Discussion:LLC, SE Tax, and Bifurcation of Income

No SE tax would be a best case scenario and certainly the most aggressive tact. I'm not sure that having outside full time employment should having bearing on whether they are considered part-time "workers" of their LLC. At best--since both are involved with the operation of the business--it might be structured so that the husband is a general partner and wife is a limited partner. But again, passing the functional test of 1402 would be dificult. The proposed split of income--at some ratio--seems like a reasonable approach given the way the business would operate and each members partcular SS tax exposure. So let me guess, you'd go for a 99/1 split? ... :)

50/50 ownership does not mean that profits need to be split 50/50 in an LLC. Under an S-Corp you would be correct however.

Assume that the couple will work equal hours in the business, as I stated in the first post. Under such a scenario, what would be an appropriate split of profits if one member was "worth" more than the other, in terms of the skills they bring to the business. My conservative estimate would be that 60/40 to 70/30 would be appropriate, but, that 75/25 or less would be pushing it. Thouhgts.

Given the nature of this proposed business and the associated liabilities, a single member(with the husband as the owner) LLC does not make sense. As I have stated the wife would be involved with the business, and as such, if she were to fall into legal jeopardy, then her assets could be at risk--which means the husbands assets are also at risk. Essentially, by using the single member approach for this couple, asset protection does not exist if the wife were to get into trouble.

My thinking on this is that check the box and the resulting taxation of LLCs was done wholly by regulation. Sec 7701(a) defines corporation, partnership, etc., and there is a whole body of case law that sets forth the tests for determining where one falls based on the various attributes. It was definitely a trap for the unwary, but it was the law (actually, I think it still is). Then the IRS publishes the Check the Box regs and changes everything.

I'm not saying the check the box regs are unconstitutional, though I could articulate an argument, but rather that I believe the IRS will have a lot of leeway in determining the tax consequences of LLC members since they created the tax formula in the first place.

Sometimes the client would rather pay $1,000 in tax than $5,000 in representation fees.

An LLC taxed as a partnership has gross income from the personal services of the members plus income from the sales of products - roughly 1/2 each. I come up with a ratio/% and report the resulting % of net profit from personal services as subject to SE tax and the portion of profit allocable to the sale of the products as not subject to SE tax.

As a result, I have sort of a middle of the road result - a little less aggressive than not paying any SE tax, but not "rolling over and playing dead" by paying SE tax on all of the profit.

This is all done after the fact, when the 1065 is prepared. All of the profits are drawn out by the owners throughout the year.

Thanks.

You can't file for SCORP election for 2006 since it is already too late for that unless it is a newly formed LLC within the 45 day thresh hold. SE TAXes are going have to be paid 1 way or another.

Things would be easier if my wife could be classified as a LP under the 1997 proposed regs, but given how we will run this, its not possible. But then again, proposed regs are just that...proposed! Seems like one big circuitious bungled tax conundrum!

Is nobody willing to take the position that a member with limited liability is a "limited partner?" That is contrary to the proposed reg, but if the Service doesn't like that, they should get off their asses and issue some actual regs.

Please let me know if my thoughts are not accurate: Guaranteed payments are deducted on page 1 of the 1065 - then the amount paid to the each partner as guaranteed payments is placed on each partner's k1 in box 4. They are then labeled as limited partners and the balance of the profit rolled over is not treated as se income in box 14. Am I correct - or am I way off track?

This works for those that are nonmanaging members. What about those that ARE general partners/managing members? Are you overriding the amount in box 14 with box 4 and adding a note as the other posting had stated she does?

We are working on one of these right now. A limited partner in the truest sense, however has personally guaranteed a $100,000 letter of credit for the partnership. He does not make any management decisions as is primarily there for capital contributions when needed. It is going to be hard to determine a guaranteed wage on someones that does not provide much in the way of services. However, due to his large partnership interest (78%), if we leave him as a general partner, he will have to pay tax on $350,000 of income (does not seem "fair" - do I sound like a kid or what) - what are your thoughts on this.

After reading the article - seems legit to determine a "fair" wage. Awaiting your responses.......

As the business has grown, my partner and I have become less “hands-on” and more involved with managing, scheduling & coordinating. Last year we discontinued paying ourselves based on actual job assignments and just disbursed a set monthly amount of income to each other. In your opinion do you see ANY room in this interpretation that exempts us from SE, or am I just grasping at straws here?"

If she is not involved in the delivery of services isn't she precluded from deducting losses because this is a passive activity?  What is the census now regarding taxation of LLC members payments from the LLC?

Now that nearly three years have passed since this thread started and the comments creating it, I wonder if just showing guaranteed pay for reasonable comp and leave the rest untaxed for SE is the simplist approach...?

You might set it up as JR suggests -- reasonable compensation for her services TO THE LLC as a guaranteed payment subject to SE tax, and the remainder (if any) not. It doesn't sound to me as though this is a passive activity for her even if there is distributable income or loss after deduction of the GPs. She's still actively involved with the business.

Of course we are still in the world of mules, where there are no rules (cf. Ogden Nash).

Second: I don't know about this guranteed pay on the fly either, or ipso facto (whatever that means) to be decided in December or later, but I'll expect we'll have some court cases on it before it's over. That's a topic for another discussion.

If any of the big firm lawyers, or regular lawyers or anyone else has run into legal issues ( or disputes) like this with GP, please let us know. Also, if I'm wrong to have this concern, please let us know.

Teacher Kevin!!!!!!!!!!!!!!???????????

I'm learning here too. That's why if I'm wrong about the partnership accounting or the law on this, let the legal and partnership experts enlighten us.

My understanding of the gurantee is that it IS a gurantee. I don't know if I could be amended on the fly without unanimous agreement. Maybe this is just an operating agreement issue that would need attention (amendable on majority vote). I just don't know.

One thing for sure though, I still favor the S. These LLCs are going to be litigation factories one day. I guess it's good for us lawyers.

Whether an LLC member is a "limited partner" for this purpose, and whether the answer to that is the same as the answer for passive activity purposes, is the question we have to wrestle with. But you can't get out of it just by thinking that a pro-taxpayer answer is unreasonable. If you use an actual limited partnership, I don't think there's any basis for taking the position that a percentage of profits is subject to SE tax, and you risk being accused of social security fraud if your return says it is.

On the other point, isn't this known as the "high risk" option with LLCs, not saying it's not legal. i.e. no gp, no se at all? We have a withdrawn reg, so have at it?

The real "problem" here is that you are a limited partner by law under the LLC statute, but you don't act at all like a limited partner in fact in most operating LLCs. Nevertheless, there is no permanent reg. to resolve this.

Ogden Nash observed that

"In the world of mules

There are no rules."

That's where we are.

Nash also suggested

"If called by a panther

Don't anther."

That may be good advice too <G>

Send them to an experienced lawyer (not me) and let them take the risk of advising your client and the other partner if need be.

We are using the word limited partner here, and we are talking about LLCs. These are not exactly the same thing, though they can be. Limited partner is a term of art. The truth is that the LLC was invented in Wisconson, a state known for cheese and not law. It's got holes in it, just like some of the cheese. Then the IRS got involved, I won't say more. Members of an LLC are limited partners for liability purposes is what WI was thinking about, they weren't thinking about tax IMHO.

Speaking of the classical Limited Partner, the last thing you would want them to do is get involved in the business making mgt. decisions. But again, we are talking about that rascal the LLC.

Finally, we have not resolved tax preparers recommending guaranteed payments. My warning stands on this issue that a court might well consider them "guaranteed" indeed. :). Nevertheloess, it's done every day, and I would do it.

P.S. I should warn you, the cost of seeing the fancy lawyer (who might also be somewhat mystified) will far exceed the amount of the SE tax. It might be better if she saved the money and followed the advice we gave here, whatever it was.

Wisconsin didn't have an LLC law until 1994. Wyoming's was enacted in 1977. There weren't any more until the IRS issued a revenue ruling, in 1988, explaining how LLCs would be taxed (as corporations if the entity had more than two of the corporate characteristics in the old 7701 regulations, otherwise as partnerships). Then everybody got on the band wagon. By 1997 all states had enacted LLC statutes. In 1998 the IRS got tired of issuing rulings on how particular LLCs, with particular characteristics, would be taxed and issued the "check the box" regulations.

I would surely mention Crow's warning about the possibly binding effect of a guaranteed payment and recommend legal advice on the wording of an amendment to the operating agreement.

Wisconsin didn't have an LLC law until 1994. Wyoming's was enacted in 1977. There weren't any more until the IRS issued a revenue ruling, in 1988, explaining how LLCs would be taxed (as corporations if the entity had more than two of the corporate characteristics in the old 7701 regulations, otherwise as partnerships). Then everybody got on the band wagon. By 1997 all states had enacted LLC statutes. In 1998 the IRS got tired of issuing rulings on how particular LLCs, with particular characteristics, would be taxed and issued the "check the box" regulations.

I would surely mention to a client Crow's warning about the possibly binding effect of a guaranteed payment and recommend legal advice on the wording of an amendment to the operating agreement providing such payments.

Hawaii's statute was enacted in 1996 (1996 Hi. ALS 92). You can read it the current text at http://www.capitol.hawaii.gov/hrscurrent/Vol08_Ch0401-0429/HRS0428/ (the first link is the table of contents).

Vermont's was adopted in 1995 (1996 Vt. ALS 179); full text at http://www.leg.state.vt.us/statutes/sections.cfm?Title=11&Chapter=021 .

It's been a while since any state didn't have one.

Someone used the term "Ipso Fatso" with me when I was a kid & my brother beat the crap out of him (just kidding :)

And move on.

You have a university law school around there where you live? If it's a public university, you can use their law library.

Try to look up this article: "Why Not Form a New Business As An LLC" Immerman & Millar (auth). The Practical Tax Lawyer, Spring 2005, pp. 21-32.

This is a good article from a tax standpoint.

It should be found among the law reviews and journals party of the library. Call ahead to see if they have the journal. It's possible that some good courthouse law libraries would have it also. Good luck.

Proposed-regulation,1.1402(a)-2,Computation of net earnings from self-employment.

(h)Definition of limited partner

(1)In general.— Solely for purposes of section 1402(a)(13) and paragraph (g) of this section, an individual is considered to be a limited partner to the extent provided in paragraphs (h)(2), (h)(3), (h)(4), and (h)(5) of this section.

(2)Limited partner.—An individual is treated as a limited partner under this paragraph (h)(2) unless the individual—

(i) Has personal liability (as defined in §301.7701-3(b)(2)(ii) of this chapter for the debts of or claims against the partnership by reason of being a partner;

(ii) Has authority (under the law of the jurisdiction in which the partnership is formed) to contract on behalf of the partnership; or

(iii) Participates in the partnership's trade or business for more than 500 hours during the partnership's taxable year.

(h)(5)Exception for service partners in service partnerships.— An individual who is a service partner in a service partnership may not be a limited partner under paragraphs (h)(2), (h)(3), or (h)(4) of this section.

(h)(6)(iii) - 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.

Good discussion - thanks everybody.

There is nothing unreasonable or otherwise suspicious about a husband giving his wife, as a gift, an interest in a partnership he owns, and the partnership then distributing profits in accordance with ownership percentages, subject to sec. 704(e).

(5) Exception for service partners in service partnerships. An individual who is a service partner in a service partnership may not be a limited partner under paragraphs (h)(2), (h)(3), or (h)(4) of this section.

I am not aware of any state where a CPA, attorney, physician, or dentist can practice as a limited partner. In fact, wouldn't you expect that any limited partner who performs services in a limited partnership to lose his state law limited liability status?

AFAIK, no state allows actual limited partnerships to practice a regulated profession. If they did, or in a non-regulated service business like consulting, it would not be hard for a limited partner to provide services without jeopardizing his limited liability. In Delaware, I don't think there are any circumstances where a limited partner becomes generally obligated for the partnership's debts; even if he "participates in the control of the business," which is defined very narrowly, he is liable "only to persons who transact business with the limited partnership reasonably believing, based upon the limited partner's conduct, that the limited partner is a general partner."

Likewise, the limited range of things that LLP members are liable for would make them "limited partners" under the proposed regulation but for the service-partner issue.