LLC - To SE or not SE

[Albe]

I have an LLC client with two members. Member #1 is a "silent member" with no say in the day to day operations of the LLC. Member #2 does all of the bookkeeping while his wife conducts all other day to day operations of the business. Total Ordinary Income is approximately $10,000 and is to be split 40% to Member 1 and 60% to Member 2. Since Member #1 is a silent member, I will consider them as an "other LLC Member" on their K1 and their share of ordinary income of $4,000 will not be subject to SE on their 1040. What about Member 2?

I have two schools of thought for Member 2. The first one is that Member 2 is actively involved with the business via his participation with the bookkeeping (and his wife's active involvement as well) and his entire share of the ordinary income would be subject to SE on his 1040.

The second idea is that since Member 2 receives 20% more of the income, this would be considered his "management fee" subject to SE and that the other 40% would not be subject to SE similar to Partner #1.

Any input to the validity of these scenarios is greatly appreciated. Thank you in advance.

[cpadan]

How much money did either partner draw out? Possible guaranteed partner payments can be a factor. Especially when allocating SE income.

[Albe]

They distributed all of the current year income prior to year end. I don't think these were necesarily classified as guaranteed payments, rather they were just each member's distributive share of the income.

[cpadan]

How have they handled it in the past? Is this the first year of business? If all the earnings are from an active business, then that amount is SE income that must be allocated and passed through to the partner as SE income.

[Albe]

2002 - Prepared by Firm #1 - No SE Income Reported on K1
2003 - Prepared by Firm #2 - 20% of Total Income reported as SE to active partner 40% of total income reported as non-SE income to each member.
2004 - Prepared by my firm (someone other than me prepared the return) - No SE Income reported on K1.

Unfortunately, following prior years in this case does not provide a lot of clear cut guidance. Is there any basis for following along with the same treatment as 2003, or would you say the entire amount for the active partner would be subject to SE no matter what?

[Gretel]

Well, Congress and IRS refuse to give any guidance. More agressive preparers look at it the same way as S-Corps., meaning guaranteed payments for services and some income not subject to SE for investment and investment risk.

No way not to report any SE income. Same will happen as with audited S-Corps = all income will be subject to SE then.

More conservative preparers will allocate all income to SE.

I would take a reasonable approach for the allocation and at least allocate some income to investment income.