Preface: An LLC with more than one member can be taxed as a partnership, but this brings up an interesting question regarding self-employment tax. Who is a limited partner in an LLC for purposes of the SE tax exemption? The Internal Revenue Code and related regulations do not say.
LLCs and Limited Partner SE Classification Taxation
Credits: Jake Dietz, CPA
Do you get a K-1 from an LLC every year that lists various types of income? Perhaps it also lists self-employment income, which may or may not include all the income on the K-1. This article looks specifically at reporting self-employment income on the distributive share of income for LLC’s taxed as a partnership.
First, let’s look at how partners in a partnership get taxed. Partnerships are pass-through entities for federal tax purposes. The partners of the partnership receive a K-1 allocating to them a share of the partnership’s activity, and then the partner files their personal tax return using information on the K-1. Because partnership items pass-through to the partners, a partner may pay tax on income he never personally received. For example, suppose Samuel is a 50% general partner and received $45,000 for his services to the partnership, which he helps manage. These payments are called guaranteed payments and can be deducted by the partnership. After all expenses were deducted, including the guaranteed payments, the partnership made $20,000 of net income, which it kept in the partnership for future use. Samuel would be subject to income tax on the $45,000 he received as guaranteed payments plus the 50% distributive share of the $20,000 partnership net income, or $10,000. If Samuel is not exempt from self-employment (SE) tax, then he must pay SE tax on the $45,000 guaranteed payments and the $10,000 distributive share.
How would Samuel be taxed if he were a 25% limited partner? Assume Samuel is a limited partner, and he worked for a few days to earn $500 in guaranteed payments. His distributive share of the partnership net income is $5,000. In this scenario, the full $5,500 would be subject to income tax, but only the $500 of guaranteed payments would be subject to SE tax. Why is the $5,000 not subject to SE tax? The Internal Revenue Code in §1402(a)(13) specifically exempts the distributive share (in this example $5,000) of a limited partner’s income from SE tax.
An LLC with more than one member can be taxed as a partnership, but this brings up an interesting question regarding self-employment tax. Who is a limited partner in an LLC for purposes of the SE tax exemption? The Internal Revenue Code and related regulations do not say.
The tax court, however, ruled in Castigliola, T.C. Memo. 2017-62. We can look to this court ruling for guidance. The court considered whether the LLC members were “functionally equivalent to that of a limited partner in a limited partnership.” The court noted that “limited partners typically lack management power but enjoy immunity from liability for debts of the partnership.” The court also noted that the LLC in the case was member-managed. No LLC operating agreement existed that limited the members’ management. Furthermore, the facts indicated that the LLC members participated in management. They were therefore not functionally equivalent to limited partners. The court also noted that “Because there must be at least one partner who is in control of the business, there must be at least one general partner.”
What can we learn from this ruling? If all the LLC members participate in management, then the LLC should probably report the distributive share of income as subject to SE tax, as well as the guaranteed payments. Although the LLC members may enjoy immunity from partnership debts, they should not expect to enjoy SE tax exemption on their distributive share of income if they help manage the LLC.
If the equivalent of limited partners exist in the LLC, then there should be documentation to substantiate the facts. Is there a written operating agreement that supports the argument that they function as limited partners? Is there any other evidence to support or contradict the limited partner claim? There should also be evidence indicating that at least one other member functions as a general partner.
This article is general in nature and should not be considered tax or legal advice. If you have questions on the specifics of an LLC of which you are a member, please contact this office.