Written by Tony Nitti, Forbes contributor. Opinions expressed by Forbes contributors are their own
If you’ve worked in the tax preparation world for any measure of time, you’ve assuredly run into the following conundrum:
My client is a member in an LLC. Is his/her share of the LLC’s income subject to self-employment income?
At that point, you went one of two directions:
1. Opened up your tax research software/hard copy Code/Google machine, or
2. Said “screw it, I’ll exclude it,” and went on with your life. (Ed note: this is the option you took).
Had you bothered to take the first option, however, you would have rued your decision, as it likely would have wasted a good chunk of your day. This is because, as hard is it may be to believe, the Code and regulations do not provide any guidance on how to treat an LLC member for purposes of the self-employment tax rules. Late last Friday, however, the IRS provided another form of informal authority that shows just aggressive it will be in pursuing self-employment taxes from certain LLC members, and to be quite honest, it’s a first of its kind and a stance that warrants our attention.
Perhaps we’ve gotten a little ahead of ourselves, however. After all, you can’t appreciate the gravity of as void in the statutory and regulatory authority or the Service’s increasingly aggressive positions on the matter unless you first understand the gravity of the underlying issue: why do we care whether an LLC member is subject to SE tax, and why does no authority exist?
Let’s take it on with a little Q&A:
Q: I’m glad you decided to start from the beginning, because I confess I’m a bit lost. So…first things first: what is this self-employment tax you speak of?
A: /Gives disapproving shake of head and quotes Akryod from Ghostbusters: you never studied.
Under IRC Section 1401, “self-employment income” is taxed at 15.3%– 12.4% goes to the Old-Age, Survivors, and Disability Insurance tax, with the remaining 2.9% earmarked for the Hospital Insurance tax. In addition, beginning January 1, 2013, an extra 0.9% tax is tacked on to a taxpayer’s self-employment income in excess of $250,000 (if married filing jointly, $200,000 if single). Thus, the total self-employment tax burden under current law can reach as high as 16.2%, before considering the deduction for one-half of the self-employment tax (not including the new 0.9% surtax) as permitted by IRC Section 164(f).
Q: Got it. But that begs another question: What is self-employment income?
A: Well, that speaks to the very crux of the issue addressed in the ILM. It gets complicated, so lets take it one step at a time. Under IRC Section 1402, self-employment income is generally defined as the gross income derived by an individual from any trade or business carried on by the individual, less deductions allocated to the business.
Q: So how does that apply to a partner in a partnership?
A: Great question. Because of the pass-through nature of partnerships, partners are generally considered to be conducting the business of the partnership. As a result, explicitly included within the definition of self-employment income is a partner’s distributive share of income or loss from any trade or business carried on by a partnership.
Q: Got it. But what exactly is a partner’s “distributive share” of partnership income?
A: There are three ways a partner can receive income from a partnership. If the partner renders services to the partnership, he can be paid wages and receive a W-2, just like any other employee. While this treatment is popular, it’s also very wrong, as Revenue Ruling 69-184 states that “members of a partnership are not employees of the partnership.”
The right way to compensate an employee for services rendered is to pay them a “guaranteed payment.” This amount is governed by IRC Section 707 and is subject to self-employment tax (more on this later). Lastly, any net income of the partnership that isn’t paid out to the partners as guaranteed payments is divided among the partners, with each partner including his allocable share of the partnership’s net income (or loss) in his taxable income, whether or not the partnership actually distributes this income to the partner. This is known as the partner’s “distributive share” under IRC Section 702.
Q: How ’bout an example?
A: Sure. Partnership AB has two equal general partners, A and B. AB generates $100,000 of net income in 2016 before considering guaranteed payments. A performs services for AB, and is paid $20,000 in guaranteed payments. This guaranteed payment is included in the taxable income of A, but is also deductible by AB, reducing AB’s net income to $80,000. This $80,000 is then divided equally between A and B, with each including $40,000 attributable to the partnership in their taxable income. This $40,000 represents each partner’s “distributive share” of the partnership income, and is included in the income of A and B regardless of whether they ever see a penny in cash distributions. From a self-employment income perspective, A would include in his self-employment income both the $20,000 of guaranteed payment and his $40,000 distributive share. B would include in his self-employment income only his $40,000 distributive share.
Q: OK, so what’s the big deal? You said that guaranteed payments are included in self-employment income, and IRC Section 1402 provides that a partner’s distributive share of partnership income is included in self-employment income, so where’s the controversy?
A: IRC Section 1402, like many provisions of the Code, starts off by setting the general rule– i.e., all trade or business income, including a partner’s distributive share of partnership income, is included in self-employment income–before listing a host of exceptions to that general rule. Specific to this discussion, IRC Section 1402(a)(13) provides that the distributive share of partnership income of a limited partner– other than guaranteed payments–is NOT included in self-employment income.
Q: Great. On to our next definition. What is a limited partner?
A: That, good sir, is exactly what everybody is struggling to figure out, because there is no definition to be found anywhere in the Code. Understand this, however: when IRC Section 1402(a)(13) was added to the statute in 1977, LLCs–the most popular form of doing business as a partnership today–did not yet exist. So when the statute was written, it was intended for conventional partnership forms like limited partnerships.
In a limited partnership, there are two types of partners under state law: general partners and limited partners. General partners are free to manage and control the business; the price they pay for that control, however, is that they have unlimited legal liability. If a creditor cannot be repaid from the partnership, they can pursue the assets of the general partner. A limited partner, to the contrary, has, you guessed it…limited legal liability. A creditor can only take from the limited partner that partner’s investment in the limited partnership, it cannot pursue the limited partner’s personal assets. The cost of that limited liability to the limited partner, at least at the time the exception from self-employment income for limited partners was written into the law– is that under the Revised Uniform Limited Partnership Act of 1976, the limited partner could not take part in control of the partnership.
Q: So if a limited partner was barred from participating in the control of the partnership, what did the limited partners really add to the business?
A: Great question, and it speaks to the intent of Congress in excluding the distributive share of limited partners from self-employment income. Because a limited partner couldn’t participate in any management of the partnership, the limited partner’s involvement was essentially limited to his cash investment in the partnership. It would follow, then, that the limited partner’s distributive share of partnership income was akin to earnings on a passive investment, rather than income from the active conduct of a trade or business. As a result, Congress decided, it shouldn’t be included in self-employment income. If the limited partner performed any services for the partnership and was paid a guaranteed payment, that guaranteed payment would be included in his self-employment income, however.
Q: OK. So, a general partner’s distributive share of partnership income is self-employment income. A limited partner’s distributive share of partnership income is not self-employment income. Seems simple enough. What’s the issue?
A: The issue, smart guy, is that after IRC Section 1402(a)(13) was added to the Code, “Limited Liability Companies” became a thing. In an LLC, unlike a general or limited partnership, ALL of the members of the partnership have limited legal liability. That would seem to indicate that ALL of the members are limited partners. As opposed to limited partners, however, LLC members are permitted to some degree to participate in the management of the LLC, with that permissible degree varying from state to state. As a result, LLC members are a hybrid of general partnership and limited partnership interests that didn’t exist back in 1977, and this poses a huge problem for a tax law that doesn’t yet specifically address the issues created by these hybrid partnership interests.
Q: I just checked Wikipedia, and it says LLCs started in Wyoming in 1977. Last time I checked, it’s now 2016. Are you telling me that in 39 years, the IRS couldn’t address how to treat a distributive share of LLC income for self-employment income purposes?
A: That’s exactly what I’m telling you. Though, if it makes you feel better, the IRS hasn’t found the time to address how to treat an LLC interest for purposes of the passive activity rules of IRC Section 469, either, but that’s an entirely different conversation. Here’s the problem: In 1997, the IRS issued proposed regulations that would govern whether the distributive share of partnership income of LLC members was included in self-employment income. It basically provided that an LLC member would be treated as a limited partner — and thus the distributive share would NOT be self-employment income– unless the LLC member either 1) had personal liability for the debts of the LLC under state law (this would be pretty rare), 2) has authority under state law to contract on behalf of the LLC, or 3) participated in the trade or business of the LLC for more than 500 hours during the year.
Q: Let me guess…the proposed regulations were never finalized?
A: That’s right, largely through no fault of the IRS, but rather because powerful people in Congress and media went ballistic at the idea of this “hidden tax increase,” and that’s why were in the mess we’re in. Without any concrete guidance, the IRS and the courts are left to determine whether an LLC interest is akin to a limited partnership interest on a case-by-case basis.
Q: So if there’s no guidance saying otherwise, we can exclude the distributive income of an LLC member from SE income, right?
A: Sure you can. But as Chris Rock once said, you can also drive a car with your feet, but that doesn’t make it a good idea. Just because nothing in the Code or regulations says you can’t do something, doesn’t mean the IRS won’t argue that you can’t, nor does it mean the courts won’t agree with them.
Q: So you’re saying this issue has ended up in the courts? Do tell?
A: Fine, but you know…you can read these cases just as easily as I can. Just sayin’. In Renkmeyer, 137 T.C. 137 (2011), a group of practicing lawyers formed an LLP. The partners made minimal capital contributions, and rendered significant legal services on behalf of the LLP. As a service partnership, nearly all of the revenue generated by the LLP could be traced directly to the efforts of its members. As a result, the court sided with the IRS that the members were not “limited partners” under the meaning of Section 1402(a)(13), determining that their distributive shares of LLP income were not attributable to their passive investment in the LLP; rather, the income was attributable to the services provided. Because a true “limited partner” is typically limited under state law from providing management functions and significant services, the partners in Renkmeyer more closely resembled general partners, and thus their distributive shares of income were subject to self-employment tax.
In Riether, 919 F. Supp.2d 1140 (D. N.M. 2012), the IRS and courts applied the principles of Renkmeyer to an LLC. A husband and wife set up an LLC that provided radiological imaging services. The services, as you might have guessed, were provided by the husband and wife members. To try and get around the self-employment issue, the members paid themselves a W-2 (don’t do this), and then argued that because they were “employees” of the LLC, they can’t aslo be self-employed — thus, they excluded the remaining share of LLC income from self-employment income. The IRS was not convinced; nor was the court, stating that because the members managed the LLC and provided all of its services, the LLC was not a “limited partnership” and the members were not “limited partners.” As a result, all of their LLC income — not just the income from the W-2 — was subject to SE tax.
Q: Is that it? That’s all the authority we’ve got?
A: Nope. In 2014, the IRS issued CCA 201436049, and I wrote about it back then. If you’ve been paying attention, you may have noticed that the first few items of this Q&A were stolen directly from that column, but hey: it ain’t plagiarism if you rip off yourself. In the CCA, an LLC was a large investment management company which acted as an investment manager of a family of funds. The management company managed and controlled the affairs and business of each fund, and performed activities such as purchasing, managing, restructuring, and selling all of the funds’ investment assets. Of course, partnerships don’t provide services, people do, so the actual services were provided by the members of the management company LLC. Each partner worked full-time and performed a wide range of services to the LLC.
Because the IRS had no regulations on which to rely, it began its analysis by looking to the legislative history to IRC Section 1402(a)(13). In doing so, the IRS reiterated that the exclusion from self-employment income for limited partners was intended to protect partners whose interest in the partnership represented merely a passive investment. In the facts of the ILM, however, the IRS argued that by virtue of their considerable management services, the members of the LLC represented service partners in a service partnership acting in the manner of self-employed persons. It was not the intention of Congress, the Service noted, to exempt partners who performed services for a partnership in their capacity as partners from self-employment income on their distributive share.
Relying on the legislative history and the decisions in Renkmeyer and Riether, the IRS concluded in the ILM that the services provided by the management company LLC’s members were extensive, and that those services directly correlated to the income earned by the LLC from the funds. As a result, each member’s distributive share did not represent income which is basically of an investment nature that Congress intended to exclude from self-employment income when it enacted IRC Section 1402(a)(13). Thus, each LLC member was not a limited partners, and each member’s share of the distributive income was self-employment income.
Q: OK, so after 2,500 words, I’m guessing you’re finally ready to tell us about this latest IRS determination, and what makes it so important?
A: Yes, yes I am. On Friday, the IRS issued Chief Counsel Memo 201640014, which represents the Service’s most expansive application to date of the self-employment tax rules to an LLC member. In the memo, a taxpayer purchased a number of restaurant franchises and dropped them into an LLC, with the remaining ownership interest owned by the taxpayer’s wife and a trust.
The franchise agreements required the taxpayer to personally devote full time to the operation and management of the restaurants. As a result, he was the operating manager and CEO, and conducted the day-to-day affairs of the LLC, including purchasing and selling LLC property, hiring and firing employees, establishing pension plans, and hiring the accountants, investment advisors, and legal counsel.
These were large restaurants, however; as a result, they required many employees to man the various grills, shake machines, and drive-thru windows. More importantly, as opposed to the facts in Renkmeyer, Riether, and CCA 201436049, a restaurant sells goods, not services. Thus, one could argue that the efforts of the taxpayer, while key to managing the restaurants, were not directly responsible for the LLC’s revenue; after all, if the taxpayer didn’t show up for work one day, the food would still be prepared and the resulting sales generated. Lastly, restaurants, as opposed to investment advisory firms, law firms, and radiological imaging companies, require significant capital; nearly all of which was provided by the taxpayer.
Based on these facts, the taxpayer believed that his income from the LLC was not subject to self-employment tax. Yes, he had provided significant services to the LLC, but he had also been paid a guaranteed payment for those services, which would be subject to self-employment tax.
He had also, however, contributed significant capital to the LLC, and thus it was his belief that the distributive share that flowed to him from the LLC was a return on his investment. And this, he maintained, differentiated him from the taxpayers in the previous authorities — who provided services to a service partnership, where capital was not a material income producing factor – and made him a “limited partner” in the manner that was intended when Congress enacted Section 1402(a)(13).
The IRS disagreed, subjecting the taxpayer’s distributive share of LLC income to self-employment tax.
The Service was dissuaded by the taxpayer’s appeal that he made significant capital contributions, opting instead to focus on his role in the management of the LLC:
Here, taxpayer has sole authority over the LLC and is the majority owner, operating manager, president, and CEO with ultimate authority over every employee and each aspect of the business. Even though LLC has many employees, including several executive-level employees, taxpayer is the only partner of the LLC involved with the business and is not a mere investor, but rather actively participates in the LLC’s operations and performs extensive executive and operational management services for LLC in his capacity as a partner. Therefore, the income taxpayer earns through the LLC is not income of a mere passive investor that Congress sought to exclude from self-employment tax…
Undeterred, the taxpayer argued that as opposed to service partnerships, when an LLC member 1) derives LLC income from the sale of products, 2) has made substantial capital investments, and 3) has delegated significant management responsibilities to executive-level employees, a different analysis should apply. In summary, the LLC member should be permitted to receive a “reasonable return on his capital investment” in the form of LLC income that is NOT subject to SE tax.
Once again, the IRS disagreed, concluding that even if the guaranteed payments made to the LLC member represented reasonable compensation for his services, that did not mean that the remaining income allocated to the member should be excluded from SE tax as a return of capital invested. Instead, the IRS just kept it simple: because the taxpayer participated in the management of the LLC by performing significant services, he was not a “limited partner,” and as a result, all of the income allocated to the member — even that income that may very well have represented his return on capital invested — was required to be included in SE income under Section 1402.
Q: Hey, man…this has been fun and enlightening and all, but we’re at 3,200 words. Can you wrap this up so I can move on with my life? Maybe just a quick summary?
A: No problem, I’m sure you have veerry pressing matters to tend to. Take away this from the 3,200 words: in the past, the IRS has made it clear that if an LLC member provides significant services to a service LLC, then the member is not a limited partner, because the income of the LLC is attributable to the services rendered by the members. In this latest memo, however, the IRS determined that even when the LLC is not a service partnership, but instead sells a product, it doesn’t matter…if the LLC member manages the LLC, it is the opinion of the IRS that all of the income attributable to the member is subject to SE tax, even if a portion of that income could reasonable be argued to represent a return of the LLC member’s capital investment to the LLC.
This forces us to reevaluate the way we handle our clients who are members in an LLC. The bottom line: if the LLC member is actively involved in the management of the LLC, the income needs to be subject to SE tax.