Active Members of an LLC are Subject to Self Employment Tax

Posted on Thu, Feb 26, 2015 ©2021 Drucker & Scaccetti

Attention all limited partners and limited liability members: if you think that you can escape self-employment tax, the IRS may disagree.  A limited partner may be subject to the IRS’s expanded view of the self-employment tax obligation for limited partners under a recently issued Chief Counsel Advice (“CCA”) 201436049.

 

The CCA involves a limited liability company (“LLC”) taxed as a partnership for federal tax purposes. The LLC was a general partner in an investment fund limited partnership, serving as its fund manager. The LLC’s member activities included investment and portfolio management services, legal services and all other management services. Under the LLC’s operating agreement the members were to receive income from the LLC based upon their distributive shares. The limited partnership paid management fees to the LLC, which was treated ordinary income. The LLC treated all its members as limited partners and reported only the member’s guaranteed payments as subject to self-employment tax.

 

In 1997 the IRS issued proposed regulations to define when limited partners would be subject to self-employment tax but these were never finalized.  

 

The CCA concluded the LLC members were subject to self-employment tax because the income from the LLC was derived from its services in managing the funds of the investment fund limited partnership and not from its investments. Internal Revenue Code (“IRC”) Section 1402(a)(3) provides that a limited partner’s share of partnership income is not subject to self-employment tax, except for guaranteed payments. However, the IRC does not clearly define what constitutes a “limited partner.” Although the IRC has not defined self-employment tax on members of an LLC, the Tax Court has established this view in a recent case, Renkemeyer, Campbell, and Weaver LLP vs. Commissioner (136 T.C. 137 (2011)). Here, the Tax Court found that the partners were not limited partners due to their management responsibilities as attorneys and therefore were subject to the self-employment tax.

 

Business owners chose entity structure for a variety of reasons.  As the tax profile of an entity becomes more complex, owners should consider if switching to another more tax efficient structure is warranted.

 

The Tax Warriors® at Drucker & Scaccetti have extensive experience at helping businesses determine the right structures throughout an entity’s life cycle. Complex situations involving multiple entities should be reviewed for tax benefits and efficiencies prior to entering into agreements.  Contact us if you would like a review of your business entity structure. We are always prepared to help you with this or any other tax-related matter.

Topics: partnerships, LLC, law firms, complex, self employment, Tax

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