Proposed regulation classifies LLC members for self-employment tax purposes.

The Service has proposed amendments to the Sec. 1402 regulations on the tax on self-employment income. Under Prop. Regs. Sec. 1.1402(a)-18, self-employment income includes a member's distributive share (whether or not distributed) of income or loss from a limited liability company (LLC) unless the member is treated as a limited partner. For purposes of the proposed regulation, a member is any person who owns an interest in an LLC.

Under Sec. 1402(a)(13), selfemployed income does not include a limited partner's distributive share of income or loss from a partnership, other than guaranteed payments described in Sec. 707(c) to that partner for services actually rendered to or on behalf of the partnership (to the extent that those payments are established to be in the nature of remuneration for those services). A member of an LLC will be treated as a limited partner for purposes of the exception in Sec. 1402(a)(13) only if (1) the member is not a manager of the LLC and (2) the entity could have been formed as a limited partnership rather than an LLC in the same jurisdiction and the member could have qualified as a limited partner in that limited partnership under applicable law.

For purposes of the proposed regulation, a "manager" is a person who, alone or together with others, is vested with the continuing exclusive authority to make the management decisions necessary to conduct the business for which the LLC was formed. Generally, an LLC statute may permit the LLC to choose management by one or more managers (whether or not members) or by all members. If there are no elected or designated managers (as so defined) of the LLC, each member will be treated as a manager for purposes of the proposed regulation.

For purposes of the proposed regulation, an LLC is an organization (1) formed under a law that allows the limitation of the liability of all members for the organization's debts and other obligations within the meaning of Prop. Regs. Sec. 301.7701-2(d) and (2) classified as a partnership for Federal tax purposes. The applicable tests for determining whether an entity may be classified as a partnership for Federal tax purposes are set forth in Regs. Secs. 301.7701-2 through -4.

Whether an organization is to be treated as a partnership or as a corporation must be determined by taking into account the presence or absence of each of the following corporate characteristics: (1) associates, (2) an objective to carry on business and divide the gains therefrom, (3) continuity of life, (4) centralization of management, (5) liability for corporate debts limited to corporate property and (6) free transferability of interests. Characteristics common to partnerships and corporations are not material in attempting to distinguish between them. Since associates and an objective to carry on business and divide the gains therefrom are generally common to both corporations and partnerships, the determination of whether an organization that has these characteristics is to be treated for tax purposes as a partnership or as a corporation depends on whether there exist centralization of management, continuity of life, free transferability of interests and limited liability.

An unincorporated organization that possesses more corporate characteristics than noncorporate characteristics is taxable as a corporation. In interpreting Regs. Sec. 301.7701-2, the Tax Court, in Larsen, 66 TC 159 (1976), acq. 1979-1 CB 1, concluded that equal weight must be given to each of the four corporate characteristics.

Continuity of life does not exist if the death, insanity, bankruptcy, retirement, resignation, expulsion or other event of withdrawal of a general partner of a limited partnership causes a dissolution of the partnership; furthermore, continuity of life does not exist even if a dissolution of the limited partnership may be avoided, on such an event of withdrawal of a general partner, by the remaining general partners agreeing to continue the partnership or by at least a majority in interest of the remaining partners agreeing to continue the partnership.

Centralized management exists if any person (or group of persons that does not include all the members) has continuing exclusive authority to make management decisions necessary to the conduct of the business for which the organization was formed. Persons who have this authority may or may not be members of the organization, and may hold office as a result of a selection by members from time to time, or may be self-perpetuating in office. Centralized management can be accomplished by election to office, proxy appointment or any other means that has the effect of concentrating continuing exclusive authority to make management decisions in a management group. Centralized management does not exist unless the managers have sole authority to make decisions. For example, in the case of a corporation or a trust, the concentration of management powers in a board of directors or trustees effectively prevents a stockholder or trust beneficiary, simply because that person is a stockholder or beneficiary, from binding the corporation or the trust.

Limited liability exists if under local law there is no member personally liable for the debts of, or claims against, the organization. Personal liability means that a creditor of an organization may seek personal satisfaction from a member of the organization to the extent that the organization's assets are insufficient to satisfy the creditor's claim.

Free transferability of interests exists if each of the members (or those members owning substantially all of the interests in the organization) have the power, without the consent of other members, to substitute for themselves in the same organization a person who is not a member of the organization. For this power of substitution to exist in the corporate sense, the member must be able, without the consent of other members, to confer on the member's substitute all of the attributes of the member's interest in the organization. The characteristic of free transferability does not exist if each member can, without the consent of other members, assign only the right to share in the profits but not the right to participate in the organization's management.

For a member's distributive share of an LLC's income to be exempt from the tax on self-employment income, the LLC must be treated as a partnership. Consequently, an LLC cannot possess more corporate than noncorporate characteristics. To avoid a preponderance of corporate characteristics, an LLC can possess at most two of the four characteristics used to distinguish a partnership from a corporation. Two of the four characteristics are unavoidable, namely, centralization of management and limited liability. Centralization of management is unavoidable because a member of an LLC who participates in management is not given limited partner tax treatment under the proposed regulation. Limited liability is unavoidable because the raison d'etre of an LLC is to limit liability. Consequently, an LLC must fail to be characterized by continuity of life and free transferability of interests.

Commonly, statutes that authorize the formation of LLCs provide that, unless otherwise provided for in an operating agreement, the management of the entity is vested in its members in proportion to the current percentage of the members' interest in the LLC's profits. Thus, for an LLC member to be treated as a limited partner and thus escape self-employment taxation, an operating agreement must provide for (1) designated or elected managers, (2) the dissolution of the LLC and (3) limited transferability of interests.

From Michael A. Sturni, CPA, The Reynolds and Reynolds Co., Dayton, Ohio, and Hans Sprohge, CPA, Ph.D., Wright State University, Dayton, Ohio