In a previous post, I discussed how members of an LLC taxed as a partnership can avoid being liable for self-employment tax on the net income from the business. With the limited exception of Prop. Reg. 1.1402(a)-2, the subject of that post, clear guidance on this issue has been lacking for decades. This month, the IRS created a stir by taking on the issue anew with Chief Counsel Advice memorandum 201436049. Tony Nitti, writing at Forbes, has a great article that describes the backdrop for this new pronouncement in this way:
"IRC Section 1402, like many provisions of the Code, starts off by setting the general rule– i.e., all trade or business income, including a partner’s distributive share of partnership income, is included in self-employment income–before listing a host of exceptions to that general rule. Specific to this discussion, IRC Section 1402(a)(13) provides that the distributive share of partnership income of a limited partner – other than guaranteed payments – is NOT included in self-employment income."
In general, taxpayers who earn active income owe self employment tax on that income, while taxpayers who invest and earn passive income, such as limited partners in a limited partnership, do not pay self employment tax on those earnings. IRC 1402 was passed before LLCs came into existence, and LLCs have confused the issue because all LLC members are legally akin to limited partners.
Most tax practitioners agree that, similar to how S-Corps are treated, only part of the distributive share received by members from properly-structured LLCs ought to be subject to self-employment tax, not all of it. However, with CCA 201436049, the IRS took the position that individuals who were members of an LLC that served as a general partner of an investment limited partnership and received a management fee were subject to self employment tax on the entirety of their distributive share.
CCA 201436049 makes reference to Prop. Reg. 1.1402(a)-2 in a footnote, summarizing the three tests for limited partner treatment: "[A]n individual is treated as a limited partner unless the individual: (1) has personal liability for the debts of or claims against the partnership by reason of being a partner; (2) has authority to contract on behalf of the partnership; or (3) participates in the partnership's trade or business for more than 500 hours. [There are] exceptions for certain holders of classes of interest that are identical to those held by limited partners."
With respect to the exceptions: "If the LLC has two classes of members... [and if] at least 20% of the members of the Investor Class do meet all three tests and the managing member is a member of this class," the managing member is treated as a limited partner and his or her distributive share is not subject to self employment tax. John M. Cunningham, "Using LLCs to Protect Family Assets," WealthCounsel CLE, September 14, 2011. The key is to have a properly-drafted operating agreement that clearly creates these distinct classes of membership.
CCA 201436049 stands for the idea that the distributive shares of LLC members who provide services are not wholly exempt from self employment tax simply due to the LLC structure. The proposed regulation, even though not finalized, can probably still be relied upon as a safe harbor. Beyond that, be aware that the IRS appears prepared to argue that more or all of a partnership LLC's distributive shares ought to be subject to self-employment tax.
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LLC members are not employees so no contributions to the Social Security and Medicare systems are withheld from their paychecks. Instead, most LLC owners are required to pay these taxes -- called "self-employment taxes" when paid by a business owner -- directly to the IRS
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