Self-Employment Tax Considerations for LLC Members
In today’s environment, Limited Liability Companies (LLCs) are a common form of business organization. LLCs offer members limited liability protection while maintaining flow-through taxation (provided no entity election is made to treat the LLC as a corporate entity). When making an entity formation decision, one important factor to consider is the self-employment tax that could be imposed upon members. As a general rule, multi-member LLCs are taxed as partnerships, with all income and deduction items flowing through and taxed to the individual members’ income tax filings. This income is generally subject to regular income tax and could also be subject to self-employment tax, with some notable exceptions.
Limited Partners
Included within the partnership structure is the limited partner exception. Under the Internal Revenue Code, income allocated to a limited partner is excluded from self-employment taxation. Guaranteed payments for services rendered is still subject to self-employment taxes. However, the interpretation of who qualifies for this limited partner exception in the context of an LLC is the subject of great debate and numerous court cases. Under proposed regulations, the following activities by an LLC member would preclude it from being considered a limited partner for purposes of the exception:
- Having personal liability for the partnership debts;
- Having the authority to enter into contracts on behalf of the partnership; or
- Participating in the trade or business for more than 500 hours during the year.
Under the proposed regulation, a member-manager of an LLC would not qualify as a limited partner. As member-managers, certain individuals typically provide services to the company and enter into contracts on behalf of the company as part of such services, which is a violation of the second item above. Additionally, the LLC member-manager would likely fail the 500 hour test if it is actively involved in the business.
Alternative Structures
As a result of the inherent uncertainty in the application of the limited partner exception to LLC members, there are several alternative structures that an LLC should consider to strengthen its filing position and limit potential self-employment tax liability. We highlight three primary alternatives below – formation of a management company, inclusion of spouse in ownership group, and multi-class ownership.
Formation of a Management Company
Under this alternative, a separate entity would be formed, to act as the manager of the LLC. This separate entity would have the exclusive right to enter into contracts on behalf of the LLC and would manage all other LLC business. The management company would be compensated for its services via a management fee agreement with the operating LLC, paid in the form of salaries or guaranteed payments, depending on the management entity structure. The other LLC members (including those providing services via the management company) could then be considered limited partners, as they would not have the ability to enter into contracts on the LLC’s behalf and would be providing services via the newly formed management company instead. Not only would the income likely be exempt from self-employment taxes, it could also be exempt from the net investment income tax, as the indirect participation in the management company could be used to reflect material participation.
Ownership Interest via Spouse
Another alternative is to add a member’s spouse as the majority partner in the LLC. The LLC would have one member who manages the affairs of the company and receives a guaranteed payment for services rendered. This member would hold a minority interest (for instance, 5%) and his/her guaranteed payments would be subject to self-employment taxes. If the guaranteed payments constitute reasonable compensation, the 5% share of income could then be exempt from self-employment taxes under the limited partner exception. The spouse, on the other hand, would hold the remaining majority interest. As the spouse does not participate in the management of the LLC or provide any services, the spouse would be considered a limited partner and any allocated income could be exempt from self-employment taxes. This alternative is primarily a risk minimization approach, as the potential under-reporting of self-employment tax would likely be limited to the 5% owner’s pass-through income.
Establish Multiple Ownership Classes
Yet another alternative is to form an LLC with multiple ownership classes. The proposed regulations include an exception for LLCs that have certain multi-class ownership structures. For example, consider a two class structure where Class A interests are issued to all members (i.e., managing and non-managing), and Class B interests are issued only to those managing-members providing services and receiving guaranteed payments. To qualify for the limited partner exception, other non-managing Class A members must own a substantial, continuing interest (20% or more) in that class and must have identical rights and obligations relative to that class. This alternative could provide a member the opportunity to own both Class A and B interests, with only the distributive share of income from the Class B interest, plus any guaranteed payments, being subject to self-employment taxes. Often overlooked at the time of entity formation, self-employment tax is a substantial area to consider when creating and structuring an entity. While the above provides a few structuring alternatives to consider, this is not an exhaustive list of options. Consult your Marcum tax professional to explore all options available based on your unique facts and circumstances.
Often overlooked at the time of entity formation, self-employment tax is a substantial area to consider when creating and structuring an entity. While the above provides a few structuring alternatives to consider, this is not an exhaustive list of options. Consult your Marcum tax professional to explore all options available based on your unique facts and circumstances.
