Beware of IRS Scrutiny of Self-Employment Tax for LLC Members

Beware of IRS Scrutiny of Self-Employment Tax for LLC Members

The IRS is always looking for ways to collect more tax, and limited liability companies (LLCs) are one of the latest targets. In court cases since 2011, the IRS has been giving extra scrutiny to the self-employment taxes paid by LLC members.

There is ambiguity in the law and a lack of clarifying regulations governing self-employment taxes for LLCs taxed as partnerships. Some interpret the law to mean that only guaranteed payments are subject to self-employment tax, while others hold that guaranteed payments and the distributed shares of income for active LLC members are subject to self-employment tax. I bet you can guess which option the IRS prefers.

Let’s take a look at history to understand how we got here.

Back in 1977, Congress enacted Section 1402(a)(13). This code section says that the share of earnings distributed to a limited partner in a partnership is not subject to self-employment tax. This law’s intent was to protect limited partners from self-employment taxes because these partners are likely to be passive investors. Limited partners in a partnership are shielded from liability for the partnership’s debts, but are generally precluded from management. General partners, on the other hand, participate in management and are liable for any debts of the partnership. 

When that law was enacted, LLCs didn’t really exist. Later that same year, Wyoming became the first state to authorize LLCs. The owners of an LLC, who are called “members,” enjoy limited liability from company debts. But, in contrast to limited partners in a partnership, LLC members can also manage the LLC. 

Since 1977, every state enacted its own statute authorizing LLCs. Many taxpayers and their advisors interpreted Section 1402(a)(13) to mean that the non-guaranteed payment portion of an LLC member’s share of income from a partnership is exempt from self-employment tax. Guaranteed payments, which are the form of wage compensation that partners in a partnership receive, are fully subject to self-employment tax.

So, in 1997, to crack down on what the IRS perceived as abuse, the U.S. Treasury Department introduced proposed regulations to specify when an LLC member’s share of partnership income would be subject to self-employment tax. According to those proposed regulations, an LLC member’s share of distributed income would be subject to self-employment tax if these three conditions were true:

  1. The member had personal liability for LLC debts.
  2. The member had the authority to contract for the LLC. 
  3. The member participated in the business of the LLC for more than 500 hours per year.

If these conditions were not true, then the distributed share of income would not be subject to self-employment tax.

Those proposed regulations still have not been finalized more than 20 years later, so this absence of concrete regulations provided many taxpayers and advisors justification for excluding the distributive share of LLC income from self-employment tax. 

Understandably, the IRS does not like this and a number of court cases since 2011 have largely supported the IRS’ position. Judges for these court cases, starting with Renkemyer et al. in 2011, and most recently, in Castigliola in 2017, looked to the legislative intent behind the 1977 statute, which was to shield passive investors from self-employment tax. 

According to judicial analysis, if an LLC member provides significant services to an LLC, that member is not acting as a limited partner. Because the income of an LLC is attributable to the services of active LLC members, the income distributions to those LLC members should be subject to self-employment tax. 

An apparent exception came from the 2017 case of Hardy v. Commissioner. Here, Stephen Hardy, a plastic surgeon, invested in a day surgery facility where he had operating privileges, but which was managed by an employee. The facility was organized as an LLC and taxed as a partnership. Because Hardy’s income distributions were not impacted by how much he used the facility, and because he had no say in the day-to-day operations, the court agreed that his interest in the facility was as a passive investor. Therefore, the court agreed that Hardy’s income distributions were not subject to self-employment tax.

Advisors should be aware of the scrutiny the IRS is giving LLC members and their personal tax returns. By evaluating the level of services your clients provide to their LLCs, you can inform them of the risks –or lack of risks –of taking a particular position on their tax returns.