Limited Liability Companies and Self Employment Tax

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:

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.