Ambiguity in the tax law often provides opportunities for taxpayers. For nearly three decades, how earnings of a limited liability company (LLC) are reported for self-employment tax purposes has been unsettled. (LLC in this article also refers to limited liability partnerships (LLPs) and professional limited liability companies (PLLCs).) This uncertainty has created a divergence in practice that has gone relatively unchecked until recently when the IRS started using legal action to clarify the application of self-employment tax laws to LLCs.
Sec. 1402(a)(13) provides that a guaranteed payment, under Sec. 707(c), to an LLC member for services rendered is subject to self-employment tax. A significant number of taxpayers have claimed that none of the residual profits after deducting guaranteed payments, or so-called distributive earnings, are subject to self-employment tax even if those earnings were allocated to a managing or otherwise actively working member. To be fair, some taxpayers have taken a more conservative view by applying proposed regulations and limited case law to subject some or all of their distributive share to self-employment income tax. However, taxpayers use both methods today with little consistency.
Lack of judicial precedent and authoritative guidance from the IRS has resulted in taxpayers' aggressively pursuing their own self-interested interpretation of the rules, which has contributed to an increase in the projected tax gap related to underreported self-employment income (including underreporting from LLC members on distributive shares), estimated to be about $65 billion in the years 2008-2010, according to an IRS study (tinyurl.com/y7ahe5bv).
This degree of underreporting of self-employment taxes has led the IRS to aggressively pursue both taxes and penalties on underreported self-employment income for some LLC members. Emboldened by its recent successes, the IRS appears committed to resolving the ambiguity in this area by creating a body of well-settled administrative and judicial law.
On March 13, 2018, the IRS designated as a compliance campaign issue the underreporting of self-employment taxes by partners rendering services to a partnership (see "IRS Announces Rollout of Five Large Business and International Compliance Campaigns," available at tinyurl.com/y7p3ed5k). This designation will result in the IRS's devoting an increased allocation of time and resources in auditing this issue with the ultimate goal of increasing compliance with the law in light of several recent court decisions discussed in this article. Because of this most recent round of successful IRS efforts in the courts, along with the Service's recent compliance campaign designation, taxpayers and their advisers should immediately reevaluate their reporting of self-employment income for members who are either actively involved or are member-managers in an LLC.
HISTORY OF SELF-EMPLOYMENT TAX AND LIMITED LIABILITY
Sec. 1402(a)(13), enacted in 1977, permits distributive earnings allocated to a limited partner to be excluded for self-employment tax calculation purposes. Limited partners (limited in both their ability to manage the partnership and liability for the partnership's debts) can exclude their distributive share for self-employment tax purposes. General partners (fully active in managing the partnership and unlimited in...