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Game on for self-employment tax debate

Arthur Godfrey said, “I’m proud to pay taxes in the United States; the only thing is, I could be just as proud for half the money.”

bizO-Hamil_James_BizO-640x255People do want to pay some Social Security taxes because it brings them into the Social Security system. But they would be very pleased to pay a lot less than they do.

We have had several acts that “saved” Social Security by raising the tax burden on workers. There is a real risk of more Social Security tax increases for those in the upper-middle income category and above. Right now, the 6.2 percent OASDI tax is capped at $118,500 of wages. The 1.45 percent Medicare tax is assessed on all covered wages.

Proposals have been floated for years to either eliminate the OASDI wage cap or to create a “doughnut” cap, where the 6.2 percent goes away for some range and then comes back, say at $250,000 of wages.

People who have their own business can try to control the Social Security tax liability by limiting their compensation. This works best when they own an S corporation, so that they are entitled to all corporate earnings, and the only issue is how much is classified as wages and how much as distributions.

The IRS has been on to S corporation owners for some time. If you remember, in the 2001 vice-presidential debate, Dick Cheney accused John Edwards of using an S corporation to avoid Social Security taxes.

What is less clear is self-employed people who operate a business through a partnership. The self-employed pay as much as 15.3 percent tax because they have to pay both halves of the Social Security tax.

Partners are self-employed and cannot play the salary-distribution game that an S corporation owner plays. Under normal partnership tax principles, a partner is considered to be in the same business as the partnership.

This means that, if the partnership has business income, the partner must pay self-employment (SE) tax on his share at rates as high as 15.3 percent. It doesn’t even matter if the partner works in the business – the partnership activities are imputed to the partner.

The Tax Court reached this conclusion in April in a case called Methvin. The taxpayer was a minority partner, with limited rights to participate, with a working interest in an oil and gas deal. His net income was $6,760.

The question was, did he owe SE tax? He said no because he had a minority interest, or because the entity elected out of partnership treatment, or because IRS had approved no SE tax in prior years.

The Tax Court was not persuaded by any of his arguments. And they were his arguments, as he represented himself. I would argue he did not make the best arguments, but he might have lost in any event.

One of Methvin’s problems was that, while he was passive, he was not a limited partner. Limited partners do not pay SE tax on partnership earnings unless they are paid for services rendered.

What remains unclear, and is the focus of most of my problems in this area, is what happens when the business is a limited liability company (LLC). LLC members are not general partners, but they are not limited partners. So how does the SE tax apply to them?

If Methvin had been a member of an LLC, he might have won his case, particularly if the right arguments were made. Or he could have lost anyway.

There are two reasons for this confusion.

First, the IRS has largely avoided the issue of SE tax for LLC members. So has Congress. Second, what is likely the “right” answer depends on exactly what the LLC member does and what the operating agreement allows him to do.

LLCs are popular business entities and are even growing in popularity. SE taxes are high and very likely going higher. The pieces are in place for a battle.

Some members will claim limited partner SE treatment. Others will not, but will try to limit SE tax by paying a fixed amount for services and pay SE tax only on the fixed amount. The stakes are huge and the answers are few. But the game is on.

James R. Hamill is the director of Tax Practice at Reynolds, Hix & Co. in Albuquerque. He can be reached at jimhamill@rhcocpa.com.

 

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