By Kenneth H. Bridges, CPA, PFS December 2014
Tax rules which were enacted long before the LLC format came into existence provide that a general partner’s K-1 ordinary business income is subject to self-employment tax, while a limited partner’s K-1 income is not (except for “guaranteed payments”). So what about an LLC member? Should an LLC member be treated as a “general partner” or a “limited partner” for purposes of self-employment tax?
IRS regulations which were proposed in 1997, but which have never been finalized, provide that an LLC member will be subject to self-employment tax if:
- He or she has personal liability for the debts of or claims against the LLC because he or she is a member of the LLC;
- He or she has authority to contract on behalf of the LLC;
- He or she participates in the LLC’s business for more than 500 hours per year; or
- Substantially all of the activities of the LLC involve the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, or consulting.
As noted above, these proposed regulations have never been finalized, leaving this as an unresolved issue with taxpayers taking varying positions. As discussed in the August issue of our newsletter, in a recent district court case (Reither, in the U.S. District Court for New Mexico), the court ruled that an LLC member’s K-1 income was subject to self-employment tax. Since the publication of that newsletter, the IRS has issued a Chief Counsel Advice in which it determined that the members of an LLC management company (providing investment management services) were subject to self-employment tax on their K-1 income, notwithstanding their argument that they had been paid reasonable compensation for their services via W-2.
In light of the recent district court case and this IRS CCA, we can probably expect to see increased IRS scrutiny of LLC member K-1 income treated as not being subject to self-employment tax; particularly in the context of LLC members who are active in a services business where the income is more attributable to the provision of services than a return on invested capital.
Michael A. Sudduth, CPA is a partner with Bridges & Dunn-Rankin, LLP an Atlanta-based CPA firm.
This article is presented for educational and informational purposes only, and is not intended to constitute legal, tax or accounting advice. The article provides only a very general summary of complex rules. For advice on how these rules may apply to your specific situation, contact a professional tax advisor.