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.