Self-Employment Tax for LLC Members: New Regs. Proposed

LLCs are tax-favored business entities which possess the essential features of limited liability and flow through taxation. Their allure was greatly enhanced by a recent decision of the IRS to withdraw a 1994 NPRM which would have required LLC members to pass a stringent test in order to exclude distributive share amounts from self-employment tax.

Code Sec. 1402 provides that “net earnings from self-employment means the gross income derived by an individual from any trade or business carried on by such individual … plus his distributive share (whether or not distributed) of income or loss described in section 702(a)(8) from any trade or business carried on by a partnership of which he is a member.” Sec. 1402(a)(13) excludes from gross income for self-employment taxes the distributive share of any item of income or loss of a limited partner other than guaranteed payments for services actually rendered to the partnership.

Seeking to impose restrictions on the application of Sec. 1402(a)(13) to LLC members, the IRS proposed in 1994 to treat an LLC member as a limited partner for self-employment tax purposes only if (1) the member lacked the authority to make management decisions; (2) the LLC could have been formed as a limited partnership in the same jurisdiction; and (3) the LLC member could have qualified as a limited partner under state law.

The IRS agreed to withdraw the proposed regulations when they were harshly criticized for making an LLC member’s federal tax liability dependent upon state law characterization. For example, some states allow a limited partner to participate in a partnership’s business, while others do not.

Thus, an LLC non-manager member who participated in business decisions would qualify as a limited partner for tax purposes only in the state in which a limited partner could participate in the partnership’s business. In the state in which limited partners were barred from participating in business decisions, self-employment tax would be imposed on the non-manager member since the LLC member could not have qualified as a limited partner under state law.

Under the new proposed regulations, state law characterization of the entity is irrelevant for purposes of determining whether LLC members are limited partners for purposes of Code Sec. 1402(a)(3). Moreover, for purposes of determining the tax status of an individual, the same standards apply both to limited partners in a state law limited partnership, and to LLC members in an LLC formed under state law.

The new proposed regulations provide that an individual will be treated as a limited partner unless the person (1) has personal liability for the debts or claims made against the partnership (or LLC); (2) has the authority to contract on behalf of the partnership under the statute or law pursuant to which the partnership is organized; or (3) participates in the partnership’s trade or business for more than 500 hours during the taxable year. The objective of the new rules is to exclude from an individual’s net earnings from self-employment amounts that are shown to be returns of invested capital, rather than compensation for services performed.

Limited partner status for self-employment tax purposes will be unavailable to any individual — even one meeting the 500 hour participation test — if that individual performs any services to a partnership or LLC substantially all of the activities of which are in the fields of health, law, engineering, architecture, accounting, actuarial science, or consulting.

The proposed regulations also allow an individual who is not a limited partner for purposes of Sec. 1402(a)(3) to exclude from net earnings from self-employment a fraction of that individual’s distributive share if more than one class of interests are held. In such a case, however, the individual may exclude no more of his distributive share on a proportional basis than could other partners who qualify as limited partners but who hold only a single interest in the partnership or LLC.

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