Using the Right Kind of An Entity to Reduce Self-Employment Tax

Overview

With many things, it is true that there is a right way and a wrong way to do things.  The same maxim holds true in business entity structuring.  There is a right way to structure and a wrong way to structure the entity when it comes to many legal and tax issues, including self-employment tax liability.  A recent Tax Court case illustrates that last point – proper structuring makes a difference on the self-employment tax liability issue.

So, how can self-employment tax be minimized when the desired structure is a limited liability company (LLC)?  That’s today’s focus.

LLCs and Self-Employment Tax

Whether LLC members can avoid self-employment tax on their income from the entity depends on their member characterization.  Are they general partners or limited partners?  Under I.R.C. §1402(a)(13), a limited partner does not have self-employment income except for any guaranteed payments paid for services rendered to the LLC.  So what is a limited partner?  Under existing proposed regulations (that were barred by the Congress in the late 1990s from being finalized), 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).  If none of those tests are satisfied, then the member is treated as a limited partner. 

The Castigliola case.  In Castigliola, et al. v. Comr, T.C. Memo. 2017-62, a group of lawyers structured their law practice as member-managed Professional LLC (PLLC).  On the advice of a CPA, they tied each of their guaranteed payments to what reasonable compensation would be for a comparable attorney in the locale with similar experience.  They paid self-employment tax on those amounts.  However, the Schedule K-1 showed allocable income exceeding the member’s guaranteed payment.  Self-employment tax was not paid on the excess amounts.  The IRS disagreed with that characterization, asserting self-employment tax on all amounts allocated. 

The Tax Court agreed with the IRS.  Based on the Uniform Limited Partnership Act of 1916, the Revised Limited Partnership Act of 1976 and Mississippi law (the state in which the PLLC operated), the court determined that a limited partner is defined by limited liability and the inability to control the business.  The members couldn’t satisfy the second test.  Because of the member-managed structure, each member had management power of the PLLC business.  In addition, because there was no written operating agreement, the court had no other evidence of a limitation on a member’s management authority.  In addition, the evidence showed that the members actually did participate in management by determining their respective distributive shares, borrowing money, making employment-related decisions, supervising non-partner attorneys of the firm and signing checks.  The court also noted that to be a limited partnership, there must be at least one general partner and a limited partner, but the facts revealed that all members conducted themselves as general partners with identical rights and responsibilities.  In addition, before becoming a PLLC, the law firm was a general partnership.  After the change to the PLLC status, their management structure didn’t change. 

The court did not mention the proposed regulations, but even if they had been taken into account the outcome of the case would have been the same.  Member-managed LLCs are subject to self-employment tax because all members have management authority.  It’s that simple.  In addition, as noted below, there is an exception in the proposed regulations that would have come into play. 

Note:  As a side-note, the IRS had claimed that the attorney trust funds were taxable to the PLLC.  The court, however, disagreed because the lawyers were not entitled to the funds.

Structuring to minimize self-employment tax.  There is an entity structure that can minimize self-employment tax.  An LLC can be structured as a manager-managed LLC with two membership classes.  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-manager interests held by members that participate more than 500 hours in the LLC’s business are not subject to self-employment tax on the pass-through income attributable to their LLC interest. Prop. Treas. Reg. §1.1402(a)-2(h)(4).  They do, however, have self-employment tax on any guaranteed payments. However, this structure does not achieve self-employment tax savings for personal service businesses, such as the one involved in Castigliola.  Prop. Treas. Reg. §1.1402(a)-2(h)(5) provides an exception for service partners in a service partnership.  Such partners cannot be a limited partner under Prop Treas. Reg. §1.1402(a)-2(h)(4) (or (2) or (3), for that matter).  Thus, for a professional services partnership (such as the law firm at issue in the case), structuring as a manager-managed LLC would have no beneficial impact on self-employment tax liability.      

However, for LLCs that are not a “service partnership,” such as a farming operation, it is possible to structure the business as a manager-managed LLC with a member holding both manager and non-manager interests that can be bifurcated.  The result is that a member 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.

Here's what it might look like for a farming operation:

A married couple operates a farming business as an LLC.  The wife works full-time off the farm and does not participate in the farming operation.  But, she holds a 49 percent non-manager ownership interest in the LLC.  The husband conducts the farming operation full-time and also holds a 49 percent non-manager interest.  But, the husband, as the farmer, also holds a 2 percent manager interest.  The husband receives a guaranteed payment for his manager interest that equates to reasonable compensation for his services (labor and management) provided 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.  The two percent manager interest is subject to self-employment tax along with the guaranteed payment that the husband receives.  This produces a much better self-employment tax result than if the farming operation were structured as a member-managed LLC. 

Additional benefit.  There is another potential benefit of utilizing the manager-managed LLC structure.  Until the health care law is repealed or changed in a manner that eliminates I.R.C. §1411, the Net Investment Income Tax applies to a taxpayer’s passive sources of income when adjusted gross income exceeds $250,000 on a joint return ($200,000 for a single return).  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.

Based on the example above, the result would be that self-employment tax is significantly reduced (it’s limited to 15.3 percent of the husband’s reasonable compensation (in the form of a guaranteed payment) and his two percent manager interest) and the net investment income surtax is avoided on the wife’s income.

Conclusion

The manager-managed LLC provides a better result than the result produced by the member-managed LLC for LLCs that are not service partnerships.  For those that are, such as the PLLC in Castigliola, the S corporation is the business form to use to achieve a better tax result.  For an S corporation, “reasonable” compensation will need to be paid subject to S.E. tax, but the balance drawn from the entity can be received self-employment tax free.  But, for farming operations with land rental income, the manager-managed LLC can provide a better overall tax result than the use of an S corporation because of the ability to eliminate the net investment income tax.    

Of course, the self-employment tax and the net investment income 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.

The decision in Castigliola would appear to further bolster the manager-managed approach – an individual that is a “mere member” appears to now have an even stronger argument for limited partner treatment.  In addition, the court didn’t impose penalties on the PLLC because of reliance on an experienced professional for their filing position.  I am not so sure about that one and believe that the judge was simply being nice, perhaps because the professional tax advisor died before the trial.  But, the outcome they were seeking was easy to obtain if they had just structured the entity properly and had taken some time to carefully draft an operating agreement.