self employment tax and LLC

[TAX4US]

I have a 2 member (husband and wife) LLC filing on a 1065 Form. H takes a reasonable salary wife does not. Husband takes distributions wife does not. Is this distribution subject to SE Tax? I find some statements says is and some not clear. I appreciate all help in this matter. Many Thanks

[Jiggers]

I have a 2 member (husband and wife) LLC filing on a 1065 Form. H takes a reasonable salary wife does not. Husband takes distributions wife does not. Is this distribution subject to SE Tax? I find some statements says is and some not clear. I appreciate all help in this matter. Many Thanks

Who did the 1065?

What do the K-1's show?

[gboykin]

Unless it's taxed as a Corporation, I don't think a partner should receive a salary. They would pay tax on the distribution of profit/loss and guaranteed payments reflected on the K-1.

[Burke]

I agree. But he said he was filing a 1065. All is treated same as guaranteed payments, subj to SE.

[JoshinNC]

No, the distribution is not subject to SE

Now, as to whether a salary can/should be taken by a partner in a partnership. Technically, no. It should be a guaranteed payment subject to SE tax, but the IRS won't balk at a partner on salary, and the LLC actually pays more in the way of taxes that way because it has to pay FUTA and SUTA, which aren't required for a GP.

[Burke]

You are saying the net profit from a 1065 is not subject to SE tax? I am assuming the "distribution" was from profits, and not from capital and/or equity.

[Roland Slugg]

It is perfectly all right for a partnership to pay a "salary" to one or more of its partners, as long as it's not reported on any payroll tax returns (F-941, F-940, state) or W-2s. Such "salaries" are called "guaranteed payments" and are taxed to the receiving partner, along with his share of partnership net income, as self-employment income. The various partners' guaranteed payments/salaries do not have to be equal, vis-a-vis one another, but they should bear a reasonable relationship to the value of the work done and services performed. Such guaranteed payments are deductible by the partnership in arriving at the partnership's net income. That net income, in turn, is taxed to all the partners in proportion to each one's profit sharing percentage as spelled out in the partnership agreement.

Distributions, per se, are generally not taxable ... only partnership net income is, plus guaranteed payments.

The above is a very simple, general overview, and anyone dealing with partnerships should definitely educate himself about the subject to a much greater extent. (The IRS's Pub 541 is actually quite good.) There are exceptions to the main points above: Some partnership income ... real estate rental income, for example ... is usually not subject to S-E tax, and sometimes distributions can be taxable or taxed differently from other income or payments.

[DaveinTexas]

I would say it depends and make sure your cilent's ducks are in a row.

I have a 2 member (husband and wife) LLC filing on a 1065 Form. H takes a reasonable salary wife does not. Husband takes distributions wife does not. Is this distribution subject to SE Tax? I find some statements says is and some not clear. I appreciate all help in this matter. Many Thanks

Here's what the proposed regulations say: (not ever adopted but still followed by IRS):

"Proposed Treasury Regulations Section 1.1402(a)-2

The premise for this SE tax treatment stems from Proposed Treasury Regulations section 1.1402(a)-2(h)(2), which effectively equalizes the positions of limited partners and certain LLC members who are not managers by treating partners or members of an LLC as limited partners unless they meet one of the following tests:

1. They have personal liability for debts or claims against the partnership;
2. They have authority to contract on behalf of the partnership; or
3. They participate in the partnership’s trade or business for more than 500 hours during the partnership’s tax year."


Using this reg along with a well written LLC Operating Agreement should do the trick; the wife's income should not be subject to SE tax. I have had 2 new clients with the exact situation. The income on the husband's K-1 was classified as SE earnings and the wife's income was not (50/50 partners). There is a good reasoning to treat it this way and I the previous return preparer had good intentions until you look at the partnership/operating agreement. In both instances the operating agreement states that the LLC is member managed and all members have the authority to contract on behalf of the partnership. Now, if you read the regs above, it state they will be treated as a limited partner unless they meet one of the following tests; they failed test number 2 above. I advised the clients to consider aligning their operating agreement with this proposed regulation (without giving them legal advice). The dilemma is, since the operating agreement was not originally written this way, are their K-1s and ultimately their personal returns prepared incorrectly? Can we retroactively state the operating agreement was written one way (probably a boilerplate obtained from a LLC formation company) but the intent was to go another direction?

What do you think Josh? (I like to get Josh's opinions because he just tells it like it is!!)

[Bees Knees]

"Proposed Treasury Regulations Section 1.1402(a)-2

The premise for this SE tax treatment stems from Proposed Treasury Regulations section 1.1402(a)-2(h)(2), which effectively equalizes the positions of limited partners and certain LLC members who are not managers by treating partners or members of an LLC as limited partners unless they meet one of the following tests:

1. They have personal liability for debts or claims against the partnership;
2. They have authority to contract on behalf of the partnership; or
3. They participate in the partnership’s trade or business for more than 500 hours during the partnership’s tax year."

Congress ruled that reg invalid when it repealed all regulations dealing with the topic prior to July 1, 1998. (Section 935 of the Taxpayer Relief Act of 1997)

However, since Congress has not dealt with the issue since, the courts have decided to act. In Renkemeyer, 136 T.C. No. 7, the court ruled all limited partnership interests in an LLP were subject to SE tax because The partners were not merely investors in the business. The fact that they participated made their distributive share of K-1 profits subject to SE tax. Even though this was an LLP and not an LLC, the reasoning used by the court should be the same in an LLC situation. The court ignored the limited liability status and said active participation is what matters for SE tax purposes.

[DaveinTexas]

I don't want to upset the great Bees, but...

Congress ruled that reg invalid when it repealed all regulations dealing with the topic prior to July 1, 1998. (Section 935 of the Taxpayer Relief Act of 1997)

However, since Congress has not dealt with the issue since, the courts have decided to act. In Renkemeyer, 136 T.C. No. 7, the court ruled all limited partnership interests in an LLP were subject to SE tax because The partners were not merely investors in the business. The fact that they participated made their distributive share of K-1 profits subject to SE tax. Even though this was an LLP and not an LLC, the reasoning used by the court should be the same in an LLC situation. The court ignored the limited liability status and said active participation is what matters for SE tax purposes.

this case did involve lawyers performing personal services (legal services) for the law firm, and for a LLP (not an LLC). It was a flimsy argument that lawyers that derive nearly all of their income from services could exclude their "limited partner" source of income distribution from SE earnings. Still, I think that the proposed reg may work in the case of a husband and wife owned business where the wife has little or no active participation.

And isn't active participation, basically, whether or not the TP participates in the activity for 500 or more hours per year? IRS would be hard pressed to say the wife, who may run some errands or deposit the checks in the bank account, participates for more than 500 hours per year. Just a thought.

[rfk]

How about...

If they are husband and wife, why wouldn't they choose the route of being treated as such (QJV) and not a partnership? They can select the disregarded entity idea and split between them any applicable SE tax etc., unless I am missing something in the equation.

rfk

[JoshinNC]

Because it's an LLC

If they are husband and wife, why wouldn't they choose the route of being treated as such (QJV) and not a partnership? They can select the disregarded entity idea and split between them any applicable SE tax etc., unless I am missing something in the equation.

rfk

And QJV treatment is not allowed for an LLC.

[DaveinTexas]

And if in a community property state

They could really treat the business as owned solely by only one of the spouses, allocating all income to one spouse. Of course, the other spouse wouldn't be due any SS credits but that could be rectified by hiring the spouse as an employee and then setting up an HRA plan....you know the rest of the story.

[JoshinNC]

Agree that the proposed Regs are worthless

Congress ruled that reg invalid when it repealed all regulations dealing with the topic prior to July 1, 1998. (Section 935 of the Taxpayer Relief Act of 1997)

However, since Congress has not dealt with the issue since, the courts have decided to act. In Renkemeyer, 136 T.C. No. 7, the court ruled all limited partnership interests in an LLP were subject to SE tax because The partners were not merely investors in the business. The fact that they participated made their distributive share of K-1 profits subject to SE tax. Even though this was an LLP and not an LLC, the reasoning used by the court should be the same in an LLC situation. The court ignored the limited liability status and said active participation is what matters for SE tax purposes.

As Congress specifically precluded them by their actions.

As for Renkemeyer, I am not convinced that the determinations in that case specifically delineate that all participating LLC Members are subject to SE tax, both because the case was decided based upon the Court's definition of a limited partner and that the Court specifically based the premise upon the statement that:
"In essence, an L.L.P. is a general
partnership that affords a form of limited liability protection
for all its partners by filing a statement of qualification with
the appropriate state authorities. See Garnett v. Commissioner,
132 T.C. 368, 375 (2009); 1 Bromberg & Ribstein, supra sec.
1.01(b)(5). In Kansas, an L.L.P. is formed under the Kansas
Uniform Partnership Act, which governs general partnerships. See
Kan. Stat. Ann. sec. 56a-1001 (2005). A Kansas partnership that
elects to become an L.L.P. “continues to be the same entity that
existed before the filing of a statement of qualification under
K.S.A. 56a-1001.” Kan. Stat. Ann. sec. 56a-201(b) (2005)."
This is not true of an LLC as an LLC is not simply a general partnership, it is a specific type o legal entity that is a hybrid of corporate and partnership functions created by state law! And is generally governed under a specific LLC statute, generally modeled after the Delaware statute. IMO, this case cannot be effectively applied to an LLC. Also, the term limited partner is never defined in the Code (only a general partner) AND the Code only says that GP's are subjec to SE tax, so avoiding GP's avoids SAe tax as currently constructed.

[TAX4US]

llc and se

I really didn't mean to stir up a can of worms. It is a H & W LLC providing security services. Only H works and gets a W-2. W only does books and banking and does not take salary. All taxes withheld on that part. This is his main employment. LLC started 2005 and I cannot find where an election was ever made and in fact 1065 has always been filed and as best I can see his income was always on a w-2 and subtracted from the gross on the 1065. What to do??? I would think that since this is a 50/50 ownership, I would pay se on his part and not on her part. Agree??