Are LLC Members Subject to Self-Employment Tax?
Ambiguity in the tax code and regulations has led many limited liability company (LLC) members to take an aggressive position regarding self-employment (SE) tax. They claim that their distributive shares of LLC income — after deducting compensation for services in the form of guaranteed payments — aren’t subject to the tax.
Recently, however, the IRS has been cracking down on LLC members it claims have underreported SE taxes, seeking back taxes and penalties, with some success in court. Considering these developments, it is a good idea for LLC members to review their treatment of SE tax. (For the purposes of this article, LLCs also refer to limited liability partnerships and professional limited liability companies.)
SE tax refresher
The SE tax is designed to ensure that self-employed individuals pay the Social Security and Medicare taxes (payroll taxes) that would otherwise be withheld by an employer. Generally, employers and employees each pay a 6.2% Social Security tax on wages up to a wage base ($128,400 in 2018) and a 1.45% Medicare tax on all wages. Thus, self-employment income is subject to a 12.4% Social Security tax (up to the wage base) and a 2.9% Medicare tax. The “employer half” is deductible as a business expense.
Generally, you are considered self-employed if you conduct a trade or business as a sole proprietor or you are a member of a partnership (including an LLC taxed as a partnership) that conducts a trade or business. General partners pay SE tax on all their business income from the partnership, whether it is distributed or not.
Limited partners are treated differently. Under the tax code, they are subject to SE tax on guaranteed payments for services they provide to the partnership. But, they are otherwise exempt from SE taxes on their distributive shares of partnership income. The rationale for this provision is that limited partners, who have no management authority, are more akin to passive investors than active business participants.
S corporation shareholders who perform services for the business are subject to payroll taxes on their salaries. Along as their compensation is reasonable, they escape SE tax on their distributive shares.
The LLC conundrum
Why all the confusion about the treatment of LLCs? Internal Revenue Code Section 1402(a)(13) was added to the tax code before the advent of the LLC. As the LLC form caught on, many LLC members took the position that they were equivalent to limited partners and, therefore, exempt from SE tax (except on guaranteed payments for services). However, there is a big difference between limited partners and LLC members. Both enjoy limited personal liability, but, unlike limited partners, LLC members can actively participate in management without jeopardizing their liability protection.
Arguably, LLC members who are active in management or perform substantial services related to the LLC’s business are subject to SE tax, while those who more closely resemble passive investors should be treated like limited partners. Unfortunately, guidance on this subject has been scarce. The IRS issued proposed regulations in 1997, but to this day hasn’t finalized them (although it follows them as a matter of internal policy).
Under the proposed regulations, an LLC member’s distributive share is exempt from SE tax unless the member:
- Is personally liable for the LLC’s debts;
- Has authority to contract for the LLC; or
- Participates in the LLC’s business for more than 500 hours per year.
However, there isa special rule for “service partners” in service partnerships, such as law and accounting firms, medical practices and engineering firms. Generally, they may not claim limited partner status regardless of their level of participation.
Some LLC members have argued that the IRS’s failure to finalize the regulations supports the claim that their distributive shares are not subject to SE tax. But, the IRS routinely rejects this argument and has successfully litigated its position in recent years. The courts have imposed SE tax on LLC members unless, like traditional limited partners, they lack management authority and do not provide significant services to the business. Additionally, some courts have ruled that mere management control is enough to defeat limited partner status, regardless of whether that control is exercised.
Review your options
The law in this area remains uncertain, particularly with regard to capital-intensive businesses. But, given the IRS’s aggressiveness in collecting SE taxes from LLCs, LLC members should review their treatment of SE taxes. Those who wish to avoid or reduce these taxes may have some options, including converting to an S corporation or limited partnership, or restructuring their ownership interests. When evaluating these strategies, bear in mind that there are other issues to consider besides taxes.
Sidebar: Capital matters
The IRS has taken the position that limited liability company (LLC) members who participate in management or provide significant services are subject to self-employment (SE) tax on their distributive shares, even if a substantial portion of that income is attributable to returns on invested capital. However, it is uncertain how this approach would be greeted in the courts.
Proposed regulations contemplate situations in which an active LLC member can exclude amounts from self-employment income that are “demonstrably returns on capital invested in the partnership.” For example, they provide that under certain circumstances LLC members may be able to segregate SE income from investment income by holding separate management and investor classes of interests, much like general partners can also hold limited partnership interests.
Know Your Tax Obligations When Hiring Household Help
There are several reasons for hiring household help, including child or elder care or general cleaning and yard maintenance. However, when you hire outside help, you become an employer. Thus, you have specific tax obligations, such as withholding and paying Social Security and Medicare (FICA) taxes and possibly federal and state unemployment insurance. Before making the hire, it is important to understand your tax obligations, as well as the penalties for not meeting them.
In general, if you pay a household worker at least $2,100 in 2018, you also must pay Social Security taxes of 6.2% on cash wages of up to $128,400 (in 2018), as well as a Medicare tax of 1.45% on all cash wages. “Cash wages” refers to compensation paid by, for instance, check or money order — but doesn’t include the value of food, lodging or other noncash compensation.
You are also responsible for submitting the employee’s share of Social Security (also 6.2%) and Medicare (also 1.45%) taxes. If you cover the employee’s share yourself (adding up to 7.65%), you’ll need to include that amount as wages for income tax purposes, but not for reporting Social Security and Medicare.
If you pay an employee $1,000 in any calendar quarter, you also may owe federal unemployment (FUTA) tax. This is 6% of the first $7,000 of cash wages per employee — up to $420 of tax each year — though this amount may be offset by a credit. Some states also impose their own unemployment tax.
Keep accurate records
You will need to record the names, addresses, Social Security numbers, and cash and noncash wages paid to household employees, as well as taxes withheld or paid, and retain this information for at least four years after the due date of the tax return on which the taxes were reported. In addition, you must obtain an Employer Identification Number, or EIN.
By January 31 of each year, you will need to provide your employees with IRS Form W-2 (“Wage and Tax Statement”) for the previous year. You also must file a copy with the Social Security Administration.
You will have to file Schedule H, “Household Employment Taxes.” After calculating the total amount of Social Security, Medicare, FUTA and withheld federal income tax, you will add this to your income tax liability for the year.
To avoid having to pay household employee taxes when you file your return, you can make estimated payments throughout the year. Or, if you are employed, you can ask your employer to increase the amount of federal income tax withheld.
Exceptions to the rules
These tax and reporting obligations do not apply in the following situations, even if the employee’s annual wages total more than $2,100:
- The employee is under age 18 (unless household employment is his or her primary occupation);
- The employee is your spouse;
- The employee is your child and under age 21; and
- The employee is your parent — though some exceptions apply that might cause the wages to be included.
Using an independent contractor also can relieve you of some tax and reporting obligations — but the individual must be actually be an independent contractor. The distinction between employee and contractor hinges on several factors, including how much control the worker has over the work done, and whether he or she offers services to the general public.
Turn to your advisor
If you are considering hiring outside household help, it’s critical to understand your tax obligations. To avoid penalties due to missteps, consult with your tax advisor.