Self-Employment Tax: The Rubik’s Cube for Partnerships
How do businesses treat the mysterious self-employment tax?
Have you ever sat down with a Rubik’s Cube and thought you solved the puzzle, only to find one square still out of place? If you are the owner of an unincorporated business treated as a partnership for income tax purposes, the mysterious self-employment tax treatment you receive may just be the ultimate Rubik’s Cube! Under the Internal Revenue Code, all partners are not equal. As a result, the treatment of various types of partners for self-employment tax and certain other income tax purposes is generally very different. Let’s take a quick look at the variety of entities that are most often treated as partnerships:
- General Partnerships – a rare form of business these days, but still conveniently easy to form.
- Limited Partnerships – a very common and often self- employment tax-friendly vehicle.
- Limited Liability Partnerships – the choice of professionals seeking some limitation on liability.
- Limited Liability Companies – the best limited liability vehicle that is not a corporation.
General Partnerships: All general partners are subject to self- employment tax on their share of profits in a partnership. This includes the general partner of a limited partnership. There seems to be no controversy regarding this very basic rule.
Limited Partnerships: Limited partners in a limited partnership receive special treatment under P.L. 95-216, Social Security Amendments of 1977. Under this law, a limited partner is subject to self-employment tax for the payments he or she receives for services rendered to the limited partnership. These payments are called “guaranteed payments,” and if you are a limited partner who receives a Schedule K-1 from a limited partnership for which you perform services, you may have noticed an entry on Line 4 called “Guaranteed payments.” You may have also noticed an amount reported on Line 1 called “Ordinary business income or (loss).” If a positive number appeared on Line 1, this was your share of profits as a limited partner. Thanks to the Social Security Amendments of 1977, this share of profits as a limited partner is not subject to self-employment tax. How can you tell? Look at Line 14 on your Schedule K-1, “Self-employment earnings (loss).” If you are a limited partner, Line 14 should only include the amount of guaranteed payments reported on Line 4.
You might ask yourself, as you try to solve the puzzle, why is this important to me? After all, the
maximum social security wage base is capped at $127,200 for 2017, and who cares if I have more net earnings from self-employment than that? Until 1994, probably no one! However, the wage base for the Medicare tax was eliminated in 1994. As a result, all self- employment earnings are subject to the Medicare tax.
For purposes of illustration, assume you are a limited partner providing services to the partnership and receive guaranteed payments of $250,000 in 2018; your share of profits is an additional $1,000,000. Under the Social Security Amendments of 1977, your $1,000,000 share of profits would not be self-employment earnings, and you would escape the 3.8% Medicare tax of $38,000. Of course, a relatively small portion of that tax would be recovered from the 50% deduction for self-employment tax. Even better, you will also escape the 3.8% net investment income tax under the Affordable Care Act, since you are active in the partnership’s business. This is a loophole that both Congress and the administration is aware of and want to eliminate.
Limited Liability Partnerships: Partners in limited liability partnerships are far less fortunate. The actual section of the Internal Revenue Code that produces the beneficial result noted above for limited partners, Section 1402(a)(13), permits the exclusion for profit from self-employment earnings only for a limited partner. The United States Tax Court and the IRS agree that the exclusion only applies to limited partners, and one early notable United States Tax Court case drives that point home.
In 2011, some attorneys attempted to limit their self-employment tax liability through the use of a limited liability partnership. The attorneys took no guaranteed payments for services rendered and attempted to treat all of their income as a share of profits excluded from self- employment earnings. The court disagreed, noting that a limited liability partner is not the same as a limited partner under state law.
Limited Liability Companies: Limited liability companies did not appear on the horizon until 1977, when Wyoming enacted the first limited liability company act in the United States. The absolute limitation of liability without incorporation was very appealing, and soon afterward every state adopted a limited liability company act. One early problem involved the income tax treatment of limited liability companies. Generally, prior to 1997, limited liability companies were treated as corporations for income tax purposes. However, that all changed with the implementation of the IRS check-the-box regulations in 1997, which treated limited liability companies with more than one member as partnerships.
Now offering both complete limited liability and taxation as a partnership, limited liability companies became arguably more popular than the more cumbersome limited partnerships, which still required a general partner with unlimited liability. However, one sticking point became the treatment of limited liability company members for self-employment tax purposes. Many taxpayers tried to mimic the results of a limited partnership by either creating a managing member who would be akin to a general partner of a limited partnership and include its share of profits in self- employment earnings and exclude the profits of the remaining members from self-employment earnings, just as if they were limited partners. Other taxpayers chose to pay guaranteed payments to limited liability company members for services rendered and treat the remaining share of profits as excludable from self-employment earnings, again treating the members as if they were limited partners. The United States Tax Court and the IRS disagreed. In fact, the current IRS website seems to indicate that all members of a limited liability company are subject to self- employment tax, even if the limited liability company member is inactive, or in other words, the limited liability company member performs no services at all for the limited liability company.
Does this make sense? Of course not! It looks like the Rubik’s Cube puzzle is still unsolved.
A recent United States Tax Court Case, Hardy vs Commissioner, T.C. Memo 2017-16 (2017), adds a new wrinkle. This case involved a limited liability company member who was only a passive investor. The United States Tax Court ruled that a member of a limited liability company that performs no services for the limited liability company is not subject to self-employment tax on his or her share of profits, notwithstanding the apparently contrary position of the IRS. In some limited respects, this decision can be viewed as even contradictory to prior United States Tax Court decisions. The United States Tax Court further ruled that the member’s share of profits constituted passive income. Passive income is generally subject to the net investment income tax, which is the virtual equivalent of the unlimited Medicare tax. However, passive income can be used to offset passive losses that would not otherwise be deductible.
Unfortunately, the position of the IRS and the United States Tax Court regarding a limited liability company member’s status as not the equivalent of a limited partner makes much more sense. Congress did not know back in 1977 that a limited liability company would be treated as a partnership for income tax purposes, and if it did, it might have excluded a member’s share of profits from self-employment earnings. However, it did not, and the simple fact remains that only a limited partner’s share of profits is excluded from self-employment earnings and therefore, not subject to the self- employment tax.
What does all this mean to you? If you are a member of a limited liability company and can influence the decisions of management, you should seriously consider an immediate conversion to a limited partnership structure if the conversion will result in meaningful self-employment tax savings. The optimum structure might include a 1% general partner who would be subject to self-employment tax on a 1% share of profits, with the remaining 99% of the profits being allocable to the limited partners as a share of profits not subject to self- employment tax, but only after thelimited partners receive a reasonable amount of compensation as guaranteed payments subject to self- employment tax. These guaranteed payments will fund the deductibility of a profit-sharing plan or a 401(k) deduction and qualify the limited partner for the deduction for health insurance premiums incurred by a self-employed individual.
The application of self-employment tax to partners continues to puzzle taxpayers and tax professionals. Very recently proposed legislation included in
The Tax Cuts and Jobs Act would change the rules again and eliminate forever the self- employment tax savings opportunity currently available to limited
partners. Sometimes, you have to put the Rubik’s Cube down, having done the best you can and move on. But before you do, consult your
Marcum tax advisor!