Guaranteed payments for the use of capital may result in self-employment tax.

The elimination of the Medicare wage base cap, effective in 1994, significantly increased the total tax associated with self-employment (SE) income. This increased price tag, coupled with the proliferation of limited liability companies (LLCs), has heightened the awareness of the tax on guaranteed payments made to certain partners and LLC members.

The general rule under Regs. Sec. 1.707-1(c) is that guaranteed payments are regarded as a partner's distributive share of ordinary income. Net earnings from SE are defined in Sec. 1402(a) to include a partner's distributive share of income or loss from a trade or business carried on by a partnership of which he is a member. The regulations under Sec. 1402 go on to say that net earnings from SE include payments received by a partner from a partnership of which he is a member for services rendered to the partnership or for the use of capital by the partnership, to the extent the payments are determined without regard to the partnership's income.

Without exceptions to this general rule, all partners would be subject to SE tax on guaranteed payments, whether those payments are for services or use of capital. It is interesting to note that there is an exception, but only for limited partners. Sec. 1402(a)(13) excludes from the definition of SE income the distributive share of any item of income or loss of a limited partner, other than guaranteed payments to that partner for services actually rendered to the partnership.

Thus, general partners pay SE tax on guaranteed payments for use of capital and limited partners do not. For LLCs, proposed regulations under Sec. 1402 address the treatment of SE tax for LLC members. The general rules are the same as for partnerships, but the proposed regulations set out to define which members may qualify for the limited partner exception under Sec. 1402(a)(13). To qualify, two conditions must be met: (1) the member must not be a manager and (2) the entity must have been able to be formed as a limited partnership in its jurisdiction and the member must have been able to qualify as a limited partner under applicable law. Thus, a nonmanager LLC member may be treated as a limited partner. However, a minimal amount of managerial involvement could cause the LLC member to be treated as a general partner, creating a potentially harsh result for members who are essentially investors.

What can be done to avoid this unequal treatment between general and limited partners? General partners could loan money to the partnership as a bona fide debt and receive interest on their loans. Sec. 1402(a)(2) provides an exclusion from SE tax for interest on any bond or other evidence of indebtedness. Loans can be made by either general or limited partners. This would require the actual payment or accrual of interest on the debt, rather than creating a preferred return to the capital provider. In some situations this may not be feasible from a business standpoint.

However, if a bona fide loan is acceptable, adequate care should be taken to make the loan a true evidence of indebtedness. This includes preparing a written loan agreement, paying a reasonable interest rate, setting a maturity date and possibly providing some form of collateral.