Ambiguity in the tax law often provides opportunities for taxpayers. For nearly three decades, how earnings of a limited liability company (LLC) are reported for self-employment tax purposes has been unsettled. (LLC in this article also refers to limited liability partnerships (LLPs) and professional limited liability companies (PLLCs).) This uncertainty has created a divergence in practice that has gone relatively unchecked until recently when the IRS started using legal action to clarify the application of self-employment tax laws to LLCs.
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. A significant number of taxpayers have claimed that none of the residual profits after deducting guaranteed payments, or so-called distributive earnings, are subject to self-employment tax even if those earnings were allocated to a managing or otherwise actively working member. To be fair, some taxpayers have taken a more conservative view by applying proposed regulations and limited case law to subject some or all of their distributive share to self-employment income tax. However, taxpayers use both methods today with little consistency.
Lack of judicial precedent and authoritative guidance from the IRS has resulted in taxpayers' aggressively pursuing their own self-interested interpretation of the rules, which has contributed to an increase in the projected tax gap related to underreported self-employment income (including underreporting from LLC members on distributive shares), estimated to be about $65 billion in the years 2008—2010, according to an IRS study.
This degree of underreporting of self-employment taxes has led the IRS to aggressively pursue both taxes and penalties on underreported self-employment income for some LLC members. Emboldened by its recent successes, the IRS appears committed to resolving the ambiguity in this area by creating a body of well-settled administrative and judicial law.
On March 13, 2018, the IRS designated as a compliance campaign issue the underreporting of self-employment taxes by partners rendering services to a partnership (see "IRS Announces Rollout of Five Large Business and International Compliance Campaigns"). This designation will result in the IRS's devoting an increased allocation of time and resources in auditing this issue with the ultimate goal of increasing compliance with the law in light of several recent court decisions discussed in this article. Because of this most recent round of successful IRS efforts in the courts, along with the Service's recent compliance campaign designation, taxpayers and their advisers should immediately reevaluate their reporting of self-employment income for members who are either actively involved or are member-managers in an LLC.
HISTORY OF SELF-EMPLOYMENT TAX AND LIMITED LIABILITY
Sec. 1402(a)(13), enacted in 1977, permits distributive earnings allocated to a limited partner to be excluded for self-employment tax calculation purposes. Limited partners (limited in both their ability to manage the partnership and liability for the partnership's debts) can exclude their distributive share for self-employment tax purposes. General partners (fully active in managing the partnership and unlimited in liability) are subject to self-employment tax on their distributive shares of income. However, with the development of LLCs, federal tax law now clashes with state entity statutes. An LLC member can enjoy limited liability and yet still participate actively in the LLC's management. This situation was never contemplated when Congress created the self-employment tax limited partner exception, because at that time active participation by a partner would always mean unlimited liability.
Since 1977, when Wyoming became the first state to enact a statute authorizing limited liability companies, LLCs have been faced with determining whether a member in an LLC could qualify as a "limited partner" under the Sec. 1402(a)(13) exception and thereby exclude his or her distributive share of income from self-employment tax even though the member might manage the LLC and still enjoy limited liability for the LLC's debts.
In 1997, in an effort to resolve the issue, the Treasury Department issued Prop. Regs. Sec. 1.1402(a)-2, which provided that an LLC member's distributive share would not be subject to self-employment tax unless the member had:
- Personal liability for the LLC's debts;
- Authority to contract for the LLC; or
- Participated in the LLC's business for more than 500 hours per year.
In addition, "service partners" in a service partnership were automatically excluded from claiming limited partner status; all their distributive share of income would be subject to self-employment taxes.
Immediately after the proposed regulations were issued, politicians and pundits alike claimed that the regulations were an attempt by Treasury to legislate without Congress's approval. Congress subsequently passed a one-year moratorium prohibiting Treasury from finalizing the regulations (Section 935 of the Taxpayer Relief Act of 1997, P.L. 105-34). Treasury has yet to finalize the regulations some 20 years later. This failure to issue final self-employment tax regulations has provided some taxpayers with support for a reporting position to claim that distributive income allocated to an LLC member, even a service partner, is excludable for self-employment tax purposes. The IRS has historically disagreed with this position and has recently begun to litigate perceived abusive fact patterns in the courts to counteract this otherwise unchecked reporting position.
RECENT CASE LAW FILLS THE VOID
In a series of recent court cases, the IRS has, for the most part, successfully challenged LLC members who have attempted to exploit the ambiguity created from the IRS's failed effort to issue final self-employment tax regulations. In attempting to discern who should be treated as "limited partners" for self-employment tax purposes, the courts have examined the legislative intent underlying the Sec. 1402(a)(13) exception and found that members or owners who provide services to a business, who have management authority, or who possess other characteristics inconsistent with those of traditional limited partners should be subject to self-employment tax. In this regard, these decisions seem to have come full circle in that they are judicially reviving two of the three original factors included in the 1997 proposed regulations used to determine the status of LLC members for self-employment tax purposes: management control and participation.
The first case involved a group of tax attorneys who had organized their firm as an LLP (Renkemeyer, Campbell, and Weaver, LLP, 136 T.C. 137 (2011)). The attorneys' interests in the LLP had been split into "general managing partner partnership units" and "investing partnership units," and the partners had treated income allocable to the investing partnership units as limited partnership investment income not subject to self-employment tax. The Tax Court rejected this approach on two grounds. First, the court noted in passing that all the partners had management authority under state law governing LLPs. Second, and more importantly, the court emphasized that none of the partnership's income should be excluded from self-employment tax because all of the partners were active participants in the partnership's business. In its decision, the Tax Court stated: "The legislative history of section 1402(a)(13) does not support a holding that Congress contemplated excluding partners who performed services for a partnership in their capacity as partners (i.e., acting in the manner of self-employed persons), from liability for self-employment taxes." After Renkemeyer, taxpayers were put on notice that LLC members providing services to an LLC would be at risk of having their distributive shares treated as self-employment income.
Following on the heels of Renkemeyer, a 2012 district court case examined the extent to which a husband and wife who were the sole members of an LLC and received W-2 wage income from the LLC should be able to exclude their distributive shares of the LLC's income from their self-employment income (Riether, 919 F. Supp. 2d 1140 (D.N.M. 2012)). The couple had argued that their distributive shares were akin to investment income since they had paid themselves a salary as compensation for the services they provided to the LLC. Citing Rev. Rul. 69-184, the court first noted that "a partner who participates in the partnership business is a 'self-employed individual'" and cannot simultaneously be treated as an employee.
The most relevant and novel part of the court's ruling, however, suggested that management control alone would be sufficient to taint an LLC member's income. Explaining its position, the court stated that the taxpayers did not "resemble limited partners, which are those who lack management powers ... whether the Plaintiffs were active or passive in the production of the LLC's earnings, those earnings were self-employment income" (emphasis added).
In 2017, the Tax Court revisited this issue when it heard a case involving a law practice organized as a Mississippi member-managed PLLC (Castigliola, T.C. Memo. 2017-62). The members received guaranteed payments approximating a fair salary for their services, which they treated as self-employment income. However, they did not pay self-employment taxes on their residual distributive shares from the PLLC. The Tax Court found that the members should not be treated as limited partners for self-employment tax purposes because the members shared control of the PLLC under state law, and limited partners lose limited liability protection under Mississippi state law if they participate in the control of the business. Further, the court ruled that the members should be treated as general partners for self-employment tax purposes and pay self-employment taxes on their distributive shares.
Because of its focus on management control only, Castigliola has caused a significant amount of consternation in the tax practice community and has been heavily criticized for its emphasis on form over substance. It could have far-reaching consequences, because the decision could be applied to treat distributive-share income allocated to LLC member-managers as self-employment income solely because LLC members have management authority.
WHAT THE FUTURE HOLDS
With this string of recent cases decided in its favor, the IRS now has more tools to attack strategies for reducing LLC members' self-employment tax liability, and it is likely to become more aggressive in attacking what it perceives as abusive strategies in this area going forward. Indeed, recent Chief Counsel memorandums (see ILM 201436049 and ILM 201640014) suggest that the IRS is willing to use management control or participation, or both factors in combination, to stop LLC members who attempt to avoid self-employment tax on their distributive shares.
LLC members wanting to avoid self-employment tax may want to consider a few options. First, they may want to avoid member-manager status perhaps by carving managerial rights out into a separate interest or by avoiding member-managed structures entirely. Second, LLC members providing services should consider opportunities for segregating their involvement into separate interests or separate entities (see Hardy, T.C. Memo. 2017-16). Interestingly, in doing these things, LLC members would essentially be complying with the proposed regulations issued in 1997. Finally, members may want to instead consider forming an S corporation to better manage self-employment taxes in situations where the S corporation eligibility requirements are satisfied and state law permits the business to be organized in corporate form.
Even with the recent court decisions discussed in this article, significant uncertainty remains in this area of the law. For example, the law remains unclear as to when an LLC member's income is deemed to come from services or from capital, and whether an LLC member's service-based income is sufficient to taint his or her income that is a result of capital investment. This could occur when an LLC member provides some level of services, but where his or her income from capital is significant relative to his or her income from services. To address this and other uncertainties in this area, the IRS placed this issue on its 2016—2017 Treasury Priority Guidance Plan.
The IRS has signaled that it intends to litigate reported exclusions of self-employment taxes on distributive earnings to LLC members who are in a position of management control or who provide significant services to an LLC. This increased enforcement effort, combined with the IRS's successes in Renkemeyer and Castigliola, makes it imperative for taxpayers and their advisers to reevaluate their reporting positions for self-employment income in LLCs where members are managing the enterprise, are providing meaningful services, or otherwise have authority to legally bind the LLC. Failure to do so could lead to tax assessments as well as underpayment penalties for those LLC members.
About the authors
Troy Lewis (firstname.lastname@example.org) is manager of Lewis & Associates CPAs LLC and an associate teaching professor of accounting at Brigham Young University in Provo, Utah. He is the immediate past chair of the AICPA's Tax Executive Committee. Ron Worsham (email@example.com) is an associate professor of accounting at Brigham Young University.
To comment on this article or to suggest an idea for another article, contact Sally P. Schreiber, a JofA senior editor, at Sally.Schreiber@aicpa-cima.com or 919-402-4828.
- "Partners' Limited Liability and Self-Employment Tax," The Tax Adviser, July 2011
- "Using LLCs to Minimize Taxes," Tax Insider, July 17, 2014
- Tax Fundamentals of LLCs and Partnerships — Tax Staff Essentials (#157674, online access; #GT-TSE.TFLP, group pricing)
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