Category: Individuals Copyright 1998, The Tax Resource Group. All rights reserved. Telephone 800-578-3498. Internet: www.taxresourcegroup.com IRC Section 1402(a)(1) excludes from the definition of self-employment income all income and related deductions from real estate rentals and the rental of related personal property. IRC Section 1402(a)(13) excludes from the definition of self- employment income allocable to a limited partnerexcept for guaranteed payments. Both these statutes and their related regulations were enacted prior to the existence of limited liability companies. Members of limited liability companies (LLC's) share certain things in common with limited partnersmost notably, limited liability. At the time Section 1402(a)(13) was enacted, most state limited partnership statutes prohibited limited partners from participating in management. As such, a limited partner could expect to be a passive participant, and the exclusion from self-employment tax was justifiable on those grounds. Application of the general rule of Section 1402(a)(13) to all LLC members would shield such members from self-employment tax. Since all LLC members have limited liability, even those members actively involved in management, it is arguably inequitable to apply to them the rules designed to shield passive limited partners from imposition of the self-employment tax. In 1994, the IRS issued proposed regulations treating an LLC member as a limited partner provided the member does not have authority to participate in management, the LLC could have been formed as a limited partnership in the same jurisdiction, and the member could have qualified as a limited partner. Proposed Regulation 1.1402(a)- 18. The 1994 regulations were withdrawn when the IRS issued a new set of proposed regulations in early 1997. Proposed Regulation 1.1402(a)-2. The 1997 proposed regulations treat a limited liability company member as a limited partner unless: 1) the member has personal liability for LLC debts: 2) the member has authority to contractually bind the LLC under state law; or 3) the member participates in management for more than 500 hours during the taxable year. In addition, the 1997 regulations provide that if substantially all the activities of the LLC involve performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, or consulting, the member of such an LLC who provide services as part of that activity cannot be considered a limited partner for purposes of the self-employment tax. Section 935 of the 1997 Tax Act prohibits the IRS from issuing temporary or final regulations on the definition of a limited partner for self-employment tax purposes prior to July 1, 1998. Note that this rule does not counteract the 1997 regulations; rather, it simply prevents the IRS from making this regulation (or any other such regulation) final until July 1, 1998. It has been suggested that there is a rule to the effect that some member of an LLC must pay self-employment tax on his or her earnings. While I can find nothing directly requiring that result, I think the 1997 proposed regulations (and perhaps even the 1994 regulations) have exactly that effect. I suppose it is almost unavoidable that some LLC member must have the ability to contractually bind the entity; otherwise, how could the entity be managed and controlled. As such, it seems inescapable that someone in the LLC must be subject to self employment tax because someone must have the power to bind the entity in order to manage the LLC. It has also been suggested that the controversy surrounding self-employment taxation of LLC income somehow subjects real estate rental income to self-employment taxation if the real estate is owned by an LLC. Based on my reading of Section 1402, I think it is clear that this suggestion is incorrect. I can find no hint in authoritative tax literature or in any commentary sources available to me that this might be the case. The controversy surrounding self-employment tax on LLC members stems from the uncertainty associated with determining whether an LLC member should be treated as a limited partner or a general partner for self-employment tax purposes. In my opinion, underlying this whole controversy is the assumption that the LLC in question is engaged in a trade or business and the income from the LLC is deemed to be self- employment income. Otherwise, the question of whether a particular member's share of LLC income is subject to self-employment tax becomes moot. In other words, it is necessary to have self-employment income in the first instance in order to even reach the question as to whether a given class of owners of the entity producing that income should be subject to self-employment tax on their distributive shares from the entity. There is absolutely no reason to conclude that Section 1402(a)(1) which explicitly excludes income from real estate rental from the definition of self-employment income is somehow invalidated by the choice of entity. If this were really the case, then the same should also be true for other classes of income excluded from the definition of self-employment income such as interest, dividends, and capital gains. 
|