2-person (spouses) LLC

[Lion EA]

The SE savings comes from profits that are NOT due to services of the shareholders, but a return of capital, work of employees, that kind of thing.  If most of the income comes from services of the shareholders, then their "reasonable" salaries will be most of the profits, and there won't be much of an SE savings.  I charge more for a 1120S than for a 1065 and a lot more for an 1120S than a Schedule C and even more for a 1065 than a Schedule C (gotta make the balance sheet balance, for instance).

 

If they meant to be a partnership when they organized the LLC, then they can't tell you in 2015 that they weren't a partnership in 2014.  Or, use Lynn's method.  Ask them a lot of questions, preferably face-to-face, to help them tell you what tax entity they were during 2014.

[NECPA in NEBRASKA]

In my client's case, the income is only from his services. He has minimal expenses and is not planning on doing this work for more than a few years. He really thought that he was going to be an S corp, because he was told that he wouldn't have pay anything but income taxes, because he could take it all as distributions. I informed him that was incorrect as long as I was preparing the returns. That's what happens when you get your tax advice from a construction guy. His wife informed him that he was going to do their returns the correct way. 

[kcjenkins]

Way to go !!!   The abuse of the S Corp to avoid SE tax on earnings for personal services is one that needs to be clamped down on hard.   The fact that some of the worst abusers have been Senators and Representatives should infuriate every honest taxpayer! 

[DANRVAN]

.

 

I think you should delete that document from your post because, unless that information is all a matter of public record, you shouldn't be disclosing that on a public forum.

 

I don't believe it is ever appropriate to disclose any client provided material to anyone without permission, or to disclose who your clients are. Even though it might be public information, it might be considered sensitive and private to your client.

 

Although the chance of anything from this board getting back to your client is next to nothing,  the best practice is to black out name, address, etc.

[Janitor Bob]

It is neither sensitive nor private...it is public information available to anybody who wants it..  seeing the names and addresses was integral to my question.  However, since an appropriate viewing time has passed, I have deleted it.

[Cathy]

There was recently a new CCA (Chief Counsel Advice) on the SE tax question relating to limited partners.  You can see the full text of the ruling at CCA 201436049.  The email I received follows below. I've seen where CCA's pulled a lot of weight over other IRS Memos, etc..even to the extent that returns would be audited to make sure the taxpayer followed the CCA's procedures regarding sensitive issues. I realize the CCA doesn't directly answer JB's initial question, however, I did see where several members of the forum say that limited partners owe SE taxes regardless, which can be in direct conflict with the CCA.  Towards the end of the email highlighted in blue is the basic findings in the CCA.

 

 

 

 

Limited partner income in LLCs probably not subject to SE tax

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Unsubscribe from this list   Dear Tax Professional,

Western CPE is committed to presenting cutting-edge tax law, case analysis, and case presentation to you so that you are always in the know. When you attend one of our annualFederal Tax Update seminars, you will not only receive the most comprehensive tax manual available, you will get season-long manual updates and breaking news straight to your inbox. Just take a look below as we present the IRS’s latest update on self-employment tax for LLC members. Be sure to sign up for one of our seminars today—seating is limited!

Warm regards, 

Vern Hoven, CPA, with a Master’s in Tax eTax Alert™ IRS (Finally) Discusses SE Tax for LLC Members A new Chief Counsel Advice (CCA) addresses the issue of when LLC members are subject to self-employment (SE) tax on their distributive share of LLC income. Section1402(a)(13) provides that the distributive share of income of a limited partner is not included in self-employment income¹. Accordingly, limited partners are not subject to SE tax. Is an LLC member like a limited partner? If an LLC member is treated like a limited partner, the LLC member would not be subject to SE tax on his or her share of the LLC income. In 1997 (yes, 17 years ago), the IRS issued proposed regulations² that would have determined when the distributive share of LLC income is included in the member’s SE income. The regulations were never finalized, even though LLCs are now recognized in all 50 states, and more than 2.1 million LLCs file Form 1065 each year. Finally in a new CCA, the IRS discusses the SE tax issue.
 

Note: The first LLCs were established in Wyoming in 1977.

Management Company LLC provides services to a family of funds. In the CCA, the Office of the Chief Counsel looked at a large investment management company organized as an LLC that acts as the manager of a family of funds, each organized as a limited partnership. The investment management company, Management Company LLC, generally has full authority and responsibility to manage and control the affairs and business of each fund. Thus, Management Company LLC is primarily responsible for carrying out the extensive market research and trading activity of each of the funds. It carries on all investment activities, such as the purchasing, managing, restructuring, and selling of the funds’ investment assets. Members of Management Company LLC and its employees provide these extensive services to the funds. Management Company LLC’s primary source of income is from fees for providing management services to the funds.

Members were treated as employees of Management Company LLC. The members of Management Company LLC worked full-time, performing a wide range of professional services, including services related to investment management, analysis, trading, portfolio management, accounting and tax, information technology, etc. Each member was paid wages and received a Form W‑2 from Management Company LLC.
 

Note: Rev. Rul. 69-184 states that “members of a partnership are not employees of the partnership.” The members should have been compensated with a guaranteed payment. It is likely that Management Company LLC paid wages to its members so that it could make the argument that follows regarding reasonable compensation.

Management Company LLC says its members should be treated like S Corporation employee/shareholders. On its Form 1065, Management Company LLC treated all of its members as limited partners not subject to self‑employment tax on their distributive share. Management Company LLC stated that the “wage” amounts represent “reasonable compensation” for each member, and that each member is a limited partner with respect to his or her distributive share. Management Company LLC reasoned that because Management Company LLC has the same role and business as the S corporation it succeeded, it can continue to apply the same “reasonable compensation” wage rules applicable to corporations. However, if Management Company LLC wanted its members to have the same tax treatment as S corporation shareholders, then it should have stayed an S corporation. The LLC must obey partnership tax law.
 
Management Company LLC members perform services for the business. Members perform extensive investment and operational management services for the LLC in their capacity as members (i.e., acting in the manner of self‑employed persons) and Management Company LLC derives its income described in §702(a)(8) from the investment management services performed by its members. The income earned by members through Management Company LLC is not income that is basically of an investment nature of the sort that Congress sought to exclude from self‑employment tax when it enacted the predecessor to §1402(a)(13). Accordingly, members of Management Company LLC are not limited partners within the meaning of §1402(a)(13), and they are subject to self‑employment tax on their distributive shares of Management Company LLC’s income described in §702(a)(8).

Why are limited partners different? Section 1402(a)(13) was enacted to exclude for coverage purposes certain earnings that are basically of an investment nature and akin to that of a passive investor. The applicable statute did not, and still does not, define a “limited partner³.” In 1997, the Treasury Department and the IRS promulgated proposed regulations defining “limited partner” for §1402(a)(13) purposes. The proposed regulations (which were never finalized) generally provide that an individual is treated as a limited partner unless the individual:

1. Has personal liability for the debts of or claims against the partnership by reason of being a partner,
2. Has authority to contract on behalf of the partnership, or
3. Participates in the partnership’s trade or business for more than 500 hours.

Additionally, the 1997 proposed regulations provided that service providers in service partnerships (e.g., law firms, accounting firms, and medical practices) may not be limited partners. The 1997 proposed regulations applied to all partnerships (including LLCs).

What did we learn from the CCA? If the member performs services in the business of the LLC, the IRS position is clearly that the member’s distributive share of LLC income is subject to SE tax. If the member’s ownership interest resembles that of a limited partner, in that he or she cannot participate and does not participate in the business of the LLC, the distributive share of LLC income is probably not subject to SE tax.
 

Planning idea: For years, we have been saying, “Put it in writing.” If you want your member to be treated like a limited partner, then the LLC operating agreement should spell out that the member is a “non-managing member” and restrict the member’s ability to participate in the management of the LLC’s business. If the member’s income is like a limited partner’s, then it will be passive (§469) and may be subject to the new 3.8% tax on net investment income.
 

See the full text of the ruling at CCA 201436049.
¹Guaranteed payments as described in §707© are included in self-employment income for general and limited partners.
²Congress imposed a “temporary” moratorium on finalizing the 1997 proposed regulations, which expired in 1998.
³At the time of the statute’s enactment, the Revised Uniform Limited Partnership Act of 1976 provided that a “limited partner” would lose his limited liability protection if, in addition to the exercise of his rights and powers as a limited partner, he takes part in the control of the business. Revised Unif. Ltd. Pship. Act (1976), sec. 303(a), 6B U.L.A. 180 (2008).

Sharon Kreider © 2014