Small Business Taxes & ManagementTM--Copyright 2017, A/N Group, Inc.
Employees have social security and medicare taxes withheld from their pay at the rate of 7.65%; the employer pays a similar amount for a total of 15.3%. Sole proprietors pay the full 15.3%, but only on 92.35% of their net earnings and can deduct half of that on the front page of their Form 1040. The social security portion of the tax tops out at income of $127,200 (2017 amount; indexed for inflation). S corporation shareholders who are employees and receive a salary are taxed the same as regular employees. (Shareholders who are active in the business must take a salary commensurate with their work. The IRS has been aggressively pursuing shareholders who don't.) Partners in a partnership or LLC members are treated the same as sole proprietors--their share of all the income is subject to the self-employment tax, regardless of amount distributed to the partners. (Note. It's assumed in this discussion that when an LLC is mentioned, it's taxed as a partnership. You can elect other treatment, such as being taxed as a corporation. Single member LLCs are taxed as sole proprietorships.)
Partnerships and LLCs
But the rules can get trickier for partnerships and LLCs. Looking at the partnership rules (not LLCs) will make it a little easier to understand. Tax law recognizes two types of partnerships--general and limited. Professionals (doctors, lawyers) have often organized as a general partnership. Each partner is jointly and severably liable for the partnership debts. The partners have broad discretion in allocating profits and capital interests. Thus, a senior partner who put up $100,000 of capital gets 40% of the profits and losses. Ten junior partners who each put up $50,000 may work as hard (if not harder) than the senior partner have profits interests varying from 5% to 10% depending on various factors determined by the partnership. Technically each partner has a say in management. If the partnership has a profit of $900,000 the senior partner would have self-employment income of $360,000 (40% x $900,000); a junior partner with a 10% profits interest would have $90,000 in self-employment income.
The second type of partnership is a limited partnership. A limited partnership is determined under state law and the partnership decides to organize as a limited partnership. A limited partnership must have one general partner. General partners have management power and unlimited personal liability. (But the general partner can be a corporation holding a very small percentage interest. That's typical for a large limited partnership organized to own real estate or another venture.) In a limited partnership the limited partners are not responsible for the debts of the partnership, but have virtually no management power. (Actual rules can vary slightly from state to state.) Limited partners can become liable for partnership debts if they take part in the control of the business.
Limited partners can perform services for the partnership. In that case they would receive "guaranteed payments" (partners in a general partnership can also receive guaranteed payments). Guaranteed payments reduce partnership income, but are subject to the self-employment tax.
In a limited liability company (LLC) all the members have limited liability. They enjoy that limited liability regardless of their management involvement. The question is, are all the members of an LLC subject to the self-employment tax, none of the members, or some of the members? And if it's some, how do you differentiate them?
While the question has been addressed before, the issue came up in a recent Tax Court case (Vincent J. Castigliola and Marie Castigliola, et al.; T.C. Memo. 2017-62). The Court looked to a prior holding noting it first had to inquire whether the person claiming the Section 1402(a)(13) exemption (exempting limited partners in a partnership from the self-employment tax) held a position in an entity treated as a partnership for Federal tax purposes that is functionally equivalent to that of a limited partner in a limited partnership. The Court noted all three individuals were members of a member-managed PLLC (professional LLC). The PLLC had no written operating agreement, nor was there any evidence to show that any member's management power was limited in any way. The Court noted that all the members participated in making decisions regarding their distributive shares, borrowing money, hiring, firing, and rate of pay for employees. Under Sec. 1402(a)(13) they were not limited partners. The Court held their distributive shares were subject to the self-employment tax.
While in many small businesses organized as LLCs all the members would be considered managers, that may not be true for all businesses. For example, Fred, Sue and Sharon start a manufacturing business and organize as an LLC. To get additional capital they take on Bill who has other business interests and just sees the venture as a way to get a return on his capital. Bill might be able to avoid the self-employment tax, but only if he's careful. The LLC should have a statement in it's operating agreement formally restricting any management powers.
Unfortunately, there's no defintion of limited partnership in the law, nor does it mention LLCs. A 2011 Tax Court case (Renkemeyer) is the only other guidance. This is an area where you want to get good advice. The self-employment tax can be significant. On $100,000 the tax would be about $14,000 before taking into account the deduction on Form 1040. It's not unusual for a small business owner for this tax to exceed the regular income tax.
Copyright 2017 by A/N Group, Inc. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is distributed with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional should be sought. The information is not necessarily a complete summary of all materials on the subject. Copyright is not claimed on material from U.S. Government sources.--ISSN 1089-1536
--Last Update 05/22/16