When are LLC members subject to self-employment tax?

For nearly three decades, the manner in which earnings of a limited liability company (LLC) are reported for self-employment tax purposes has been in dispute.

Lack of authoritative IRS guidance has resulted in aggressive interpretations of the rules, causing the IRS to pursue both taxes and penalties on underreported self-employment income. This is of particular relevance to real estate investors, who frequently use LLCs to hold real estate.

Net income from self-employment is defined in IRC Section 1402(a) as net income from any trade or business plus the distributive share of income or loss from any trade or business carried on by a partnership, regardless of whether it was distributed. Revenue Ruling 65-272 provides that members of an entity classified as a partnership are generally subject to self-employment tax on their share of the partnership’s income from a trade or business unless otherwise excluded under Section 1402(a).

Limited partners are granted an exception to this general rule under Section 1402(a)(13). Although not fully settled, the IRS has taken the position that LLC members (and limited partners in limited partnerships) may be treated as general partners and subject to self-employment tax in circumstances where those members are active in management or perform substantial services related to the LLC’s business. Self-employment income is subject to a 15.3% tax rate, consisting of 12.4% for Social Security (up to the wage base) and 2.9% for Medicare.

LLC members should also be aware of the areas detailed below as they relate to self-employment tax:

Guaranteed payments

Sec. 1402(a)(13) provides that a guaranteed payment, under Sec. 707(c), to an LLC member for services rendered is subject to self-employment tax.

General partners pay self-employment tax on all their business income from the partnership, whether it’s distributed or not. However, limited partners are subject to self-employment tax only on guaranteed payments for services they provide to the partnership. The rationale is that limited partners, who don’t have any management authority, are like passive investors.

When an LLC’s income is consistent, a member might want a preferred allocation of LLC income opposed to a guaranteed payment. Income via a preferred allocation would be included in the member’s share of rental income and excluded from self-employment income, whereas a guaranteed payment would be deemed self-employment income and subject to the associated taxes.

Under Section 707(a)(2), if a member performs services for an LLC and receives a related income allocation and distribution, the arrangement may be treated as a payment to a third party for services. When this disguised-payment-for-services rule applies, the income would become subject to self-employment tax.

Retirement payments

If the following two requirements are met, retirement payments made to LLC members aren’t subject to self-employment tax: (1) the payments are made under a written retirement plan that provides for bona fide retirement payments on a periodic basis to a class of members and (2) the payments continue at least until the member’s death. To be deemed bona fide payments, they must be paid on account of retirement and measured by age, physical condition, years of services, etc.

Members as employees

Generally, a partner in a partnership or member in an entity treated as a partnership for federal tax purposes cannot simultaneously be treated as an employee. Rather than admitting a member, employees are provided bonuses as their incentive compensation.

Rental income

In general, rental income from real property is exempt from self-employment tax to the extent that it qualifies as passive income. However, income from renting personal property is deemed self-employment income if the taxpayer is actively involved in that trade or business.

Further, income derived from renting living space such as a private residence or condo may be subject to self-employment tax depending on the services provided to the occupant. Services provided primarily for the occupant’s convenience such as maid service; access to Wi-Fi and recreational equipment; and prepaid vouchers for ride-share services would subject the rental income to self-employment tax. Services such as heat and light; cleaning public entrances, exits, stairways and lobbies; or collecting trash wouldn’t subject the income to self-employment tax.

It's crucial for taxpayers and their advisers to revisit the reporting of self-employment income in LLCs when members are involved in management, providing services or have legal authority over the LLC. If you have any questions, contact us for additional information.