LLC Self-Employment Regulations Can Be Taxing
The limited liability company has emerged as the ownership vehicle of choice for real estate in most jurisdictions. Because of federal "check-the-box" regulations — which allow newly formed entities to choose how they will be taxed for federal income tax purposes by virtue of checking a box on the appropriate federal form — and the fact that all 50 states now have statutes that provide for their formation, LLCs are flourishing in today’s tax landscape.
Not all of the issues regarding LLC taxation have been settled, however. Specifically, the question of whether or not LLC members are subject to self-employment tax has been a focus of debate since the 1997 proposal of a new income tax regulation.
Under the check-the-box regulations, an LLC with two or more members that does not elect to be treated as an association automatically is treated as a partnership for federal income tax purposes. Accordingly, LLCs generally are subject to the various federal income tax rules that govern partnerships. One set of rules is enumerated in Internal Revenue Code Section 1402 and the accompanying income tax regulations.
Section 1402(a) generally defines net earnings from self-employment for purposes of determining a tax base to which self-employment taxes will be applied. Specifically, net earnings for self-employment include the distributive share of income or loss from any trade or business carried on by a partnership.
However, Section 1402(a)(13) provides an exception, stating that the distributive shares of income or loss of limited partners, other than guaranteed payments, will be excluded from net earnings from self-employment income. Accordingly, limited partners or members of a partnership or LLC are exempt from paying self-employment taxes on their distributive share of income or loss. The issue — and the controversy among taxpayers over who is liable for self-employment taxes — stems from how the statute defines a limited partner for purposes of determining net earnings from self-employment.
Limited Partner Defined
The definition of a limited partner has narrowed in recent years, ultimately making it more difficult for LLC members to qualify for the limited partner exception of Section 1402(a)(13). For example, Section 1402 regulations that were proposed in 1994 — but never were finalized — made a distinction between individuals owning an interest in limited partnerships and those owning interests in LLCs. Specifically, under the 1994 regulations, a taxpayer owning an interest in an LLC was treated as a limited partner if the individual did not make management decisions concerning the LLC’s business; the LLC could have been formed as a limited partnership in the same jurisdiction; and the member could have qualified as a limited partner in the limited partnership.
The 1994 regulations were revised by regulations proposed in 1997. While the 1994 regulations distinguished between taxpayers owning an interest in limited partnerships and taxpayers owning interest in LLCs, the 1997 regulations apply to any entity classified as a partnership for federal income tax purposes, regardless of its classification under applicable state statute. Accordingly, the same standards apply in determining the self-employment tax status of taxpayers that own interest in limited partnerships and in LLCs. Specifically, proposed Section 1.1402-2(h)(2) allows a member of an entity that is classified as a partnership for federal income tax purposes to be treated as a limited partner that is not subject to self-employment tax, unless the taxpayer is a service partner in a service partnership or meets any one of the following tests. The taxpayer:
- has personal liability for the debts of or claims against the entity by reason of being a member;
- has the authority to contract on behalf of the entity; or
- participates in the entity’s trade or business for more than 500 hours during the entity’s taxable year.
Federal Self-Employment Tax Implications
Although Congress, as part of the Tax Relief Act of 1997, placed a moratorium on finalizing the 1997 regulations until July 1, 1998 — and they were not yet finalized at this writing — the 1997 regulations provide some authority that an LLC member under appropriate circumstances qualifies as a limited partner, thus precluding the member’s proportionate share of LLC income from self-employment tax pursuant to Section 1402(a)(13). However, LLC members should be cautious in taking a federal income tax return position that is contrary to the narrow construction of the 1997 regulations. LLC members that are service members of an LLC or meet any of the above tests should be prepared to report their proportionate share of income from LLC activities as earnings from self-employment. Moreover, LLC members should consult with their tax adviser to plan effectively for the intricacies of these rules.
In many cases, LLCs have been a great tool for real estate investors. However, even the best tools have potential weaknesses. With the right circumstances, LLCs can provide a safe harbor from self-employment taxes, but until more definitive legislative guidance exists, taxpayers may be resigned to ante up.