LLCs and liability for self-employment taxes.

Letter Ruling 9432018 apparently represents the first written determination in which the IRS has addressed an important open issue for members of limited liability companies (LLCs). The Service ruled that a member's distributive share of an LLC's trade or business income will be subject to self-employment tax. Like many other recent rulings, the ruling primarily addresses the conversion of a general partnership to an LLC. The LLC would engage in the performance of unidentified "professional services" and the management and operation of any property that came to the partnership by way of fees or investment. All partners would continue to be actively engaged in the business.

Sec. 1402(a) generally includes in "net earnings from self-employment" (NESE) an individual's distributive share of income or loss (as defined in Sec. 702(a)(8)) from any trade or business carried on by a partnership of which the individual is a partner. However, Sec. 1402(a)(13) generally excludes from NESE a limited partner's distributive share of partnership income. Practitioners have been unsure whether (and in what circumstances) LLC members might qualify for the exception. After all, if an LLC is classified as a partnership, its members are partners whose liability is limited. This question illustrates the most significant type of tax issue facing LLCs classified as partnerships: how to apply provisions that distinguish between general and limited partners.

The ruling holds that the members' distributive shares cannot be excluded from NESE under the limited partner exception in Sec. 1402(a)(13). The IRS explained that the classification of the LLC as a partnership meant the members were partners for self-employment tax purposes, and that the Sec. 1402(a)(13) exception did not apply. The ruling thus leaves open questions, such as whether the Service might have ruled differently if a partner did not actively participate in the LLC's business, if the LLC did not conduct a professional service business, if the LLC conducted more than one line of business, or if the preconversion partnership had been a limited partnership rather than a general partnership.