Thursday, September 22, 2016
An aspect of estate and business planning for farmers and ranchers (and other small businesses) that has popped-up since the enactment of the health care law in 2010, includes planning to minimize the impact of the Net Investment Income Tax (NIIT). Often, clients have a desire to simultaneously minimize self-employment tax. The strategy to minimize both taxes involves the use of the limited liability company (LLC) – a particular type of LLC. That’s the topic of today’s blog post
If we look at the applicable proposed regulations, an LLC member has self-employment tax liability if: (1) the member has personal liability for the debts or claims against the LLC by reason of being a member; (2) the member has authority under the state’s LLC statute to enter into contracts on behalf of the LLC; or (3) the member participated in the LLC’s trade or business for more than 500 hours during the LLC’s tax year. Prop. Treas. Reg. §1.1402(a)-2(h)(2). However, the LLC could be structured as a manager-managed LLC with two membership classes as a means of minimizing self-employment tax. With that approach, the income of a member holding a manager’s interest is subject to self-employment tax, but if non-managers that participate less than 500 hours in the LLC’s business hold at least 20 percent of the LLC interests, then any non-managers that participate more than 500 hours in the LLC’s business are not subject to self-employment tax on the pass-through income from their LLC interest. Prop. Treas. Reg. §1.1402(a)-2(h)(4). They do, however, have self-employment tax on any guaranteed payments.
This all means that it is possible to utilize a manager-managed LLC with the taxpayer holding both manager and non-manager interests that can be bifurcated. The result is that an individual holding both manager and non-manager interests is not subject to self-employment tax on the non-manager interest, but is subject to self-employment tax on the pass-through income and a guaranteed payment attributable to the manager interest.
Let’s look at an example on this issue prepared by Paul Neiffer, the author of the farmcpatoday.com blog:
Example: Bob and Mary, a married couple, operate their farming business in an LLC. Mary works full-time as a nurse and is not involved in the farming operation. She does, however, have a 49 percent non-manager ownership interest in the LLC. Bob, works on the farm and has a 49 percent non-manager interest along with a 2 percent manager interest. Bob receives a guaranteed payment for his manager interest that equates to reasonable compensation for his services to the LLC. The result is that the LLC’s income will be shared pro-rata according to the ownership percentages with the income attributable to the non-manager interests (98 percent) not subject to self-employment tax.
Now here’s the application to the NIIT. While a non-manager’s interest in a manager-managed LLC is typically considered passive with the income from the interest potentially subject to the 3.8 percent surtax, a spouse can take into account the material participation of a spouse who is the manager. I.R.C. §469(h)(5). Thus, the material participation of the manager-spouse converts the income attributable to the non-manager interest of the other spouse from passive to active income that will not be subject to the 3.8 percent surtax.
If we return to the example again, the end result would be that self-employment tax is significantly reduced (15.3 percent of Bob’s reasonable compensation (in the form of a guaranteed payment)) and the NII surtax is avoided on Mary’s income.
Bottom line: The manager-managed LLC can provide a better overall tax result than the use of an S corporation with land rental income because of the ability to not only reduce self-employment tax, but also the ability to eliminate the NIIT. It also produces a better result than a partnership.
Of course, the NIIT and S.E. tax are only two pieces of the puzzle to an overall business plan. Other non-tax considerations may carry more weight in a particular situation. But for some, this strategy can be quite beneficial.