SE tax for LLC member

[taxxcpa]

I have this situation. Last year my client was an employee of an LLC and received a salary of $ 132,000. This year she became a partner/LLC member. Her draws were $ 162,000 which is probably close to her share of LLC income (don't have K-1 yet). Assuming that she gets a K-1 showing $ 162,000+/- as ordinary income, would it all be subject to SE tax?

How would you handle self-employment tax for this LLC member?
Pay it only on guaranteed payments?
Pay it on the every dollar of K-1 income?
Pay on guaranteed payments plus a "reasonable salary" equivalent?
Don't pay it at all?

I know that the Tax Book suggests paying on guaranteed payments plus, if necessary, to equate it to a reasonable salary under S-Corp rules. What I need to know are some thoughts on you might report it in a situation as I've described above--for example show $100,000 subject to SE tax and report the rest as not subject to SE tax--or maybe more than $ 100,000, or less than $ 100,000.

[AJsTax]

What type of entity

is the LLC? At first you talk about partner and then a mention of S corp.
the rules are different for Partnerships , which a multi-member LLC is by default , unless it has selected corp status, but I think you know all that.
Is the TP a partner or a share holder?

[BHoffman]

Bifurcation

I remember talking about this on another thread:

http://www.thetaxbook.com/forums/showthread.php?t=12802&highlight=bifurcation

and I found this interesting article:

http://www.nysscpa.org/cpajournal/2006/606/essentials/p32.htm

Hope it helps.

[Gretel]

This was an open questions until last year. At a seminar I learned of a court case that pretty much established the requirement to pay SE for all income from a LLC partnership.

Although the case was not about SE, it was about passive income, it was established that the income from an LLC is active income despite the limited liability status of a LLC member. That sort of pulls the ground away from the arguments against SE liability.

[taxxcpa]

LLC partners

is the LLC? At first you talk about partner and then a mention of S corp.
the rules are different for Partnerships , which a multi-member LLC is by default , unless it has selected corp status, but I think you know all that.
Is the TP a partner or a share holder?

Partner is not the technical name for an LLC member, but it is the term LLC members use.
If they had elected S-Corp taxation, there would be no question, but they did not.

One of the local law firms whose senior partner is also a CPA takes the position that no SE tax is due. Apparently the "partners" in that LLC get by with it, right or wrong, just as a lot of S-Corp owners get by without taking a salary.

I will advise my client of the risks in following the no-SE approach. So far everything seems to be based on what the expected rule would be if there were anything official.

[Bees Knees]

Although the case was not about SE, it was about passive income, it was established that the income from an LLC is active income despite the limited liability status of a LLC member. That sort of pulls the ground away from the arguments against SE liability.

I disagree. Passive activity status has nothing to do with SE tax status. You can be a passive member of your Schedule C business (Item G on the Schedule C), subject to passive loss rules, and STILL be subject to SE tax if there are any profits.

They are two different issues. Just because the court ruled an LLC member is not automatically treated as a limited partner for passive loss rule purposes, that does not mean the same applies for SE tax purposes, and any seminar speaker making such a connection is wrong.

[Bees Knees]

BTW, you have to be careful using court cases to interpret tax law. Court rulings apply to a specific set of facts and apply only to a specific code or regulation that is in question. Thus, they often contradict other areas of tax law that appear to have similar concepts.

In the case you cite, the question was whether or not an LLC member is automatically treated as a limited partner for purposes of the passive activity rules. In general, a limited partner is automatically assumed to be treated as a passive participant in the limited partnership activity, unless the limited partner participates in management. If the limited partner does participate in management, then the limited partner can use test 1, 5, or 6 of Regulation Section 1.469-5T(a) to establish active participation status.

The only thing your cited court case did was establish that an LLC member can use all 7 of the tests under Regulation Section 1.469-5T(a) rather than the three tests that apply to limited partners. It was a very narrow ruling, carving out a technicality in a temporary regulation that was originally written for limited partnerships. It is a stretch to apply it to any other area of tax law.

[Gretel]

I disagree. Passive activity status has nothing to do with SE tax status. You can be a passive member of your Schedule C business (Item G on the Schedule C), subject to passive loss rules, and STILL be subject to SE tax if there are any profits.

They are two different issues. Just because the court ruled an LLC member is not automatically treated as a limited partner for passive loss rule purposes, that does not mean the same applies for SE tax purposes, and any seminar speaker making such a connection is wrong.

Bees, I know I cannot win any argument with you and I am not even trying. You are saying there is no connection, whatsoever. I think the IRS, especially money hungry agents, still will try to make this connection.

Even in my mind I have a hard time not to bring this together. Isn't one of the argument that a LLC member is not subject to SE for the earnings that he is a limited member? Taking that away, would also take away SE, no?

You see, I wouldn't be able to argue that it is not so since my mind seems to be confused on the issue(s).

[Burke]

I think where you are confused is in the terminology. A Limited Liability Company only refers to limited liability. It has nothing to do with limited participation.
These are two different issues. An LLC member may be a limited partner, based on his percentage of ownership (which can be 100% or 2%). His active participation may or may not be limited in the company. His degree of material participation is what determines the SE tax status.

[Bees Knees]

His degree of material participation is what determines the SE tax status.

No, his degree of material participation is what determines his active or passive status under Code Section 469. The passive activity rules under Code Section 469 limit losses when a person is not an active participant in the activity.

The SE tax status is determined under Code Section 1402. Material participation is not considered. Section 1402 applies SE tax to all income from a trade or business, with the exception of specific activities described in Section 1402(a), numbers 1 through 17. Section 1402(a)(13) provides one exception to the SE tax requirement:

(13) there shall be excluded the distributive share of any item of income or loss of a limited partner, as such, other than guaranteed payments described in section 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;

Nothing in that paragraph says anything about material participation. It says a limited partner is not subject to SE tax, except for guaranteed payments under Section 707(c).

Section 707(c) says nothing about material participation. It says:

To the extent determined without regard to the income of the partnership, payments to a partner for services or the use of capital shall be considered as made to one who is not a member of the partnership...

.

Thus, if you provide services to the partnership (or LLC taxed as a partnership), the payment for those services determined in a manner other than as a percentage of profits is considered a guaranteed payment, and is subject to SE tax regardless of your limited liability status in the partnership. If the payment is not a guaranteed payment for services rendered, then the determining factor of whether or not it is subject to SE tax is based on your status as either a general partner or a limited partner. If you are a limited partner, it is not subject to SE tax.

[Bees Knees]

What IRS will do is say a portion of your distributive share is actually a guaranteed payment for services rendered, and thus it is subject to SE tax even if you are a limited partner (or LLC member).

It does not give them the right to reclassify all of your income as SE taxable if the partner (or LLC member) has limited liability status.

This is why I advise my LLC clients to pay a guaranteed payment for services rendered. That way it is just like an S Corp, where the payments for wages to the S corp shareholder are subject to FICA, and the distributive share of profits is not subject to FICA. Absent a law to the contrary, I will fight any auditor tooth and nail if they try to make the claim an LLC member does not have limited liability status.

[Gretel]

That was a nice roundup. Thank you so much. I hope you never switch over to the other side (IRS). I sure would like to be part of this fight if it ever comes to it.

[luke]

bite your tongue

Bees over to the darkside - NEVER!

[Burke]

Thus, if you provide services to the partnership (or LLC taxed as a partnership), the payment for those services determined in a manner other than as a percentage of profits is considered a guaranteed payment, and is subject to SE tax regardless of your limited liability status in the partnership.

I agree with that, although I did not address guaranteed payments per se.

If the payment is not a guaranteed payment for services rendered, then the determining factor of whether or not it is subject to SE tax is based on your status as either a general partner or a limited partner. If you are a limited partner, it is not subject to SE tax.

And that is what I was trying to convey, although not very clearly.