Discussion:LLC Self Employment Tax Bifurcation

Of course, electing S-corp status (if eligible) and having comparable officer salaries and distributions would work.

Those cases did not address SE tax.

SE taxation has little to do with participation. It only has to do with the rights of the LLC member to participate in management. If the LLC documents say it is member managed, all income on K-1's is subject to SE tax even if you never work a lick.

I have read about using bifurcated interests; some are for a management interest and some are for an investment interest without management rights. This appears to be the cleanest way to go to shield some income from SE tax. Of course the investment interest would also most likely be passive.

I realize the cases didn't address SE tax, but I think the time will come when someone who is an LLC member actively working in a business will not be able to say that their income isn't subject to SE tax.

I just took a refresher seminar that discussed this. The proposed regs give three things to look at and it only takes one yes to get to SE taxation. REG-209824-96

(h)(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.

I beleive that (h(2)(ii) is the one that focuses on using the blanket term "shall be member managed" in the LLC operating agreement. To change that result, an LLC should name a specific manager so the other members would only have to look to the 500 hour rule. Many times in real life though that can be difficult because the other members want their voice in management when they have invested their money.

They certainly do allow classification as a limited partner for someone who does work for the partnership (in anything but a PSC-type business), either for up to 500 hours or for an unlimited amount by holding a class identical to non-working limited partners.

A member having authority to contract on behalf of the partnership is a very specific test, completely separate from whether the partnership is member-managed; certainly it has nothing to do with whether members have a voice in management. In any sane state, with an LLC, authority to contract is decided by what the LLC agreement says specifically about that. See, for example, Delaware LLC Act sec. 18-402.

I then stated that I had just attended a seminar where the discussion focused on the members who participate in management being subject to SE tax regardless of hours worked. I've seen many LLC agreements that have been drawn up to simply state they will be "member managed" without naming one specific manager. My seminar instructor stated this would lead to all the members being subject to SE tax. Maybe this is peculiar to Texas LLC's? When I tried to relate that to the proposed regs, I felt that (h)(2)(ii) probably was what he referred to. I did notice that the 1994 first set of proposed regs did say specifically members who participated in management would be subject to SE tax.

I have not seen an LLC set up with bifurcated interests yet.

Personally I would read authority to mean authority, so, with a Texas company, a member of an LLC without managers is not, by virtue of that fact, disqualified from being a limited partner.

Here's some interesting info -

I just finished the Gearup Business Entities course and the instructor said that at a seminar in the Midwest an attendee told him that she had filed an LLC tax return on which she had arbitrarily considered a part of the income subject to SE tax in an amount that would be consistent with a reasonable salary, as if it were an S corporation.

The return was audited and the auditor proposed subjecting all of the profit to SE tax. The tax preparer took it to the Appeals level and lost.

She then started the process of taking it to court, at which point the IRS told her that it wasn't that much money, they don't really have the time to litigate, and conceded on the issue!

In another discussion, one of the posters (I think it was JR1), pointed out that the last thing the IRS would want to do is to litigate the issue - if they lose, all heck would break loose.

IRC §1402(a)(13) provides that where a taxpayer is a limited partner in a partnership, the taxpayer’s distributive share of income or loss of that partnership is not included in SE income. In January 1997, the IRS issued proposed regulations to address the circumstances under which an individual won’t be treated as a limited partner for purposes of SE tax. See REG-209824-96. As KathiJud points out above, Prop. Reg. §1.1402(a)-2(h)(2) provides that an individual won’t be treated as a limited partner if (1) she is personally liable for debts of the partnership, (2) she has authority to contract on behalf of the partnership, or (3) she participates in the partnership’s business for more than 500 hours during the year. Despite having been proposed more than 11 years ago, these regulations have not been finalized.

Proposed regulations have no legal force or effect until they become final. See Tedori v. United States, 211 F.3d 488, 492 (9th Cir. 2000); Estate of Howard v. Commissioner, 910 F.2d 633, 637 (9th Cir. 1990). Aside from this problem, IRC §1402(a)(13) and the proposed regulations address income from a limited partnership, and there have been three cases that have held that an interest in a limited partnership is not the same as an interest in an LLC, at least for purposes of the passive activity rules. Gregg v. United States, 186 F.Supp.2d 1123 (Dist. Ore. 2000); Garnett v. Commissioner, 132 T.C. No. 19 (2009); and Thompson v. United States, No. 1:06-cv-00211 (Ct.Fed.Cls. 2009). As a result, neither the statute nor the proposed regulations are helpful in answering this question.

I'm not advocating that NONE of the income from an LLC is subject to SE tax. Most practitioners will treat the distributive share of LLC income as SE income if the member is a managing member of the LLC, but won’t treat it as SE income if the member is not a manager. In California, even the State agencies can't agree on this. For California income tax purposes, payments to a non-managing member of an LLC are treated by the Franchise Tax Board as guaranteed payments, but for California employment tax purposes, the Employment Development Department treats them as wages.

Sort of. Last year, in Renkemeyer v. Commissioner, 136 T.C. 137 (2011), the Tax Court ruled that a partner's distributive share of income from a limited liability partnership (a law firm) was subject to self-employment tax because the flow-through income represented fees earned by the partners for legal services rendered. Discussion of this issue starts on page 15 of the opinion. This is a "regular" Tax Court opinion, so it has quite a bit of precedential value.

Effective January 1, 2011 the CUIC was amended to provide that any member of an LLC that is treated as a corporation for federal income tax purposes is a statutory employee, subject to all employment taxes with regard to any compensation paid to such a person that is deductible under IRC Sec. 162. The law also provides that a member of an LLC that is treated as a sole proprietorship or partnership is NOT a statutory employee. However, that provision only applies to UI, DI and ETT, Since no changes were made to the PIT withholding provisions, EDD applies common-law principles to determine whether a LLC member is an employee or self-employed.

According to EDD, a managing member of an LLC taxed as a partnership would be considered self-employed and would not be subject to PIT withholding. A non-managing member who performs services for the LLC, and who would be under the direction and control of one or more managing members, would be considered an employee and subject to PIT withholding.

See http://www.edd.ca.gov/pdf_pub_ctr/de231llc.pdf.

It would make sense for IRS to follow the same principles: a managing member is self-employed and subject to SE tax; a non-managing member who performs no services would not be self-employed (and not subject to SE tax); a non-managing member who does perform services would be treated as an employee with respect to compensation for such services. No doubt that would be too easy <G>.

1) An LLC taxed as partnerhip is currently under audit by LB&I examinations and IRS so far has declined to address the SE tax issue even though I drew their attention to it (very material potential tax). Examiner expects no change on a clean/outstanding taxpayer. 2) Manager managed, all members work full-time in the business, no personal liability for LLC debt, all contractual rights belong to managing member. 3) Manager member pays SE tax on full share of profits 4) Other members are treated as limited and pay NO SE tax on their share (over 70% of the business) 5) All members take at or above market wages (spare me here, we don't care, the IRS cannot do anything, and in a multi-state arena, worker comp, unemployment and benefits management, Partner Salary is the most functional way to ensure compliance and fair apportionment) 6) Manager member grants and revokes specific management tasks to other members

Disagree with D. Fogel as to application of '97 1402 regs. While LLC and Ltd are different, economics are very near and the language represents the thinking of IRS who made no attempt to differentiate. Nor did the Congressional hiatus on '97 regs differentiate. Thus they are near the top authoritatively as to guidance. Clearly in the good-faith range as to compliance effort and compliance with '97 regs even for LLCs places burden of proof squarely on the Gov't.

Agree with comments above that the IRS is shy to go to litigation. If you honor the mechanics of the operating agreement, ensure all LLC member participation is fairly compensated, then your "piglet" is cute but likely outside the "larded hog" status that begs for slaughtering. Adequate compensation is good insurance for all participating LLC members in more than just SE tax.