SE tax of LLC members.

An individual who is self-employed is subject to self-employment (SE) tax, the purpose of which is to provide Social Security and Medicare benefits. The tax is assessed on the individual's SE income. Under Sec. 1401(a) and (b), the combined rate of SE tax is 15.3%, which consists of two parts. The first part is 12.4%, which is the component for old-age, survivors and disability insurance (OASDI); the second part is 2.9%, which is the component for hospital insurance (Medicare). This tax is reported on Form 1040, Schedule SE, Self-Employment Tax, and is treated as part of the income tax. It must be included in estimated tax payments.

The OASDI component applies only to the first $90,000 (for 2005; indexed annually for inflation) of SE income; the second part, Medicare, applies to all SE income. If SE income is below $400, no SE tax is imposed. (There is also an exception when the individual is a member of a religious order and has taken a vow of poverty, as long as the income is derived from duties connected with the order.)

LLC Member Liability

A state-registered limited liability company (LLC) can be taxed as a partnership for Federal income tax purposes. However, its members, like corporate shareholders, are not personally liable for the entity's debts and liabilities. According to Rev. Rul. 2004-41, members of multiple-member LLCs are not liable for Federal employment taxes if they are not liable for the LLC's debts under state law, even if the LLC is taxed as a partnership for Federal tax purposes. Unlike limited partners, LLC members may participate in managing the partnership, while not becoming personally liable for debts. However, single-owner LLCs that are not taxed as a corporation are subject to employment tax liabilities. This is because single-member LLCs are disregarded entities for Federal tax purposes; when the single member is an individual, he or she will be taxed as a sole proprietor on Form 1040, Schedule C. Also, members of multiple-owner LLCs are not exempt from the trust fund recovery penalty imposed under Sec. 6672 on the LLC's responsible party; see Chief Counsel Advice 200235023.

There is debate about SE income of LLC members. Limited partners (LPs) are classified as such by virtue of their limited liability. LLC members also have limited liability, but the Code does not firmly establish that they are equivalent to LPs. In many cases, it is unclear whether an LLC member should be treated in the same manner as an LP, or as a general partner (GP). GPs are subject to SE tax on their share of income. The Code is clear that LPs are not subject to SE tax, except for guaranteed payments (see Sec. 1402(a)(13)); however, it is silent as to LLC members.

Prop. Regs.: The IRS tried to answer this question in proposed regulations (REG-209824-96, 1/13/97). Under the proposed regulations, if substantially all of an LLC's trade or business activity involves the performance of services, any LLC member who provides such services will be a GP for SE tax purposes. If the LLC is a nonservice partnership, the partnership will be treated as a limited partnership, and members will be treated as LPs not subject to SE tax.

The proposed regulations apply to SE tax on a member's share of profits. If the member receives guaranteed payments for services rendered, they are subject to SE tax regardless of the LLC member's liability, authority or hours of service status in relation to the LLC.

Proposed regulations are generally issued to give interested parties time to file an objection or to suggest changes prior to final regulations, and generally reflect current IRS thoughts on the subject. The proposed regulations were never finalized. As of now, there are no clear guidelines as to whether an LLC member's share of profits is subject to SE tax.

FROM KENNETH M. PARKER, CPA, PARKER & ASSOCIATES, CPAs, PLLC, JACKSON, MS