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Archives for June 2010

Self Employment Tax on All Profit from Professional S Corps?

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There Will Be Blood
(not literally of course, but it’s going to cheese off a lot a people who are already over-burdened by the tax code.)

Congress is looking to restore some fiscal restraint.  It could do so by reigning in spending, but let’s be practical—they’re going to raise taxes.  Congress is trying to drink your milkshake.See full size image

The American Jobs and Closing Tax Loopholes Act of 2010 (which is currently working its way through Congress) has a provision that subjects all profit in a professional S corporation to self employment tax of 15.3%.  Examples of professional services include accounting, legal, architectural, consulting, engineering, etc.

Here’s the kicker—the tax applies only to professional S corps that are based principally on the reputation and skill of three or fewer employees.  So the business can have more than three employees and still be subject to the full self employment tax, as long as three or fewer employees are the firm’s principal asset.  Thus, each year the business must assess (through valuation?) whether the principal asset of the firm is three or fewer key employees.


Example:  Timmy and Jimmy have a law firm that is a professional corporation.  They have filed an S corporation election and are therefore taxed as an S corporation.  The corporation has $200,000 in profit before officer salaries.  Timmy and Jimmy each take a $60,000 salary, so the remaining profit is $80,000.  Under current law, Timmy and Jimmy pay their share of FICA taxes of $4,590 ($60,000 * 7.65%) and the corporation matches their FICA contributions of $4,590 each.  This is the rough equivalent of each owner paying self employment tax of 15.3% (7.65% * 2).  The remaining profit of $80,000 is exempt from self employment tax (assuming Timmy and Jimmy are paid a reasonable salary).


Under the new law, the $80,000 remaining profit is also subject to self employment tax of $12,240 ($80,000 * 15.3%). 


What if the corporation hires a receptionist and a couple paralegals so it has more than three employees?  The result will not change because the principal asset of the firm is based on two employees—Timmy and Jimmy.


THIS LAW HAS NOT YET PASSED.  IT IS VERY UNPOPULAR, BUT WHEN HAS THAT STOPPED CONGRESS?

The IRS already has power to challenge unreasonably low compensation of S corporation owners, can reclassify profit distributions as wages, and collect FICA taxes on them. 

If passed, this new law will dramatically increase the tax burden on small businesses by increasing their taxes and imposing the new requirement to perform a quasi-valuation each year to determine if three or fewer employees are the business’ principal asset.  This will harm their ability to grow their businesses and create new jobs. 

…I’m Finished (spoiler alert)…

[youtube=http://www.youtube.com/watch?v=I1PYp-fsZOA&w=425&h=355]

How LLC Owners Can Avoid Self-Employment Tax

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There is a 15.3% tax on self employment income.  Self employment income is defined as net income from any trade or business, including partnerships.  The IRS treats LLCs as partnerships for tax purposes.

Limited partners are usually not subject to self employment tax because they act merely as investors—they are not involved in the management and daily operations of partnerships.

The issue is whether members of an LLC should be treated as limited partners and should therefore be exempt from self employment tax.

In 1997, the IRS issued proposed regulations that stated that an LLC member is a limited partner (and exempt from self employment tax) unless he:

  • has authority to enter into contracts on behalf of the LLC
  • participates in the LLC’s business for more than 500 hours during the year
  • has personal liability for debts or claims against the LLC by reason of being a member [this is not a problem in Michigan since LLC members have limited liability]

For service partnerships (accounting, legal, architectural, consulting, engineering, etc.), service partners cannot be treated as limited partners unless they only provide de minimis services to the LLC. Naturally de minimis services are not defined.

Based on the first two limitations, most active LLC owners will be subject to self employment tax on their share of the LLC’s profits.  There was such an uproar about this that Congress passed a law blocking the proposed regulations and stating that the IRS could not issue regulations defining limited partner until 1998.  Neither the IRS nor Congress has acted on this issue since.

Under the proposed regulations (which technically are not binding), there are two ways active LLC members can exclude a portion of their profit from self employment tax.

First:  Have More than One Class of Ownership Interest

An LLC can have more than one class of ownership—for example, a general class (management class) and a limited class (investment class).  An owner who owns shares in both classes will only pay self employment tax on the profit allocated to the management class.

There are two requirements:

  • limited members who are not active in the business own a substantial interest in the limited class.  Substantial interest is defined as 20% or more.
  • the active business member’s rights and obligations for his limited class is identical to the rights and obligations of the limited members’ limited class interests

Example:  Evade LLC is offering one membership unit for $1,000 and 99 investment units for $1,000 each.  The one membership unit allows the holder to manage the day to day operations of the LLC.  The investment unit holders do not participate in the management or operations of the LLC.  Sandy buys the 1 management unit and 49 investment units for $50,000.  Other limited members buy the remaining 50 investment units. 

The LLC has profit of $100,000.  Sandy has 50 units out of 100, so her share of the profits is $50,000.  Of this amount, only the $1,000 attributed to her 1% management unit is subject to self employment tax.  The remaining profit of $99,000 is allocated to limited members, including Sandy.

In most circumstances, however, the active LLC member will also receive compensation (guaranteed payments) from the LLC, and will be subject to self employment tax on these payments.

Second:  LLC Members who Participate More than 500 Hours, but Abstain from Entering into Contracts on Behalf of the LLC

The proposed regulations allow an exemption from self employment tax for individuals holding one class of interest if the individual works more than 500 hours in the LLC, but cannot enter into contracts on behalf of the LLC.

This exemption allows LLCs the flexibility to attract investors with management skill and yet shield them from self employment tax.  Note that these LLC members cannot execute contracts on behalf of the LLC.

What’s an LLC Member to Do?  Well, There are Five Options

1. Adopt the Proposed Regulations:  Follow the above rules defining limited partners and try to meet the exemptions from self employment tax.  The benefit of this approach is that following the proposed regulations will shield you from penalty if the IRS challenges your position.  The downside is that it is VERY difficult for active LLC members to avoid self employment tax

2. Adopt the Position that All LLC Members are Limited Partners: Basically, claim that all LLC members are exempt from self employment tax.  Take this position if you want to be audited!

3. Treat a Portion of Profits as Return on Investment and Exempt from Self Employment Tax: Investment gains are not subject to self employment tax because the gains are the result of investment activity, not business activity.  An owner of an LLC can claim that a portion of the profit is merely a return on the capital he invested in the LLC, and is therefore exempt from self employment tax.  This is the position the American Bar Association and American Association of CPAs are recommending Congress to adopt.

4. Adopt the Position that Only Reasonable Compensation is Subject to Self Employment Tax: This position is used by S corporation owners to avoid self employment tax.  Under this position, LLC members receive guaranteed payments for services they provide to the LLC and pay self employment tax on these guaranteed payments.  The LLC members treat the remainder of the LLC profit as being exempt from self employment tax.  This is probably the approach adopted by many LLC owners, however there is no authority for this position.

5. Simply Operate Your Business as an S Corporation: The self employment tax rules for S corporations are more established.  I have a prior blog post explaining them here.  However, the rules for S corporations that provide professional services may be about to change.  More about that in a future post.

BONUS STRATEGY:  Use an S Corporation to Own LLC Interests

S corporation owners are only subject to self employment tax on their compensation (which must be reasonable).  An S corporation can be used to own an LLC interest.  When the LLC distributes profit to the S corporation, the shareholder is taxed on the income but is not subject to self employment tax.  However, the S corporation should pay a reasonable salary to the shareholder for work performed.  Finally, a business purpose should exist for the S corporation owning the LLC interest (tax savings alone is not a valid business purpose).

This post contains general tax information that may or may not apply in your specific tax situation. Please consult a tax professional before relying on any information contained in this post.

Buzzkill Disclaimer: Any tax advice contained in the body of this post was not intended or written to be used, and cannot be used, by the recipient for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions. Any information contained in this post does not fall under the guidelines of IRS Circular 230.

Can You Deduct Transportation Costs for Business or Work? Find Out…

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This post will help those who do a substantial amount of driving for business or work and who are unsure how to deduct transportation expenses.

Commuting expenses fall into four categories:

1. Transportation from your home to your regular place of business
2. Transportation between places of business
3. Transportation to a temporary work location

4. Transportation from your home office

1. Transportation from Your Home to Your Regular Place of Business.
None of these expenses are deductible business expenses. They are considered personal expenses and are therefore not deductible.  Simple enough…

2. Transportation between Places of Business
These expenses are deductible.

Example: Jane runs a dry cleaner with two locations. The drive from her home to either dry cleaner is not deductible. However, any travel between dry cleaners is a deductible business expense. At the end of the day, her drive home from the dry cleaner is not deductible.

Example 2: Joe is an attorney who often participates in seminars. Joe is going into the office to do some work, and then will give a seminar later in the day. Again, Joe’s drive from home to the office is not deductible. Joe’s drive from his office to the seminar location is deductible because it is travel between places of business.

3. Temporary Versus Regular Place of Business
As mentioned above, travel between your home and your place of business is not deductible. The IRS provides exceptions for temporary work locations. Under certain circumstances, travel between your home and a temporary work location is deductible. A temporary work location is a location you expect to work at for one year or less.

There are two situations where this exception applies:

You have no regular work location:
If you work in a metro area, but not regularly at any specific location in that metro area, the commute between your home and a temporary work location in that metro area is not deductible. However, the commute between your home and a temporary work location outside the metro area is deductible.

The term metro area is not defined, however the Tax Court has held that travel greater than 35 miles from home is outside the metro area.

Example: Jenny is a salesperson who lives in Warren, MI. She does not work out of an office, but travels to locations within Metro Detroit to make sales calls. Even though every call Jenny goes on is to a temporary work location, none of her commuting expenses are deductible because they are within the metro area.

Example 2: Same facts as above, except that Jenny now has a sales call in Traverse City, MI. Because Traverse City is outside the metro area, commuting expenses to Traverse City are deductible.

You have an regular work location:
Again, travel between your home and your regular work location is not deductible.

However, travel between your home and a temporary work location in the same trade of business (inside or outside the metro area) is deductible.

Example: Joe is a CPA (a complete incompetent!) with an office in Birmingham, MI. Joe is hired to conduct an audit of a company in Ferndale. The audit is expected to last less than one year. Any travel between Joe’s home and Ferndale is deductible because it is a temporary work location. This is so even though it is within the metro area.

4. Transportation from Your Home Office
If your home office qualifies as your principal place of business (see my prior blog post on here) commuting expenses between your home office and another work location are deductible. Claiming all commuting expenses between your home office and other work locations is a huge advantage of claiming a home office deduction through the principal place of business criteria.

Where to Deduct Commuting Expenses
If you are a business owner, commuting expenses are deducted on your business return (i.e., Schedule C for proprietorships, Form 1120S for S corporations, or Form 1065 for partnerships). If you are an employee, commuting expenses are deducted on Schedule A of your personal tax return as a miscellaneous itemized deduction. Miscellaneous itemized deductions must be reduced by 2% of your Adjusted Gross Income (the bottom line on page 1 of your Form 1040). So, if your Adjusted Gross Income is $50,000, your miscellaneous itemized deductions in excess of $1,000 ($50,000 * 2%) are deductible.

This posting contains general tax information that may or may not apply in your specific tax situation. Please consult a tax professional before relying on any information contained in this post.

Buzzkill Disclaimer: Any tax advice contained in the body of this post was not intended or written to be used, and cannot be used, by the recipient for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions. Any information contained in this post does not fall under the guidelines of IRS Circular 230.