Limited liability companies (LLCs) are the most popular entity used for closely held businesses. Almost every new business is formed using an LLC instead of a corporation. An important tax issue affects most LLCs - is the money you draw out subject to self employment tax (SE tax)? If so, you'll have to pay 2.9% of the amount received as hospital insurance tax. Penalties and interest may be due if you didn't pay and should have. The $64,000 question is (but over many years with interest and penalties it could be much more!) -- is your distribution SE income or just an ordinary distribution? The law is unclear, which means planning can minimize tax, and the risk and cost of an IRS audit, and potentially save significant sums. This one will get complicated, but you can hold on to your chair (or just call your CPA!).
Source of the Problem:
The uncertainty over how to treat distributions from LLCs rests on a general tax problem that affects many tax aspects of LLCs. The IRS has generally tried to apply tax laws written for limited partnerships (LPs) to LLCs. But it just doesn't work because LLCs are different creatures. Example: In an LP there are two kinds of partners: general and limited. General partners manage the business. State law prohibits limited partners from participating in management of the LP. So for SE taxes, the answer is generally pretty simple. General partners are subject to SE tax on their distributions. Limited partners are not (because they are, by law, prohibited from participating). IRC Sec. 1402(a). So the IRS would like to make the analogy to an LLC. If the LLC is a manager managed LLC (that means you designate specific persons to manage the business), it will have managers and members (the name given to owners, analogous to shareholders in a corporation or limited partners in an LP). If managers manage and members don't distributions to managers (they can be owners/members too) are subject to SE tax. Distributions to members aren't subject to SE tax. Simple. But, most LLCs aren't the plain vanilla comparison to an LP so the IRS analogy won't work. Consider a few examples:
o Members of an LLC can participate in management, there is no prohibition (unless you put one in the legal documents).
o Some members can participate, others may not.
o You can have different classes of members with widely different rights.
o You can have different types of managers, some actively participating, some only occasionally. A common example is LLCs that want to have officers and directors (since most non-lawyers remain more comfortable with that terminology). Easy to do...One class of managers are directors, and a second class of managers are officers that report to the first class. The managers/directors may provide some services while the managers/officers may work full time.
Now try to apply the IRS analogy of LPs to LLCs...it doesn't work! But herein is the key to planning! The more steps which you can take to differentiate your situation from the "typical" general partner in an LP, the better your position that you don't have to pay SE taxes.
Proposed Regulations were issued to address the characterization of LLC distributions for self employment tax purposes in December 1994 and January 1997. These regulations, because of the controversy they created, were held in abeyance by the 1997 Tax Act. Neither Congress nor the Service has acted since. Hey, if neither the IRS nor Congress can figure it out why should you be at risk for an audit and penalties? 'Cause, that's how it is!
What Approaches Exist:
Lot's of Approaches exist, and likely your LLC will face some combination of several:
Approach 1: If a partner devotes his time to the partnership trade or business he will be deemed a self employed person rather than an employee. Rev. Rul. 69-184. This concept should generally apply to members who provide services to an LLC. Further, if you're a member of an LLC that is a service LLC all your distributions will likely be subject to SE tax. Reg. Sec. 1.1402(a)-(2)(h)(6). A service LLC is an LLC in the fields of health, law, engineering, architecture, accounting actuarial science or consulting.
Approach 2: The relationship between a member and the LLC could be that of an employer and employee. Treas. Reg. Sec. 31.3121(d)-1(a)(3); GCM 34001 and 34173. If the LLC is deemed the employer, then the LLC and the employee member could each be liable for the hospital insurance tax of 1.45% on all compensation income. IRC Sec. 3101(b)(6).
Approach 3: If you're personally liable under state law for LLC obligations then distributions to you as a member will be subject to employment taxes to the extent of your share of income. Liability for debts may refer to liability created under the operating agreement. The concept is that if you're personally liable, your position is analogous to that of a general partner in an LP who has personal liability. Since a general partner is liable for SE taxes, then under this reasoning, so should you.
Approach 4: If you participate in the LLC business for more than 500 hours per year all your distributions will be subject to SE Tax. The flaw in this is that you may in fact participate for well over 500 hours, but that does not negate the possibility that a significant, even predominant, portion of your return is really a return on capital invested in the LLC, not compensation for services. Proving a return on capital, and documenting your actual hours, may solve part of the problem.
Approach 5: If you have authority to make contracts on behalf of the LLC under state law all your distributions are subject to SE tax. Perhaps your operating agreement should expressly preclude you from being able to contract.
Approach 6: If you can be a member in a manager managed LLC, not work more than 500 hours (and document that fact), not be liable for any LLC debt, and prohibit your right to contract for the LLC in the operating agreement, there should be little issue of SE tax.
Approach 7: If you like to ride in the front seat of the front car of a roller-coaster, consider the following. There is an argument some commentators have advanced based on Private Letter Ruling 9452024 that by analogy to the passive loss limitation rules a member in an LLC should be treated as a limited partner. This means no SE tax, ever.
Approach 8: Managers are usually analogous to general partners, but merely because you are a manager should not necessarily determine that all compensation is subject to SE tax. But, your LLC operating agreement (analogous to a shareholders' agreement) can restrict your endeavors to provide an argument to limit SE tax.
Approach 9: Distributions subject to SE tax should be limited to the amount of the distributions that is reasonable compensation for the services you actually provide. Use compensation studies, industry data, etc. to corroborate this. A concern in applying this approach is that the law has characterized as all LP distributions as being subject to SE tax regardless of services. Earnings from a partnership that owned oil and gas leases, managed by an agent, were characterized as earnings from self employment for a partner in spite of the modest involvement he had. Rev. Rul. 58-166, 1958-1 CB 324.
Approach 10: Some professionals advocate using a compensation figure pegged to the Social Security wage base, this is complete arbitrary and may merely serve to highlight the lack of support for the position taken. Join your friend in the front seat on the roller coaster.
Approach 11: Return on capital arguments can be used. Demonstrate that a portion of the distribution to you is a return on capital invested (e.g. value of equipment) and not compensation subject to employment taxes.
Approach 12: Combine both a reasonable compensation analysis and a return on capital argument. If these analyses are each completed separately, parameters are established for determining the proper allocation of all income from the LLC. If there is a gap between reasonable compensation and return on capital (i.e., the separate calculations together account for a significant portion, but not all, of LLC earnings) it would appear that the only amount for the Service to dispute would be the portion unaccounted for.
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