has been cracking down on these claims and has seen some success in court against LLC members who have underreported SE income.
SE Tax Policy
Self-employment income is subject to at 12.4% Social security tax (up to the wage base) and a 2.0% Medicare tax. Generally, members of a partnership (including an LLC taxed as a partnership) that conduct a trade or business are considered self-employed.
General partners pay SE tax on all business income from the partnership, whether the income is distributed or not. Limited partners are only subject to SE tax on guaranteed payments for services that they provide to the partnership. Limited partners have no management authority, and are akin to passive investors, and are taxed accordingly.
This excludes service partners, such as partners in law firms, medical practices, and architecture and engineering firms. Service partners generally may not claim limited partner status no matter their level of participation.
LLC Policy Uncertainty
Many LLC members have taken the position that they are limited partners, and should, therefore, be exempt from SE tax except on guaranteed payments for services. However, LLC members are not limited partners. While both LLC members and limited partners have limited personal liability, LLC members can actively participate in management without jeopardizing their liability protection: limited partners can’t.
In 1997 the IRS proposed regulations to differentiate between LLC members who have active roles in management or perform substantial service related to the LLC’s business and those who more closely resemble passive investors for SE tax purposes, but the proposal has not been finalized. Despite the failure to pass the 1997 regulations into law, the IRS does follow them as a matter of internal policy.
LLC members argue that the IRS’s failure to finalize the regulations supports the claim that their distributive shares should not be subject to SE tax. However, the IRS has successfully refuted this argument in court. The courts generally impose the SE tax on LLC members unless they act as limited partners and do not provide significant services to the business and lack management authority.
Review Your Situation
While the law surrounding the SE tax for LLC members remains uncertain, the recent IRS aggressiveness in collection SE taxes suggests LLC members should assess their SE taxes.
For those wishing to avoid or reduce SE taxes in the future some options might be available. For example, converting to an S corporation or limited partnership, or restructuring ownership interests can all provide means to lower SE taxes. When looking into these alternatives, it’s important to take into account financial features beyond taxes.
We can Help
We can look into your situation and discuss options. Contact us at 949-860-9902 or click here, and we will contact you.