LLC members

Resolving a major issue

From The Tax Adviser:

LLC Members and Self-employment Tax

L imited liability companies (LLCs) are proving to be a very popular form of doing business in the many states that now allow their creation (48 states and the District of Columbia, at last count). However, since such entities are still relatively new, many questions and issues relating to their taxation (and the taxation of their members) have yet to be resolved.

SELF-EMPLOYMENT TAX
One critical issue is the self-employment tax-that is, whether an LLC member will be subject to this tax on his or her share of the LLC’s trade or business income.

The Internal Revenue Service held that LLCs may be treated as partnerships for federal tax purposes (depending on the specific provisions in the LLC’s operating agreement and the applicable state law); as such, LLC members are in effect limited partners. At the same time, self-employment income normally includes a partner’s distributive share of income and loss from any trade or business carried on by the partnership-with an exception for limited partners’ shares of partnership income (not including guaranteed payments). Although, under this rule, LLC members would not be subject to self-employment tax on their shares of the LLC’s income, such a conclusion had never been specifically stated.

1994 proposed regulations . To resolve this issue, in 1994 the IRS proposed regulations providing a two-part test to determine an LLC member’s status either as a limited or general partner for self-employment tax purposes. An LLC member could be treated as a limited partner (and therefore not subject to self-employment tax on the LLC’s income) if (1) the member was not a manager and (2) the LLC could have been formed as a limited partnership in the same jurisdiction and the member could have qualified as a limited partner in that limited partnership.

In effect, state limited partnership laws would have determined the federal tax status of the LLC members.

New proposed regulations . While the 1994 proposals provided some degree of certainty for taxpayers, the reliance on state law caused differing treatment for LLC members whose situations were similar but whose LLCs were formed in different states. To provide more uniform treatment, the IRS recently amended the proposed regulations to remove state law characterization from the equation.

Under the new proposals, an individual generally would be treated as a limited partner unless he or she

• Had personal liability for the partnership’s debts (or claims) by reason of being a partner.
• Had authority (under state law) to contract on behalf of the partnership.
• Participated in the partnership’s trade or business for more than 500 hours during the tax year.

One class of interest exception. If an LLC member fails the general test simply because he or she participates in the partnership’s trade or business more than 500 hours during the entity’s tax year, the member still may be considered a limited partner if (1) he or she has only one class of interest and (2) immediately after acquiring that interest

• Other members, already limited partners under the general rule, own a substantial, continuing interest in that specific class of partnership interest.
• The member in question has rights and obligations identical to those of the specific class of partnership interest held by those other limited partners.

Note: Although a “substantial interest” would be based on all the relevant facts and circumstances, ownership of 20% or more of a specific class of interest would be considered substantial.

Service partnership exception. If substantially all a partnership’s activities involve performing services in the fields of health, law, engineering, architecture, accounting, actuarial science or consulting, any individual who provides services as part of that trade or business is not considered a limited partner.

For a more detailed discussion of this and other recent developments, see the Tax Clinic, edited by Terence Kelly, in the May 1997 issue of The Tax Adviser .

— Nicholas Fiore, editor
The Tax Adviser

Clarification

The March 1997 From The Tax Adviser column, “Tax Legislation Affecting Individuals in 1996” (page 32), dealt with legislation that was enacted during 1996, not provisions effective in 1996.