For income tax purposes, a single-member LLC is a “disregarded entity,” which means its operations are reported on the owner’s tax return as if the LLC did not exist.
An LLC with two or more owners is treated as a partnership. The LLC must then file a partnership tax return and is subject to the general tax provisions governing partnerships.
There are a few exceptions to the above tax classification. First, if the only owners of the New Mexico LLC are spouses, and their ownership is as community property, they can either disregard the entity or treat it as a partnership.
LLC owners, without regard to the number of members, can also elect to treat the LLC as a corporation for income tax purposes.
With that background, I’ll move on to my real topic of interest, which is how does a member of an LLC report self-employment tax earnings? One could say just do it the same way you would for a proprietor (disregarded entity) or a partner (partnership status), depending on how you file.
Of course, it’s not that easy. But it is important. The SE tax is paid by self-employed individuals, and it represents both the employer and employee shares of the Social Security taxes.
This means 12.4 percent for the OASDI tax and 2.9 percent for the Medicare tax, or 15.3 percent in total. The self-employed person can then claim one-half of the SE tax as an income tax deduction.
In 2016, the OASDI tax applies only to the first $118,500 of wages; in 2017, that limit increases to $127,200. The Medicare tax applies to all income.
So, most proprietors, partners and members of LLCs prefer to take any actions that might reduce the 15.3 percent SE tax. Proprietors have no flexibility as the tax applies to their net earnings as reported on IRS Form Schedule C.
For partners, including members of LLCs reporting as partnerships, it gets more interesting. The general rule is simple – partners are deemed to be in the business of the partnership and they pay SE tax on any business income of the partnership. That is, they are taxed just like proprietors.
In 1977, Congress created an exception for limited partners. Because limited partners do not generally perform services to help produce partnership income, but are instead often passive investors, a limited partner’s share of partnership income is exempt from SE tax.
If the limited partner does work for the partnership and is compensated with a fixed (“guaranteed”) payment that is not subject to the entrepreneurial risk a partner usually accepts for his income, the fixed payment for services is subject to SE tax.
This special exception was enacted before LLCs became popular and Congress did not consider the proper SE treatment for LLC members, nor have they done so since. So, some taxpayers have argued that LLC members should be subject to the limited partner SE rule.
The IRS Chief Counsel’s Office, which sets litigation policy, has recently issued two memos that deny the limited partner status to members of an LLC. It is not clear that their policy is correct, but it seems that the IRS is looking to ramp up its efforts to subject LLC members to SE tax.
This policy follows a 2011 victory in the Tax Court, but the 2016 memos suggest a newfound vigor in challenging LLC members who have sought to reduce SE tax burdens.
In 1997, the Senate Finance Committee directed IRS to issue no guidance on this issue until July 1, 1998. One could read between the lines that perhaps the Senate planned to do something itself?
Well, of course not. It has become one more thing punted by the legislative and executive branches to the judicial branch. For many years, the punt has been rolling down the field with no one willing to pick up the ball.
The two recent Chief Counsel memos suggest that maybe the IRS is now planning to pick it up and run with it. Taxpayers should start planning to defend against this offensive.
James R. Hamill is the director of Tax Practice at Reynolds, Hix & Co. in Albuquerque. He can be reached at firstname.lastname@example.org.