Tcl - Self-employment Tax and Choice of Entity - December 2005 - Tax Tips

• Publication year: 2005
• Pages: 109
• Citation: Vol. 34 No. 12 Pg. 109

34 Colo.Law. 109 Colorado Bar Journal 2005.

2005, December, Pg. 109. TCL - Self-Employment Tax and Choice of Entity - December 2005 - Tax Tips

The Colorado Lawyer
December 2005
Vol. 34, No. 12 [Page 109]

Articles
Tax Tips
Self-Employment Tax and Choice of Entity
by Benjamin W. Chase

This column is sponsored by the CBA Taxation Law Section to provide timely updates and practical advice on federal, state, and local tax matters of interest to Colorado practitioners.

Column Editors:

Larry Nemirow, Denver, of Davis, Graham & Stubbs LLP, (303) 892-7443, larry.nemirow@dgslaw.com; and John Warnick, Denver, of Holme Roberts & Owen llp - (303) 861-7000, warnicj@hro.com

About The Author:

This month's article was written by Benjamin W. Chase, Denver, an associate with Fairfield and Woods, P.C. - (303) 830-2300, bchase@fwlaw.com.

Before recommending an entity to address concerns of self-employment tax, an advisor must understand the requirements for imposition of self-employment tax, as well as the self-employment tax consequences on various entities commonly used to conduct trades and businesses.

The S corporation is often the entity of choice for individuals when faced with the issue of self-employment tax ("SE tax"). This choice is driven in great part by the fact that a shareholder of an S corporation is never subject to SE tax on the shareholder's allocable share of the trade or business income of the S corporation. Recently however, the exclusion of S corporation shareholders from SE tax has come under scrutiny. One recent study indicates that Social Security and Medicare tax revenues would increase by more than $60 billion by 2010 if shareholders of S corporations were subjected to SE tax.1

Because of recent proposals to impose SE tax on shareholders of S corporations and an initiative announced by the Internal Revenue Service ("IRS") to study compliance issues with respect to S corporations, practitioners should reevaluate the general rule that the S corporation is the entity of choice for SE tax purposes. This article reviews the statutory requirements for imposition of SE tax. It also discusses the impact of SE tax on the forms of business organizations available to individuals who carry on trades and businesses.

Background of SE Tax

Social Security and Medicare are funded in part by taxes imposed on self-employment income pursuant to the provisions of the Self-Employment Contributions Act of 1954 ("SECA").2 In 2005, SECA imposes a 12.40 percent tax on the first $90,000 of an individual's self-employment income to fund Social Security through old-age, survivors, and disability insurance,3 and a 2.90 percent tax on the entire amount of an individual's self-employment income to fund Medicare through hospital insurance.4 Thus, the combined rate of SE tax is 15.30 percent. An individual subject to SE tax is granted a deduction equal to one-half of the individual's SE tax liability.5

Imposition of SE Tax

SECA generally defines "self-employment income" as net income derived from a trade or business carried on by an individual through a sole proprietorship, or an individual partner's distributive share of the trade or business income of a partnership.6 Under this definition, two elements must be present for the imposition of SE tax: (1) a "trade or business" and (2) a "sole proprietorship" or "partnership."

Trade or Business

SE tax is imposed only on income derived from a "trade or business." SECA states that "trade or business" has the same meaning that it has in Internal Revenue Code ("Code") § 162.7 Whether a trade or business exists under § 162 is determined by examining the surrounding facts and circumstances to ascertain whether an activity is regular, frequent, and undertaken for the primary purpose of profit.8 An activity undertaken merely for investment does not constitute a trade or business.9

Congress has limited the scope of the term "trade or business" under SECA by providing statutory exclusions for certain items of income from the computation of SE tax. These excluded items include: (1) certain items of services-based income; (2) certain items of property-based income; and (3) distributive shares of limited partners.

Exclusions of Services-Based Income: The following items of services-based income are excluded from the computation of SE tax, provided that all applicable requirements set forth in SECA are satisfied:

* income received for services as an employee10

* income received for services as a public official11

* income received for services subject to tax under the Railroad Retirement Tax Act12

* income received for services as a minister, member of a religious order, or practitioner of Christian Science13

* income received by a nonresident alien derived from a trade or business carried on within the United States and its territories14

* income received by a retired partner from a partnership15

* income received by a retired insurance salesperson attributable to previously earned commissions.16

Exclusions of Property-Based Income: SECA excludes the following items of property-based income from the computation of SE tax:

* rentals received from real estate (unless received by a dealer in real estate)17

* dividends and interest (unless received by a dealer in stocks or securities)18

* gains from capital assets19

* gains arising under Code § 631 from timber, coal, and iron ore20

* gains from property that is not stock in trade, inventory, or held primarily for sale to customers in the ordinary course of a trade or business.21

Exclusion of Distributive Shares of Limited Partners: A limited partner excludes his or her distributive share from the computation of SE tax to the extent that such amounts are not attributable to guaranteed payments received for services actually performed by the limited partner for the partnership.22

Imposition of Self-Employment Tax on Owners of Entities Engaged in Trades or Businesses

Type of Entity

Owners Subject to Self-Employment Tax?

Sole Proprietorship

Yes

General Partnership

Yes

Limited Partnership

Yes, if general partner

No, if limited partner

Joint Venture

Yes

Limited Liability Company

Yes, if member of single-member LLC taxed as a sole proprietorship

No, if member of single-member LLC taxed as a corporation

Uncertain, if member of multiple-member LLC taxed as a partnership

No, if member of multiple-member LLC taxed as a corporation

Corporation

No, but shareholders of S corporations must receive reasonable compensation that will be subject to employment taxes

Cooperative

Yes, if member receives taxable patronage dividends or value-added payments

Trust

No, unless the trust is characterized as an economic sham

Sole Proprietorship or Partnership

SE tax is imposed only on income derived from sole proprietorships and partnerships that carry on trades or businesses. For purposes of SECA, a "sole proprietorship" is any form of unincorporated organization by which a trade or business is carried on directly by an individual or an individual's employees and agents.23 Under SECA, a "partnership" includes a state law partnership, syndicate, group, pool, joint venture, and any other unincorporated organization that carries on a trade or business.24 The term "partnership" does not include any organization that is taxed as a corporation, trust, or estate.25

SE Tax and Choice of Entity

The following sections discuss the imposition of SE tax on individual owners of...