Limited Liability Companies and Self Employment Tax

Limited Liability Companies and Self Employment Tax

By: Martin M. Shenkman, CPA, MBA, JD

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? If so, you will 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 comes down to this: is your distribution self employment income or ordinary distribution? The law is unclear, thus, planning can minimize tax, the risk and cost of an IRS audit, and potentially save significant sums.

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 does not work because LLCs and LPs are different creatures altogether.

For 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 self employment taxes, the answer is simple: general partners are subject to self employment tax on their distributions and limited partners are not (because they are, by law, prohibited from participating. IRC Sec. 1402(a)). The IRS would like to make this analogy to an LLC. If the LLC is a manager-managed LLC (i.e., 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 do not, distributions to managers (they can be owners/members too) are subject to self employment taxation. Distributions to members are not subject to self employment tax. Simple. But, most LLCs are not a plain vanilla comparable to an LP so the IRS analogy will not work.

Consider these examples:

  • Members of an LLC can participate in management; there is no prohibition (unless you put one in the legal documents).
  • Some members can participate, others may not.
  • You can have different classes of members with widely different rights.
  • You can have different types of managers, some actively participating, some only occasionally. A common scenario is with LLCs that want to have officers and directors. Easy to do: the first class of managers is directors, and a second class of managers is 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 you take to differentiate your situation from the "typical" general partner in an LP, the better your argument that you do not have to pay self employment taxes is.

Proposed Regulations:

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 Internal Revenue Service has acted since.So 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 are a member of a service LLC (an LLC in the fields of health, law, engineering, architecture, accounting, actuarial science or consulting) all of your distributions will likely be subject to self employment tax. Reg. Sec. 1.1402(a)-(2)(h)(6). If you are devoting your time and efforts to the LLC, then you are acting as a type of manager and are therefore required to pay the tax.
  • 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 are 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 the income. Liability for debts may refer to liability created under the operating agreement. The concept behind this is that if you are 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 self employment taxes, then under this reasoning, you are too.
  • Approach 4: If you participate in the LLC business for more than 500 hours per year all your distributions will be subject to self employment 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 and prove that not all of the money collected was really payment.
  • Approach 5: If you have authority to contract on behalf of the LLC under state law all your distributions are subject to self employment tax. Here, the government is equating the power to contract with managerial services. Perhaps your operating agreement should expressly preclude you from being able to contract.

Quick Summary:

Here's a quick summary of what we have written so far, to see if you are required to pay self-employment tax when part of an LLC. 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 self employment tax.

  • Approach 6: 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. Since a member would not take hardest hit if something were to happen to the LLC consequently she should not be liable to pay the tax, ever.
  • Approach 7: Managers are usually analogous to general partners, but merely because you are a manager should not necessarily determine that all compensation is subject to self employment tax. Moreover, your LLC operating agreement (analogous to a shareholders' agreement) can restrict your endeavors to provide an argument to limit self employment tax.
  • Approach 8: Distributions subject to self employment 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 all LP distributions as being subject to self employment tax regardless of services. Earnings from a partnership that owned oil and gas leases, and managed by an agent, were characterized as earnings from self employment for a partner in spite of his modest involvement. Rev. Rul. 58-166, 1958-1 CB 324.
  • Approach 9: Some professionals advocate using a compensation figure pegged to the Social Security wage base. This is completely arbitrary and may merely serve to highlight the lack of support for the position taken. If you have no real reason to have an exemption for paying the tax, then pay it. Join your friend in the front seat on the roller coaster.
  • Approach 10: Make a return on capital argument; Demonstrate that a portion of your distribution is a return on capital invested (e.g. value of equipment) and not compensation subject to employment taxes. There is no reason that you should be forced to pay employment taxes on money that is just being paid back to you.
  • Approach 11: 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 unaccounted portion.

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