T A X A T I O N

c o r p o r a t e t a x a t i o n

Minimizing Self-Employment Taxof LLC Managing Members

^\' Jatiet Meaile

A lthough a limited liability com-pany (LLC) is rapidly becomingthe entity of choice for most

new closely held businesses, the self-employment (SE) tax treatmentof LLC members, who areclassified as "partners" for fed-eral income tax purposes,remains ambiguous. Largelybecause of this ambiguity, manyadvisors are hesitant to recom-mend using LLCs, optinginstead for S corporations. Butcontrary to widespread belief, Scorporations do not necessarilyenjoy an automatic advantageover LLCs in the SE tax realm.

Self-Employment TaxThe SE tax is an additional

tax of 15.3% that is levied on anindividual's SE income in excessof $400. Generally, SE incomeincludes income derived fromany trade or business carried onby an individual, plus the distributive shareof income or loss from any trade or busi-ness conducted by a partnership of whichthe individual is a partner under the taxlaw. Certain types of income, including realestate rentals, dividends, interest, and cap-ital gains, are not necessarily consideredSE income, ln addition. SE income doesnot generally include most of an individ-ual's earnings attributable to limited part-nership interests, other than guaranteedpayments for services. The rationale behindthis treatment is that general partners derivetheir income from the performance of ser-vices, while limited partners derive theirincome from capital.

The different treatment of general andlimited partners in certain circumstancesallows a partner in a limited partnership

to bifurcate partnership distributions.Guaranteed payments and income alloca-ble to a partner's general partnership inter-est are classified as SB income :ind iire sub-ject to SE tax, while income allocable toa partner's limited partnership interest is

not. A partner who receives both incomebased on services rendered to the partner-ship and income derived from capitalinvested in the partnership may conse-quently be allowed to have only the ser-vice income subject to SE tax.

When the allocations are reasonable, anS corporation shareholder is allowed a sim-ilar bifurcation of income because the SEincome of such a shareholder includes onlyamounts received as compensation for ser-vices rendered to the S corporation. Thus,payments of salary, bonuses, and profes-sional fees are subjeet to SE tax, whileother Items of income or loss that auto-matically pass through to the shareholderfrom the S corporation avoid taxation. Bothan S corporation shareholder and a limit-ed partner consequently may receive sim-

ilar SE tax treatment on their distributiveshares of income or loss.

In contrast to the well-defined rules gov-erning partners and S corporation share-holders, the SE tax treatment of membersof an LLC classified as a partnership for

federal tax purposes is ambigu-ous. Many practitioners assumeIhat the SE tax treatment of amanaging member of an LLC isthe same as that of a genera! part-ner in a partnership, and that non-managing tnembei"s ;ire treated thesame as limited partners. Thus,they classify all of a managingmember's earnings and distribu-tive income as subject to SE tax,while excluding the distributiveincome of the nonmanagingmembers from the tax.

Proposed TreasuryRegulations Section 1.14021a)-2

The premise for this SE taxtreatment stems from ProposedTreasury Regulations sectionl.l402(a)-2(h)(2). which effec-

tively equalizes the positions of limitedpartners and certain LLC members whoare not managers by treating partners ormembers of an LLC as limited partnersunless they meet one of the following tests:

• They have personal liability for debtsor claims against the p;irtncrship;• They have authority to contract onbehalf of the partnership; or• They participate in the partnership'strade or business for more than 500 hoursduring the partnership's tax year.

The 500-hour test is modified lorLLCs engaged in professional services,such as medicine, law, engineering, archi-tecture, accounting, actuarial science, orconsulting. For those entities, no memberwho provides more than some de min-imis amount of services to the LLC can

32 JUNE 2006 / THE CPA JOURNAL

qualify for treatment as a limited partnerfor SE tax purposes.

Proposed Treasury Regulations sectionl.l4O2(a)-2 was originally issued by theIRS in 1997. However, because of contro-versy over the SE tax treatment of limitedpartners who are active in a partnership'sbusiness. Congress prohibited the IRS frommaking the regulations final before July I,1998, believing instead that Congressshould formulate such mics. Since the expi-ration of the moratorium, neither Congressnor the IRS has acted to clarify the SE taxtreatment of LLC members, leaving the pn>posed regulations as the only administra-tive guidance on the matter. Thus, while theproposed regulations are not entitled to judi-cial deference, because they do not repre-sent a legal position, they can be relied onto avoid a penalty under IRC section6406(f), and there is judicial precedence, inElkins [81 T.C. 669 (1983)], to reasonablyconclude that the courts will sustain theposition of a taxpayer who relies on pro-posed regulations.

Given the historical significance ofproposed Treasury Regulations section1. 14O2(a)-2. the strategies below have beenproposed as ways to minimize the SE taxof an LLC member. While none of thesestrategies are effective for LLC membersengaged in one of the seven professionslisted above, they can be used by membersof other LLCs.

Bifurcation of a Member's InterestIf an LLC member fails the limited part-

ner test because that member participatesin a nonprofessional LLC for more than 500hours during the tax year, Prt)pt>sed TreasuryRegulations section I.l4()2(a)-2(h)(4) allowsthat member to be taxed as a limited part-ner for SE tax purposes if she owns onlyone class of interest and if. immedi^ely afteracquiring the interest, the member has rightsand obligations identical to those of the othermembers who are already classified aslimited partners and who own a substantial(i.e., at least 20%) eontinuing interest in thatclass of interest.

In addit ion. Proposed TreasuryRegulations section 1.1402(a)-2(h)(3)allows an LLC member of a nonprofes-sional LLC who fails one or more of thelimited partner tests, but who holds morethan one class of interest, to be treated asa limited partner with respect to a partic-

ular class of interest if, immediately afteracquiring the interest, the member hasrights and obligations identical to those ofthe other members who are already clas-sified as limited partners and who own asubstantial (i.e., at least 20%) continuinginterest in that class of interest.

Because application of the SE tax to LLCmembers under the proposed regulations

depends not only upon their formal statusas members or managing-members but alsoon their level of participation in the entity,strategies for minimizing an LLC member'sSE tax exposure generally involve the gov-erning provisions of the LLC. This isbecause issues such as the designation of amanager and the extent of authority givento nonmanaging members, while funda-

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mentally business consider^ions. have sig-nificant tax implications.

The proposed regulations specifieallyallow bifurcation of an LLC member'sdistributive share of income in situationswhere the member holds dual classes ofinterest, one of which is the same asnonmanaging members. Eurthermore,the proposed regulations seem to sanctiona nominal amount of income attributableto a general-partner interest as long as areasonable guaranteed payment is madefor services rendered to, or on behalf of,the LLC. One strategy for SE tax reduc-tion is to issue two classes of interest, amanaging interest and an investment inter-est, to the same individual.

ExampleM and N form an LLC with managing

interests and investment interests. Holdersof units in each class are entitled to one voteper unit on matters affecting the LLC. Theyare also entitled to share in the profits andlosses of the LLC in pniportion to their shareof total contributions to the LIX'. Only hold-ers of the inanaging units, however, can con-tract on behalf of the LLC.

M purchases one managing unit and 69investment units. N purchases 30 invest-ment units. Under the operating agreementof the LLC, the managing member is toreceive a guaranteed payment of $30,0(X)for his services. At the end of the first year,the LLC has net profits of $100,(X)0. afterdeducting M's guaranteed payment. Mwould report $31,000 as SE income($30,(XX) guaranteed payment plus 1% of$]00,0(X) for his one managing-memberunit). The remaining distributive incomesof $69,000 to M and S30.000 to N areattributable to their investment units, andtherefore would not be SE income.

Eor this strategy to succeed, severalrequirements must be met. First, the LLCmust not provide professional serviees inmedicine, law. engineering, architecture.accounting, actuarial science, or consult-ing. Second, at least one member other thanthe managing member must hold unitsrepresenting a 20% investment ownershipintere,st. and this member (or members) can-not hold a managing interest or ptirticipatein the management of the LLC. As such,this technique is not available to single-member LLCs or those assigning manage-ment responsibilities to all members.

Because the proposed regulations con-tain no family-attribution mles, however,the requirement for a 20% passive owner-ship interest could be satisfied by splittingownership in the LLC between familymembers, provided that the overall allo-cation of income has a "substantial eco-nomic effect" ;uid satisfies the requirementsof IRC section 704(b). The same resultswould be obtained in the example aboveif M and N were husband and wife.

As an alternative for spouses as mem-bers of the LLC. children and other fami-ly members could be included. This strat-egy has the advantage of spreading incomeacross tax rates when children or other fam-ily members are in lower tax brackets, suehas for children not subject to applicationof the "kiddie" tax rules because they areat least 14 years old at the end of the taxyear. As mentioned above, any allocationof income to the members of the LLC musthave a "substantial economic effect" andsatisfy the requirements of IRC section704(b) for it to be respected by the IRS.

Prerequisites to BifurcationEor an allocation of income to have a

"substantial economic effect," the bifurca-tion must be driven by a significant invest-ment business purpose. Generally, thisrequires that the allocation be consistentwith the underlying economic arrange-ments of the members, and that the non-tax economic effect of the allocation besubstantial. An allocation will be consid-ered to have an economic effect if the LLCmaintains its book capital accounts inaccordance with IRC section 704(b), miikesdistributions in accordance with positivecapital accounts, and requires LLC mem-bers to restore deficits in their capitalaccounts upon liquidation of their interest.The economic effect of the a!kx:ation willbe considered substantial if a reasonablepossibility exists that the allocation willsignificantly change the income to bereceived by the members from the LLC.independent of the tax consequences.

An additional pret^uisite to bifurcatingthe managing member's share of distributiveincome from the LLC is that the managingmember's guaranteed payments from theLLC must be high enough to be construedas reasonable for the services rendered.Although numerous court cases have estab-lished criteria for determining reasonable

compensation for employed S corporationshareholders, no comparable standards existto detemiine the sufllciency of a guaranteedpayment to an LLC managing metnber forsimilar services. The amount of the guaran-teed payment must be set with care.

When it is not feasible to have the man-aging member hold dual interests in theLLC, the managing member's SE tax expo-sure can still be minimized by naming amanager wht) is not a member of the LLC.Many states allow outside managers, andwhen this strategy is adopted, none of theLLC members would be subject to SE taxon their distributive share of LLC income.The niiinager. however, must be compen-sated by the LLC for any serviees ren-dered and. as such, would be subject to SEtiix on this compensation (unless it were anentity not subject to SE tax, such as a cor-porate affiliate of an LLC member). In thissituation, however, the IRS might treat theuse of a related-entily manager as a shamtransaction unless the management ser-vices were provided at arm's length andvyith a reasonable business purpose.

Be Certain the CircumstancesAre Right

These proposed bifurcation strategies arenot without risk. Proposed TreasuryRegulations section l.l4O2(a)-2. upon whichthe strategies rely, was issued over eight yearsago and never adopted As such, it is not enti-tled to judicial deference. The IRS, howev-er, has privately stated that until it issues fur-ther guidanc-e in this area, it will not chal-lenge LLC members on SE tax if the mem-bers ;uid the LLC conform to the proposedregulations. Despite this assurdiice. the IRScould, and probably would, challenge anybifurcation of a managing member's incomeif it lacked a "substantial economic effect"or was made without regard to the reason-ableness of the member's guaranteed pay-ment. Thus, these bifurcation strategies areappmpriate only in certiiin circumstances. Butwhen those circumstances exist, bifurcationof an LLC managing member's incomecan create SE tax savings comparable tothose of an S corporation. G

Janet Meade, CPA, PhD, is an associateprofessor in the C.T. Bauer College ofBusiness at the University of Houston.Houston. Texas.

34 JUNE 2006 / THE CPA JOURNAL