SE Tax Planning for LLCs: How to Get the Wishbone
It’s the holiday season once again, and people are wrestling to get the turkey’s wishbone for good luck. Likewise, tax professionals continue to grapple with the structuring of LLCs to minimize self-employment (“SE”) tax exposure for the LLC’s members. Will LLC members end up getting the wishbone or will they be served on a platter to the IRS coffers like a turkey? This month’s Partner’s Perspective will discuss the current state of affairs of the SE tax classification of LLC income and explore some planning possibilities to keep LLC members out of the SE tax slaughterhouse.
The Current SE Tax Menu
The starting point in analyzing the SE tax characterization of LLC income is Code Sec. 1402, which ostensibly provides that SE income is the net income derived by an individual from any trade or business, subject to various statutory exceptions. One of the key exceptions is contained in Code Sec. 1402(a)(13), which exempts a limited partner’s distributive share of partnership income (other than guaranteed payments for services) from characterization as net earnings from self-employment. The $64 questions is how does Code Sec. 1402(a)(13) apply to a member of an LLC.
The first crack the IRS took at this was the issuance of Proposed Regulations in December,1994. These proposed regulations only addressed the characterization of LLC income, and contained numerous flaws. In January, 1997, the 1994 proposed regulations were replace by another set of proposed regulations, which address the SE tax characterization of both limited partnerships and LLCs, attempting to put both types of entities on equal footing.
As will be explained in more detail below, the 1997 proposed regulations often can be followed to obtain a “fair” SE tax result. However, the proposed regulations have some shortcomings and were met with criticism, so much so that the 1997 Tax Act contained a provision that prevented the IRS from issuing temporary or final SE tax regulations until after June 30, 1998. This moratorium was designed to provide Congress with the opportunity to consider and resolve the issue. However, many a turkey day has passed since the moratorium lapsed and we still do not have an answer from Congress. We also have no movement on the IRS front, presumably because it is waiting from guidance from Congress.
As a result, we are in no-man’s land. This may not be so bad, because if one can obtain the desired result by working within the proposed regulations, it is highly unlikely that the IRS would take a position contrary to its own regulations. (Note, however, that, as discussed below, the Proposed Regulations do not apply to service partners in a service partnership.) On the other hand, if the proposed regulations do not provide the desired results, there are structuring alternatives that should be able to fall under the current regulations.
The Approach of the Proposed Regulations
As noted above, the Proposed Regulations subject limited partnerships and LLCs to the same standards for determining the SE income status of a “partner’s” distributive share of income. The Proposed Regulations adopt an approach that does not depend upon state law labels, but rather is one that is “functional” in nature. Let’s see how this is designed to operate.
As provided in Code Sec. 1402(a)(13), the Proposed Regulations provide that net earnings from self-employment do not include an individual’s distributive share of income or loss “as a limited partner.” Being a limited partner, however, is not a function of state law, rather an individual is a limited partner for purposes of the Proposed Regulations (or all or a portion of the individual’s partnership interest is treated as a limited partner interest), if the individual falls into one of three categories. Let’s examine each of these categories separately.
Category #1. A partner is automatically classified as a limited partner, unless the individual (1) has personal liability for the debts of or claims against the partnership (or LLC) by reason of being a partner; (2) has authority to contract on behalf on the entity; or (3) participates in the entity’s trade or business for more than 500 hours during the taxable year. Needless to say, this category knocks out general partners and LLC managers from limited partner status, but it is not necessarily a knockout punch. Limited partner category #2 status still might be achievable.
Category #2. If an individual, such as a general partner or LLC manager, is not considered to be a limited partner under category #1, such individual holding more than one class of partner interest is treated as a limited partner with respect to a specific class of partner interest if, immediately after the individual acquires that class of interest, (1) limited partners (within the meaning of category #1) own a substantial, continuing interest in that specific class of partner interest, and (2) the individual’s rights and obligations with respect to that specific class of interest are identical to those of the limited partners. Whether an ownership interest is considered to be substantial is a facts and circumstances determination, but according to the Proposed Regulations, ownership of 20% or more of a specific class of partner interest will be considered substantial.
This category of limited partner classification raises a difficult issue. What is considered to be a second class of partner interest? Assume Abby and Chloe form Pet Store LLC as equal members, with each contributing an equal amount of capital. While the store will have a full-time manager, the members decide the Abby will be the manager to oversee operations; however, it is not expected that Abby will spend more than a few hours per month involved in LLC operations. Chloe will be a non-managing member. Under such a structure, Abby cannot qualify as a limited partner under any of the three categories of limited partner classification. She does not qualify as a limited partner under category #1 because she is the LLC manager (and, consequentially, can contract for the LLC). She flunks category #2 because she is not regarded as holding two classes of interest and, as explained in more detail below, LLC managers cannot qualify under category #3.
This situation leads to the question of what is necessary to create a second class of partner interest, so that Abby’s distributive share of income, which, in our example, is 100% based upon capital, can escape classification as net earnings from self-employment. For example, what if in exchange for Abby providing the minimal supervisory services that are necessary each year, she were given a partner interest that provided a priority allocation of some percentage of the LLC’s first profits, if any, and she also then received an additional allocation of LLC profits identical to that received by Chloe? It would seem that Abby should be considered as having two classes of partner interest [one of which is identical to the partner interest received by a person (i.e., Chloe) qualifying as a limited partner].
On the other hand, according to the Proposed Regulations, a guaranteed payment for Abby’s services would not create a second class of partner interest. However, there is often not a substantial difference between a guaranteed payment and the receipt of a first level, priority profit allocation (although the latter is not guaranteed to occur). Does it matter if the priority allocation is de minimis? Is this a trap for the unwary?
Category #3. The Proposed Regulations further allow an individual to qualify for limited partner status, without having a second class of partnership interest, but only if the reason the individual did not qualify as a limited partner under category #1 is that the individual participated in the entity’s trade or business for more than 500 hours during the taxable year (in other words, he was not a traditional general partner-type with the ability to contract for the partnership, nor was he liable for partnership obligations). In addition, in order for an individual to qualify for limited partner status under category #3, just as is required by category #2, limited partners must own a substantial, continuing interest in the specific class of partner interest held by the individual, and the individual’s rights and obligations with respect to that specific class of partner interest must be identical to those of the limited partners.
The following example is probably typical of what would fall into category #3. Assume Abby, Chloe and Pablo form the Pet Store LLC. Abby, the idea person, contributes no capital, but is the managing member holding a 30% profits interest in the LLC. Chloe and Pablo each contribute $250,000 of capital and each is provided a 35% share of profits. Chloe is employed as the buyer and provides more than 500 hours of service during the LLC’s taxable year, for which she receives a guaranteed payment.
Pablo would be categorized as a limited partner under category #1 because he does not have liability for the debts of the LLC, does not have the authority to contract on behalf of the LLC (because he is a non-managing member) and does not participate in the LLC’s business for more than 500 hours during the taxable year. On the other hand, Chloe does not qualify as a limited partner under category #1, because of her 500 hour participation, and does not qualify as a limited partner under category #2, because she does not hold more than one class of partner interest. However, Chloe does qualify as a limited partner under category #3 because Pablo, a limited partner by definition under category #1, owns a more than 20% partner (member) interest that is identical to Chloe’s interest (other than the guaranteed payment for services).
Abby does not qualify as a limited partner under any category. She fails category #1 and category #3 because she is a manager, and fails category #2 because she holds only one class of interest. It is critical to note that category #3 is available only to those individuals who fail category #1 because of the “500 hour” rule. Consequently, the distributive share of income of a general partner of a limited partnership and a manager of an LLC that is “attributable” to their contributed capital can only escape SE income characterization, if they hold two classes of partner interest, and the “capital” interest they hold is identical to that of a capital interest held by a qualifying limited partner. Needless to say, this puts more pressure on the definition of what constitutes a second class of partner interest.
In addition to the “guaranteed payment problem,” without doing some structure tweaking, the proposed regulations do not permit a return on capital, even if there are two classes of interest, where there are no qualifying limited partners. For example, assume Abby and Chloe form the Pet Store LLC as equal members, with each contributing $250,000 of capital for necessary inventory and leasehold improvements. They both are to work full-time in the business and both will be managing members. In this circumstance, even if there two classes of interest, one to provide a reasonable payment for the services and the other to constitute a return on the capital contributed by the members, all of Abby’s and Chloe’s income would be SE income under the approach of the proposed regulations, because there are no other qualifying limited partners to “match up” against Abby’s and Chloe’s second class of interest.
Other Menu Choices
In this latter example, or where a guaranteed payment is the desired second class of interest, it is necessary to structure outside the Proposed Regulations (if one does not want to ignore or, potentially, challenge the Proposed Regulations). Sometimes, tax professionals will recommend using an S corporation. In such a situation, a reasonable payment should be made for services rendered, which would be W-2 income, and the remaining income would pass out to the shareholders as non-SE income. This is a perfectly acceptable solution from the standpoint of the SE tax rules; however, the taxpayer then has to live with the inflexibilities working under the S corporation structuring framework.
In some circumstances, a tax professional might suggest returning to
the tried and true limited partnership, with a guaranteed payment being
made to the general partner for services rendered. Of course, it generally
would be recommended that the general partner be a corporation for liability
protection purposes. In our Abby/Chloe situation, they would then be employed
What recently has become a popular approach is a slight variation on the limited partnership theme. Abby and Chloe would form Pet Store LLC and receive non-managing membership interests in exchange for their capital contributions. They would then form a C corporation to be a non-owner manager of the LLC. Abby and Chloe would provide services to the LLC in the capacity of employees of the C corporation. And because the manager is a C corporation, Abby and Chloe could receive C corporation perquisites, such as participating in a cafeteria plan, being provided with fully deductible health insurance and participating in a medical reimbursement plan (if the plan does not otherwise violate discrimination rules). These benefits could not be provided on a deductible basis, if Abby and Chloe received them as partners of a partnership or as shareholders of an S corporation general partner. The LLC would pay a guaranteed payment to the corporation to reimburse it for the cost of services rendered by Abby and Chloe and for the cost of their benefits.
This latter structure is a bit more flexible than the limited partnership format because (1) if the general partner is an S corporation, the perquisites cannot be provided and (2) if the general is a C corporation, it is required to have some ownership interest to be recognized as a partner, meaning that there is some potential double tax cost. On the other hand, if the SE tax regulations are ever adopted in a format that provides reasonable returns on capital, it is easier to make a non-owner manager (which is permitted by LLC statute) to “go away” without a tax cost. This structure should provide Abby and Chloe with the wishbones they both desire.
As a final note, the Proposed Regulations provide that an individual
who is a service partner in a service partnership cannot qualify as a
limited partner under any of the three categories described above. A service
partner is an individual who provides more than a de minimis amount of
services, and a service partnership is one where substantially all the
activities of which are services in the fields of health, law, engineering,
architecture, accounting, actuarial science or consulting. The theory
here may be that if service partnerships still qualify for favorable treatment
under Code Sec. 736 with respect to payments to retiring partners for
their share of goodwill (see Partner’s Perspective at 9558) because
it is deemed that capital is not a material income-producing factor in
a service partnership, then no service partnership income should escape
self-employment tax. Although beyond the scope of this column, service
partnerships having various categories of income might consider segregating
their activities in a manner that avoids the impact of the Proposed Regulations
(which, in any event, are merely in proposed form).