When is LLC income SE earnings?

• Author: Lynch, Shannon E.
• Position: Limited liability company, self employment

The treatment of limited liability company (LLC) income for self employment (SE) tax purposes is not new, but continues to generate controversy. The LLC has become the entity of choice for many businesses; LLCs are generally treated as partnerships for Federal income tax purposes, unless an election is made to be treated as an association taxable as a corporation. LLCs combine the S corporation benefits of flowthrough taxation and limited liability with partnership-type flexibility of distributions and ownership.

Overview

One of the disadvantages of operating as a partnership and/or LLC, rather than as an S corporation, involves SE tax. SE tax is the Social Security tax that a self-employed individual pays, and includes both the employer and employee's portion of the tax. In 2004, the SE tax rate is 15.3%, 12.4% of which is applied against the first $87,900 of earnings. The 2.9% Medicare tax rate applies to all of the taxpayer's SE income, without limit.

The SE tax applies to trade or business income of sole proprietors, independent contractors and some partners. In general, LLC members are treated as partners and are subject to SE tax. According to Sec. 1402(a), net earnings from SE include a partner's "distributive share of income or loss described in section 702(a)(8) from any trade or business carried on by a partnership of which he is a member." Partnership guaranteed payments are also treated as net earnings from SE, under Regs. Sec. 1402(a)-1(b).

Certain items are statutorily excluded in determining SE net earnings, including, under Sec. 1402(a), real estate rentals, dividends and interest, certain gains and losses front property dispositions, partnership retirement benefits and limited partners' distributive shares.

The exclusion of limited partners' earnings applies as defined in the regulations, not under state law. The IRS issued proposed regulations in January 1997 to replace 1994 proposed regulations (Prop. Regs. Sec. 1.1402(a)-(18) withdrawn partially due to disparate treatment that would have resulted for LLC members with identical rights in different states. The proposed regulations are not effective until finalized. Because there is no definitive IRS guidance, the application of the SE income tax rules has created uncertainty and flexibility for taxpayers. However, because the proposed regulations are the most definitive guidance to date, many taxpayers and tax advisers have applied their definition of a limited partner to...