Self-employment tax and the LLC member: a uniform approach.

On Jan. 13, 1997, amendments were proposed to the regulations on whether a limited liability company (LLC) member is subject to self-employment (SE) tax under Sec. 1402. The proposed regulations provide a uniform test for determining a member's status for SE tax purposes, replacing the former regulations, which relied on state law.

Under Regs. Sec. 1.1402(a)--18 (proposed in 1994), there was a two-part test to determine whether an LLC member was treated as a limited or general partner for SE tax purposes. This designation is important; under Sec. 1402(a)(13), the distributive share of any item of income or loss of a limited partner generally is not subject to SE tax. (See Tax Clinic, "Self-Employment Tax for LLC Members," TTA, May 1995.)

A member was treated as a limited partner if (1) the member was not a manager and (2) the LLC could have been formed as a limited partnership in the same jurisdiction and the member could have qualified as a limited partner in that limited partnership under applicable law. Therefore, reliance was placed on a state's limited partnership statute to determine whether the member acted as a limited partner.

However, relying on state law may cause different treatment of similarly situated members of LLCs formed in different states. Clearly, for both the LLC member and the IRS, this was not the best solution. As a result, many commentators suggested that those regulations would create much uncertainty.

The new proposed regulations solve this problem by omitting state law characterization of the LLC as part of the SE test. Under the proposed rules, an individual generally would be treated as a limited partner unless he (1) has personal liability for the debts of (or claims against) the partnership by reason of being a partner; (2) has authority to contract on behalf of the partnership under the statute under which the partnership is organized; or (3) participates in the partnership's trade or business for more than 500 hours during its tax year.

If substantially all of a partnership's activities involve performing services in the fields of health, law, engineering, architecture, accounting, actuarial science or consulting, any individual who provides services as part of that trade or business is not considered a limited partner.

In addition, if a member is not considered to be a limited partner under the general test, he nevertheless may be considered a limited partner under either of the following exceptions. First, if the member fails that test simply because he participates for more than 500 hours during the entity's tax year, he still may be considered a limited partner if he has only one class of interest and immediately after he acquires it:

--members who are limited partners under the general rule own a "substantial, continuing interest in that specific class of partnership interest"; and

--the member in question has rights and obligations with respect to that specific class of interest that are identical to the rights and obligations of the specific class of partnership interest held by those other limited partners.

Second, if a member holds more than one class of interest, he likewise still may be considered a limited partner with respect to a specific class of interest if immediately after he acquires that class of interest:

--members who are limited partners under the general rule own a "substantial, continuing interest in that specific class of partnership interest"; and

--the member in question has rights and obligations with respect to that specific class of interest that are identical to the rights and obligations of the specific class of partnership interest held by those other limited partners.