Self-employment tax for LLC members.

In Letter Ruling 9432018, members of a limited liability company (LLC), which was formed through a conversion from a general partnership, had to include their distributive shares of LLC income in net earnings from self-employment (SE). The members could not use the limited partner exception under Sec. 1402(a)(13). (See Tax Clinic, "LLCs and Liability for Self-Employment Taxes," TTA, Jan. 1995, at 35.) Subsequent unofficial and informal views publicly expressed by IRS National Office personnel echoed the position that LLC members generally would be subject to SE tax. However, recently proposed regulations acknowledge that the limited partner SE income exception may be used in certain instances. Nevertheless, several underlying issues remain unsettled.

Many IRS pronouncements hold that an LLC may be treated as a partnership for Federal tax purposes, depending on the specific provisions adopted in the LLC operating agreement and on the construction of the underlying state statute. (For example, see Rev. Rul. 88-76 and Rev. Proc. 95-10. See also Tax Clinic, "Limited Liability Companies Taxed as Partnerships Even Though Providing Corporate Liability Protection," TTA, May 1989, at 322.)

Due to the potential for partnership tax treatment, coupled with limited liability for the members, LLCs have been described as "limited partnerships with no general partners." This unique status raises the question of how LLC members (who are, in effect, limited partners for Federal tax purposes) should be treated for SE tax purposes. In determining SE net income, Sec. 1402(a)(13) excludes limited partners' distributive shares of income or loss - except for Sec. 707(c) guaranteed payments for services rendered to, or on behalf of, the partnership. Thus, income attributable to limited interests, other than income in the nature of salaries, escapes SE tax. General and limited interests held by the same partner are bifurcated. Consequently, only income from the general partner interest and qualifying guaranteed payments are SE earnings.

According to its legislative history, Sec. 1402(a)(13) was enacted to combat the proliferation of limited partnership syndications aimed at obtaining Social Security coverage for the investors based on what is essentially investment income. However, the recent removal of the cap on earnings subject to the Medicare portion of the SE tax, together with increases in the SE tax rate and earnings base, have compelled taxpayers and practitioners to focus planning efforts on reducing SE earnings.

Well aware of the potential for tax avoidance, the Service proposed Regs. Sec. 1.1402(a)-18 on Dec. 28, 1994, dealing with the application of the SE tax to members of LLCs classified as partnerships for Federal tax purposes. (See Tax Clinic, "SE Tax Treatment of LLCs' Members," TTA, Apr. 1995, at 207.)

The proposed regulation provides that SE earnings generally include distributive shares of income (or loss) from any business carried on by an LLC. However, the proposal also provides that certain LLC members may be treated as limited partners under Sec. 1402(a)(13) if prescribed conditions are satisfied, thereby excluding the LLC income (except for guaranteed payments for services) from SE tax.

To achieve "limited partner" status for this exclusion, an LLC member cannot be an LLC "manager," defined as a person who, alone or with others, is vested with continuing exclusive authority to make management decisions necessary to conduct the LLC's business. 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 LLC managers, each member will be treated as a manager.

In addition, it must be shown that 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 partnership under applicable law. Since some states prohibit limited partnerships from conducting certain activities, this requirement prevents a business operating through an LLC from obtaining an SE tax result that it would be unable to achieve as a limited partnership.

However, these proposed regulations do not address all relevant issues. For instance, the legislative history indicates that a partner holding both general and limited partnership interests should bifurcate those interests. Hence, the income from the limited interest is excluded from SE earnings and only the income from the general interest is subject to SE tax.

In contrast, the proposed regulations allow limited partner treatment only if a member is not an LLC manager. Thus, under this proposal, if a member is a manager, his entire share of the LLC's income would appear to be subject to SE tax.

The proposed regulations also do not address relationships between outside managers and LLC members. Presumably, if a separate management entity is substantially controlled by LLC members, the Service would assert that these members participate in the LLC's management through "attribution." Therefore, they would not be treated as limited partners for SE tax purposes. This conclusion clouds as the relationship becomes further removed (such as minor ownership interests or distant familial bonds between members and managers). However, given the contentiousness of this issue, it is prudent for LLC members seeking limited partner status to avoid any relationship with a management entity, no matter how distant.

These new regulations are proposed to be effective for an LLC member's first tax year beginning on or after the date that the regulations are published as final regulations in the Federal Register.