Discussion:LLC - SE tax and Sec 179 expense

It appears that if the LLC is nonmember-managed, then it would be able to avoid SE tax to the members.

However, in order for the members to be able to deduct 179 deprec, they must have income from the "active conduct" of a trade of business so as to prevent a passive investor from deducting 179. Apparently, if they "meaningfully participate" in management (e.g., meet periodically to review business developments or approve budgets) then they can qualify to deduct 179. Is this type of participation by the members permitted in an nonmember-managed LLC so that they can deduct 179 depreciation? Otherwise, it seems that they risk being considered passive investors.

Any comments or suggestions will be greatly appreciated.

The passive activity rules only act to limit the deduction of passive losses in excess of passive income. They do not change the character of the income for purposes of section 179.

For the same reasons a passive general partner still has self-employment income from a partnership that has an active trade or business.

(ii) Active conduct. For purposes of this section, the determination of whether a trade or business is actively conducted by the taxpayer is to be made from all the facts and circumstances and is to be applied in light of the purpose of the active conduct requirement of section 179(b)(3)(A). In the context of section 179, the purpose of the active conduct requirement is to prevent a passive investor in a trade or business from deducting section 179 expenses against taxable income derived from that trade or business. Consistent with this purpose, a taxpayer generally is considered to actively conduct a trade or business if the taxpayer meaningfully participates in the management or operations of the trade or business. Generally, a partner is considered to actively conduct a trade or business of the partnership if the partner meaningfully participates in the management or operations of the trade or business. A mere passive investor in a trade or business does not actively conduct the trade or business.

(iii) Example. The following example illustrates the provisions of paragraph (c)(6)(ii) of this section.

Example. A owns a salon as a sole proprietorship and employs B to operate it. A periodically meets with B to review developments relating to the business. A also approves the salon's annual budget that is prepared by B. B performs all the necessary operating functions, including hiring beauticians, acquiring the necessary beauty supplies, and writing the checks to pay all bills and the beauticians' salaries. In 1991, B purchased, as provided for in the salon's annual budget, equipment costing $9,500 for use in the active conduct of the salon. There were no other purchases of section 179 property during 1991. A's net income from the salon, before any section 179 deduction, totaled $8,000. A also is a partner in PRS, a calendar-year partnership, which owns a grocery store. C, a partner in PRS, runs the grocery store for the partnership, making all the management and operating decisions. PRS did not purchase any section 179 property during 1991. A's allocable share of partnership net income was $6,000. Based on the facts and circumstances, A meaningfully participates in the management of the salon. However, A does not meaningfully participate in the management or operations of the trade or business of PRS. Under section 179(b)(3)(A) and this paragraph (c), A's aggregate taxable income derived from the active conduct by A of any trade or business is $8,000, the net income from the salon.

While this may be a bit generic for this discussion, see the Section 179 Overview page that we just created. Feel free to add to it!

- Tim Doyle, TaxAlmanac Moderator - Talk to me 13:16, 1 December 2006 (CST)

WesR says that if you meaningfully participate in a partnership, then you cannot avoid SE tax. This comment clearly conflicts with the proposed regs for SE tax. Also, his statement that the definition in Reg 1.469-1T(d)(3) of a passive activity under 469 includes a reference to SE tax is also not correct. What the Regs say is that a passive T or B loss that is disallowed is not taken into account in computing SE tax.

Interesting stuff, eh?

Prop Reg §1.1402(a)-2

Reading it does make me think perhaps there is leeway for a "limited partner" (who makes certain management decisions but has no authority to contract, etc..) to take the 179 expense, as the tests appear different.

I really do appreciate all of the input that you guys have provided. And yes, the sun is up and shining this morning.

This means that while the income from the partnership retains its character as being from a trade or business, it is not necessarily an "active" trade or business. My experience, however, has been that most clients have sufficent "active" trade or business income that this is rarely an issue.

On this issue, I agree with those that say that to be active income it must be subject to SE tax (or payroll tax in the case of wages).

The other point I was trying to make is that the passive activity definitions of section 469 are irrelevant to section 179 or the SE tax. The reason limited partners are not subject to SE tax is not because they are passive. It is because they have limited liability. And, if a limited partner acts in away that causes the loss of limited liability, they become subject to SE tax. I think this was relevant because you are trying to avoid SE tax.

My suggestions is that you design a structure that creates a reasonable amount of self-employment income to the major owners instead of trying to completely eliminate the SE income. This would serve two purposes. First, unless all they have done is provide capital, they probably ought to have some SE income. This falls under the "pigs get fat and hogs get slaughtered" maxim of tax planning (correct me if I have that reversed). Second, much of the SE income they claim will probably be offset by the section 179 deduction.

Proseries took Section 179 for the calculation of taxable income for both members. Proseries used section 179 to calculate the self employment tax for the member with the box marked "General Partner or LLC Manager". ProSeries did not use the Section 179 deduction in calculating the self employment tax of the other member.

I can almost see the software calculating no self employment income for the "Limited Partner or LLC member" (1402(a()13), perhaps), although the material participation box would preclude that conclusion. But I cannot figure out the lack of Section 179 in calculating the self employment tax (only).

Am I missing some technical/obvious issue?

- Loss deduction for passive activities
- Self employment tax for LP's, LLC's, and LLP's
- Sec 179 deductions for LP's, LLC's and LLP's
- Investment interest deduction
- Let's not forget foreign income

I'm sure there's more . . .

Section 1402 Proposed Regulations by the IRS were never allowed to become "real". Those Proposed Regulations gave a definition of limited partner that more than likely would clear up the status of most LLC partners. It also would clear up portions of the current regulation that contradict the Tax Code, especially 1.402(a)-2(g).

Also Section 1402 has several other exclusions from self employment tax that have nothing to do with the concepts of trade or business, passive income, or active or material participation.

When a LLC member asks how much self employment tax they should pay, it is good as an accountant to be able to answer, "How much do you want it to be?"

I had a tiff with a long time client when I suggested we could structure his LLC so that he would pay SE tax on only part of his income. His partner's tax preparer insisted that all of the income should be subject to SE tax, no questions asked.

The poor client didn't know what to think!

In a different “thread Riley2 stated: “The Tax Court correctly pointed out that neither Sec. 469 nor the temporary regulations include a definition of a general partner. Therefore, the court apparently felt justified in simultaneously classifying certain working LLP and LLC members as general and limited partners with respect to the same interest for purposes of Temporary Regulation § 1.469-5T(e)(3)(ii).”

The SE rules nor regulations have such definitions. Do taxpayers and the IRS have this ambiguity in this area as well? Does it help, that in this area the taxpayer is arguing the IRS position in Garnett?: an LLC member = a limited partner = not subject to SE tax.

RoyDaleOne mentions, “I don't believe the court ruled that the members interest were held as limited partners, or were to be treated like limited partnership interest for any purpose. The court did note that this issue was stated by the fiction that LLC's were partnerships.”

Perhaps there is no definition that works for SECA and an LLC member is not addressed in the Code and only perhaps by a passive activity case.

Riley2 mentioned, “Right, which is exactly what 1.469-5T(e)(3)(ii) says. Surprise, surprise -- the Tax Court validated a temporary regulation.”

Can a Tax court validate a Proposed Regulation?

I have not heard of any reasonable compensation issues for guaranteed payments. Could LLC’s surpass S corporations in creating social security tax savings? At least for those who have S corporations currently making distributions of some significance when compared to stockholder compensation.