Self-employment tax for LLC members.

• Author: Stoops, Kenneth E.
• Position: Limited liability companies

In Letter Ruling 9432018, members of a limited liability company (LLC), which was formed through a conversion from a general partnership, had to include their distributive shares of LLC income in net earnings from self-employment (SE). The members could not use the limited partner exception under Sec. 1402(a)(13). (See Tax Clinic, "LLCs and Liability for Self-Employment Taxes," TTA, Jan. 1995, at 35.) Subsequent unofficial and informal views publicly expressed by IRS National Office personnel echoed the position that LLC members generally would be subject to SE tax. However, recently proposed regulations acknowledge that the limited partner SE income exception may be used in certain instances. Nevertheless, several underlying issues remain unsettled.

Many IRS pronouncements hold that an LLC may be treated as a partnership for Federal tax purposes, depending on the specific provisions adopted in the LLC operating agreement and on the construction of the underlying state statute. (For example, see Rev. Rul. 88-76 and Rev. Proc. 95-10. See also Tax Clinic, "Limited Liability Companies Taxed as Partnerships Even Though Providing Corporate Liability Protection," TTA, May 1989, at 322.)

Due to the potential for partnership tax treatment, coupled with limited liability for the members, LLCs have been described as "limited partnerships with no general partners." This unique status raises the question of how LLC members (who are, in effect, limited partners for Federal tax purposes) should be treated for SE tax purposes. In determining SE net income, Sec. 1402(a)(13) excludes limited partners' distributive shares of income or loss - except for Sec. 707(c) guaranteed payments for services rendered to, or on behalf of, the partnership. Thus, income attributable to limited interests, other than income in the nature of salaries, escapes SE tax. General and limited interests held by the same partner are bifurcated. Consequently, only income from the general partner interest and qualifying guaranteed payments are SE earnings.

According to its legislative history, Sec. 1402(a)(13) was enacted to combat the proliferation of limited partnership syndications aimed at obtaining Social Security coverage for the investors based on what is essentially investment income. However, the recent removal of the cap on earnings subject to the Medicare portion of the SE tax, together with increases in the SE tax rate and earnings base, have compelled taxpayers and...