The LLC and Self-employment Tax on the Members
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Description/Scope
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Employment Taxes
Self-employment income is generally subject to tax for OASDI and hospital insurance at a
maximum combined rate of 15.3%. Self-employment income is defined as the net earnings from
self-employment, including the distributive share from any trade or business carried on by
any partnership of which the individual is a member. There is an exception to this rule in
for the distributive share of any item of income or loss of a limited partner, other than
guaranteed payments for services. 56 In other words, a limited partner's distributive
share of partnership income is excluded in determining net earnings subject to
self-employment taxes to the extent that such amounts are not received as guaranteed
payments for services actually performed by the limited partner for the partnership. The
purpose of this rule is to prevent passive investors from qualifying for social security
benefits based on earnings which are basically of an investment nature. Guaranteed
payments are not exempt because, presumably, they are received by partners who are
actively involved in the business. 57
/Footnote/ 56 § 1402(a)(13).
/Footnote/ 57 For a discussion of guaranteed payments, see ¶4040, above.
The question in the context of an LLC is - are the members treated as
general or limited partners for purposes of the self-employment tax? None of the members
of an LLC are personally liable for the debts of the entity and, therefore, could arguably
be treated as limited partners. 58 Yet an LLC member can be actively involved in
management of the entity and in that respect may closer resemble a general partner.
/Footnote/ 58 See, e.g., PLR 9525058 (distributive shares of LLC not excepted from definition of net earnings from self-employment under §1402(a)(13)); 9432018 (same).
The IRS has issued proposed regulations which deal with the treatment of
LLC members for self-employment tax purposes. 59 Because LLC members are not designated as
limited or general partners, it was unclear how they should be treated for purposes of the
rule excluding a limited partner's distributive share from self-employment tax. The
proposed regulations define which partners in a federal tax law partnership are considered
limited partners for purposes of the self-employment tax rules. The regulations apply to
all entities classified as partnerships for federal tax purposes, regardless of their
state law characterization. Under these regulations, the same standards apply when
determining the status of an individual owning an interest in a state law limited
partnership or the status of an individual owning an interest in an LLC. 60 In order to
achieve this conformity, the proposed regulations adopt an approach which depends on the
relationship between the individual, the entity, and the entity's business. State law
characterizations of an individual as a "limited partner" or otherwise, are not
determinative. 61
/Footnote/ 59 REG-209824-96, 62 Fed. Reg. 1702 (1/13/97). The IRS withdrew
former proposed regulations issued in December 1994 (see EE-45-94, 1995-1 C.B. 853). The
revised proposed regulations are effective beginning with the member's first taxable year
beginning on or after the date these regulations are published as final in the Federal
Register.
/Footnote/ 60 Preamble to REG-209824-96, 62 Fed. Reg. 1702 (1/13/97).
/Footnote/ 61 Id.
Under the general rule in the proposed regulations, an individual is treated as a limited partner for self-employment tax purposes unless the individual:
(1) has personal liability 62 for the debts of, or claims against, the
partnership by reason of being a partner;
/Footnote/ 62 As defined in Regs. §301.7701-3(b)(2)(ii).
(2) has authority to contract on behalf of the partnership under the
statute or law pursuant to which the partnership is organized; or,
(3) participates in the partnership's trade or business for more than 500
hours during the taxable year. 63
/Footnote/ 63 Prop. Regs. §1.1402(a)-2(h)(2).
Example—LLC Member Treated as Limited Partner Under General Rule
A, B, and C form LLC, a state law limited liability company, to engage in a business that
is not a service partnership. 64 The LLC is classified as a partnership for federal tax
purposes and allocates all items of income, deduction, and credit to A, B, and C in
proportion to their ownership interests. A contributes $100,000 for one LLC unit. Each LLC
unit entitles its holder to receive 25% of the LLC's tax items, including profits. A does
not perform services for the LLC and is not the LLC's manager. A is treated as a limited
partner in the LLC because A is not liable personally for debts of or claims against the
LLC, A does not have authority to contract for LLC under state law, and A does not
participate in the LLC's trade or business for more than 500 hours during the taxable
year. Therefore, A's distributive share attributable to A's LLC unit is excluded from A's
net earnings from self-employment.
/Footnote/ 64 Service partnerships are specifically provided for in the
regulations and are discussed below.
The regulations set forth three exceptions to application of the general rule. The first exception provides that a service partner in a service partnership may not be considered a limited partner. A service partnership is a partnership substantially all the activities of which involve the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, or consulting. A service partner is a partner who provides services to or on behalf of the service partnership's trade or business. A partner is not considered to be a service partner if that partner only provides a de minimis amount of services to or on behalf of the partnership. 65
/Footnote/ 65 Prop. Regs. §1.1402(a)-2(h)(5) and Prop. Regs. §1.1402(a)-2(h)(6)(ii) and (iii).
Example—LLC Members in Service Partnership
A,B, C, and D form a state law LLC. The LLC is engaged in the practice of accounting. A,
B, and C perform accounting services on behalf of the LLC. D is retired and no longer
provides services, although his interest has not yet been liquidated. A is the designated
manager of the LLC. A performs approximately 1300 hours of services in the current taxable
year. B performs over 450 hours of services in the current year. C performs only 20 hours
of services in the current year. The LLC is a service partnership.
(1) A is not a limited partner under the general rule because he has the power to bind the
LLC and he performs more than 500 hours of service. A is also not a limited partner by
virtue of being a service partner. A's entire distributive share is considered net
earnings from self-employment.
(2) B is a limited partner under the general rule because he has no personal liability, no
authority to bind the LLC, and performs fewer than 500 hours of services to or on behalf
of the LLC. However, because B performs services on behalf of a service partnership, B is
a service partner who is not treated as a limited partner. B's entire distributive share
is treated as net earnings from self-employment.
(3) C is a limited partner under the general rule for the same reasons as B. However, C performs services for a service partnership. C's distributive share will be treated as net earnings from self-employment unless the amount of services performed by C is considered de minimis. Twenty hours out of a total of 1770 hours performed for the LLC will most likely be considered de minimis and, therefore, C's distributive share will not be considered self-employment income.
(4) D is a limited partner under the general rule for the same reasons as
B. As long as D continues to perform no services for or on behalf of the LLC, D is not
considered a service partner. Thus, D's entire distributive share is excluded from net
earnings from self-employment.
The second exception to the general rule applies to holders of more than one class of
interest. An individual holding more than one class of interest 66 in an LLC who is not
treated as a limited partner under the general rule is nevertheless treated as a limited
partner with respect to a specific class of LLC interest held by such individual if,
immediately after the individual acquires that class of interest:
/Footnote/ 66 A class of interest is an interest that grants the holder specific rights and obligations. If a holder's rights and obligations from an interest are different from another holder's rights and obligations, each holder's interest belongs to a separate class of interest. An individual may hold more than one class of interest in the same partnership provided that each class grants the individual different rights or obligations.
Prop. Regs. §1.1402(a)-2(h)(6)(i).
(1) Limited partners within the meaning of the general rule own a substantial, continuing
interest 67 in that specific class of interest; and,
/Footnote/ 67 The regulations provide that a substantial interest in a class of interest is determined based on all the facts and circumstances. Prop. Regs. § 1.1402(a)-2(h)(6)(iv).
(2) The individual's rights and obligations with respect to that specific class of interest are identical to the rights and obligations of that specific class of interest held by the limited partners. 68
/Footnote/ 68 Prop. Regs. §1.1402(a)-2(h)(3).
Thus, an individual who is not a limited partner for purposes of the self-employment tax general rule may nonetheless exclude from self-employment net earnings a portion of that individual's distributive share if the individual holds more than one class of interest. This exception essentially allows an individual who holds the equivalent of a general partnership interest as well as another class of interest in the partnership which is identical to the interest held by individuals deemed limited partners under the general rule to carve the distributive share from the second class of interest out from net earnings from self-employment.
Example—More Than One Interest Exception
C owns two types of interests in an LLC. The first class of interest entitles C to 25% of
the LLC's tax items, including 25% of profits not to exceed $100,000 per taxable year. The
second class of interests entitles C to an additional 5% of profits in excess of $400,000.
In other words, if the LLC generates $500,000 of profit in a taxable year, C is entitled
to $100,000 based on his ownership of the first class of interest and $5,000 based on his
ownership of the second class of interest. Assume that C performs 600 hours of services
for the LLC during the taxable year and that the LLC is not a service partnership. Assume
also that the other holders of the first class of interest are not considered limited
partners under the general rule but all of the other holders of the second class of
interest are considered limited partners. C's distributive share with respect to the first
class of interest would be considered net earnings from self-employment because C performs
more than 500 hours of services for the LLC and there is no exception that applies.
However, C's distributive share with respect to the second class of interest would not be
considered net earnings from self-employment because of the more than one class of
interest exception. The exception applies in this case because all of the other holders of
the second class of interest are considered limited partners.
The third exception to the general rule applies to an individual who is not treated as a limited partner under the general rule by virtue of the fact that the individual participates in the LLC's trade or business for more than 500 hours during the taxable year. The exception provides that the individual is still treated as a limited partner with respect to his LLC interest if, immediately after the individual acquires that interest:
(1) Limited partners within the meaning of the general rule own a substantial, continuing
interest in that specific class of interest; and
(2) The individual's rights and obligations with respect to the specific class of interest
are identical to the rights and obligations of the specific class of interest held by the
limited partners. 69
/Footnote/ 69 Prop. Regs. §1.1402(a)-2(h)(4).
Example—Exception Applicable to LLC Member Participating More Than 500 Hours
A, B, and C form LLC, a state law limited liability company, to engage in a business that is not a service partnership. The LLC is classified as a partnership for federal tax purposes and allocates all items of income, deduction, and credit to A, B, and C in proportion to their ownership interests. A contributes $100,000 for one LLC unit.
Assume that B contributes $200,000 for two LLC units. Each year B receives a guaranteed payment of $60,000 for 600 hours of services rendered to the LLC. In addition, B's LLC units entitle B to receive 50% of the LLC's tax items, including profits. B's guaranteed payment of $60,000 is included in B's net earnings from self-employment. B's distributive share of LLC income is treated as net earnings from self-employment only if B is not considered a limited partner. B is not treated as a limited partner under the general rule because, although B is not liable for debts of or claims against the LLC and B does not have authority to contract for the LLC under state law, B does participates in the LLC's trade or business for more than 500 hours during the taxable year. Further, B is not treated as a limited partner under the more than one class of interest exception because B does not hold more than one class of interest in the LLC. However, B is nevertheless treated as a limited partner because B fails the general test solely because of his participation in LLC business for more than 500 hours and because A is a limited partner under the general rule who owns a substantial interest with rights and obligations that are identical to B's rights and obligations. In this example, B's distributive share is deemed to be a return on B's investment in the LLC and not remuneration for B's service to the LLC. Thus, B's distributive share attributable to B's two LLC units is not net earnings from self-employment.
Example—Exception Not Applicable
Assume the facts in the example above. Assume that C contributes $100,000 for one LLC unit. Each year C receives a guaranteed payment of $100,000 for 1,000 hours of services rendered to the LLC. In addition, C's LLC unit entitles C to receive 25% of the LLC's tax items, including profits. C also is elected the LLC's manager. Under state law, C has the authority to contract on behalf of the LLC. C's guaranteed payment of $100,000 is included in C's net earnings from self-employment. C's distributive share of LLC income is treated as net earnings from self-employment only if C is not considered a limited partner. C is not a limited partner under the general rule because C has the authority under state law to enter into a binding contract on behalf of the LLC and because C participates in the LLC's trade or business for more than 500 hours during the taxable year. Further, C is not treated as a limited partner under the more than one class of interest exception because C does not hold more than one class of interest in the LLC. Finally, C is not treated as a limited partner under the more than 500 hours exception because C does not fail the general test solely because of C's participation in the LLC's business. C also has the power to bind the LLC. C's distributive share is, therefore, included in C's net earnings from self-employment.
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