Applying the SE tax rules to LLC members.

• Author: O'Connell, Frank J., Jr.
• Position: Self-employment, limited liability company

According to an IRS official and a national issue specialist in its Examination Specialization Program, until the Service issues further guidance, it will not challenge limited liability company (LLC) members on self-employment (SE) tax if the member and the LLC conform to the most recent (1997) proposed regulations (REG-209824-96). These regulations, however, need clarification now on the definition of limited partner (LP).

General Rules

Under Prop. Regs. Sec. 1.1402(a)-2(h)(5), if substantially all of a partnership's trade or business activities involve the performance of services (i.e., consulting), any individual who provides such services as part of that trade or business will be a general partner (GP) for SE tax purposes.

In a "nonservice" partnership, Prop. Kegs. Sec. 1.1402(a)-2(h)(2) treats a partner as an LP for SE tax purposes, unless he or she:

1. Has personal liability for the partnership's debts by reason of being a partner;

2. Has the authority to contract on the partnership's behalf; or

3. Participates in the partnership's business for more than 500 hours during the entity's tax year.

Even if a member does not meet the hours test or is not personally liable for a partnership's debts, an individual serving as a manager in a member-managed LLC would be subject to SE tax. If the LLC agreement does not precisely give the managing rights to a specific individual, all members would be subject to SE tax.

Exceptions and Clarifications

In general, under Sec. 1402(a), "net earnings from" SE include the gross income derived from any trade or business carried on by an individual, less any allowable deductions attributable to such trade or business, plus his or her distributive share of income or loss from any trade or business carried on by a partnership of which he or she is a member.

Under Regs. Sec. 1.1402 (a)-2(f), a "partnership" includes a syndicate, group, pool, joint venture or other unincorporated organization that carries on a trade or business, but is not a trust, estate or corporation.

For this purpose, gross income includes payments received by a partner from the partnership for services rendered to the partnership or for the use of capital by the partnership (guaranteed payments). However, Sec. 1402(a) provides a number of specific exceptions from SE earnings, such as (1) rental income or loss from real and personal property, (2) interest and dividend income, (3) gains or losses from sales or exchanges of capital assets and...