New equipment leasing LLCs may avoid SE tax.

Many construction companies have related equipment leasing, limited liability companies (LLCs) whose income may be subject to self-employment (SE) tax unless structured properly.

In 1997, the IRS issued proposed regulations on the SE tax treatment of limited partners in any entity classified as a partnership, including LLCs.

Under the Code, a limited partner's distributive share of income from a trade or business is excluded from SE tax. The new proposed regulations provide guidance for treating an LLC member as a general or limited partner for purposes of SE tax.

An LLC member's share of LLC income is not subject to SE tax if the member is considered a limited partner. The proposed regulations provide the following requirements for such treatment.

LLC requirements. The LLC must not be a service entity (i.e., provide health-related, legal, engineering, architectural, accounting, actuarial or consulting services).

Member requirements. A member must not:

* Have personal liability for the LLC's debts;

* Have authority (under the state law in which the LLC is formed) to contract on behalf of the LLC; or

* Participate in the LLC's trade or business for more than 500 hours during the LLC's tax year.

A member may participate for more than 500 hours if there are other members treated as limited partners and they own a substantial part of the entity.

Further, the ownership interest of all members treated as limited partners must be identical in rights and obligations. The member may not, however, have personal liability or authority to act on the entity's behalf.

If an individual fails any of the member requirements, he may still be considered a limited partner if he holds more than one type of interest in the LLC, similar to holding a general and limited partner interest. He will be considered a limited partner with regard to the type of interest substantially owned by other members treated as limited partners.

The proposed regulations indicate that an LLC can have both a limited partner- and general partner-type interest in the LLC. An individual may hold more than one class of interest in the same LLC, provided that each class of interest grants different rights or obligations.

The regulations do not, however, discuss how the rights and obligations of the different classes of interest should be structured to resemble a limited and general partner-type interest.

Recommendation: New businesses should explore this SE tax-saving opportunity, while existing LLCs should review their operating agreements to ensure that the limited partner requirements are met.

Caveat: The proposed regulations are not final and may be changed or withdrawn by the IRS.

FROM WARREN HEATLEY, CPA, KANSAS CITY, MO