Dichotomy of Tax Treatment of members in a managed vs. self managed LLC
LLC's that are managed by their members who are in the service business are going to be surprised when they file their income tax returns. The reason is that even though the LLC may generate a tax loss, the gross income of the LLC is counted as income for Social Security purposes on each member's individual tax return.
In contrast to the well-defined rules governing partners and S corporation shareholders, the SE tax treatment of members of an LLC classified as a partnership for federal tax purposes is ambiguous. Many practitioners assume that the SE tax treatment of a managing member of an LLC is the same as that of a general partner in a partnership, and that nonmanaging members are treated the same as limited partners. Thus, they classify all of a managing member’s earnings and distributive income as subject to SE tax, while excluding the distributive income of the nonmanaging members from the tax.
Proposed Treasury Regulations Section 1.1402(a)-2
The premise for this SE tax treatment stems from Proposed Treasury Regulations section 1.1402(a)-2(h)(2), which effectively equalizes the positions of limited partners and certain LLC members who are not managers by treating partners or members of an LLC as limited partners unless they meet one of the following tests:
- They have personal liability for debts or claims against the partnership;
- They have authority to contract on behalf of the partnership; or
- They participate in the partnership’s trade or business for more than 500 hours during the partnership’s tax year.
The 500-hour test is modified for LLCs engaged in professional services, such as medicine, law, engineering, architecture, accounting, actuarial science, or consulting. For those entities, no member who provides more than some de minimis amount of services to the LLC can qualify for treatment as a limited partner for SE tax purposes.
Proposed Treasury Regulations section 1.1402(a)-2 was originally issued by the IRS in 1997. However, because of controversy over the SE tax treatment of limited partners who are active in a partnership’s business, Congress prohibited the IRS from making the regulations final before July 1, 1998, believing instead that Congress should formulate such rules. Since the expiration of the moratorium, neither Congress nor the IRS has acted to clarify the SE tax treatment of LLC members, leaving the proposed regulations as the only administrative guidance on the matter. Thus, while the proposed regulations are not entitled to judicial deference, because they do not represent a legal position, they can be relied on to avoid a penalty under IRC section 6406(f), and there is judicial precedence, in Elkins [81 T.C. 669 (1983)], to reasonably conclude that the courts will sustain the position of a taxpayer who relies on proposed regulations.
Given the historical significance of proposed Treasury Regulations section 1.1402(a)-2, the strategies below have been proposed as ways to minimize the SE tax of an LLC member. While none of these strategies are effective for LLC members engaged in one of the seven professions listed above, they can be used by members of other LLCs.
Bifurcation of a Member’s Interest
If an LLC member fails the limited partner test because that member participates in a nonprofessional LLC for more than 500 hours during the tax year, Proposed Treasury Regulations section 1.1402(a)-2(h)(4) allows that member to be taxed as a limited partner for SE tax purposes if she owns only one class of interest and if, immediately after acquiring the interest, the member has rights and obligations identical to those of the other members who are already classified as limited partners and who own a substantial (i.e., at least 20%) continuing interest in that class of interest.
In addition, Proposed Treasury Regulations section 1.1402(a)-2(h)(3) allows an LLC member of a nonprofessional LLC who fails one or more of the limited partner tests, but who holds more than one class of interest, to be treated as a limited partner with respect to a particular class of interest if, immediately after acquiring the interest, the member has rights and obligations identical to those of the other members who are already classified as limited partners and who own a substantial (i.e., at least 20%) continuing interest in that class of interest.
Because application of the SE tax to LLC members under the proposed regulations depends not only upon their formal status as members or managing-members but also on their level of participation in the entity, strategies for minimizing an LLC member’s SE tax exposure generally involve the governing provisions of the LLC. This is because issues such as the designation of a manager and the extent of authority given to nonmanaging members, while fundamentally business considerations, have significant tax implications.
The proposed regulations specifically allow bifurcation of an LLC member’s distributive share of income in situations where the member holds dual classes of interest, one of which is the same as nonmanaging members. Furthermore, the proposed regulations seem to sanction a nominal amount of income attributable to a general-partner interest as long as a reasonable guaranteed payment is made for services rendered to, or on behalf of, the LLC. One strategy for SE tax reduction is to issue two classes of interest, a managing interest and an investment interest, to the same individual.