If you’re a member of a limited liability company (LLC), do you have to pay self-employment taxes? That’s a darn good question.
Our beloved Internal Revenue Code’s self-employment (SE) tax provisions were enacted long before the existence of limited liability companies. As LLCs became increasingly popular, an important question arose: how to apply the SE tax rules to individuals who are LLC members, which is what LLC owners are called. Despite IRS attempts to make it go away, that question still exists for LLCs with several members, which we will call multi-member LLCs. Here’s the muddled SE tax story for LLC members.
Individual members of ‘disregarded’ single-member LLCs (SMLLCs) are on the hook for the SE tax
Before addressing the SE tax issue for members of multi-member LLCs, let’s quickly dispose of the issue for single-member LLCs (SMLLCs), meaning those with only one owner. The existence of a single-member LLC (SMLLC) is generally disregarded for federal income tax purposes unless you make an election to treat it as a corporation — which is not done very often. In other words, a so-called disregarded SMLLC owned by you as an individual is invisible for most federal income tax purposes, including SE tax purposes.
Therefore, when you own a disregarded SMLLC that’s engaged in a business, you must calculate your SE tax hit on Schedule SE, just like a sole proprietor does. So, you will owe SE tax on any net SE income produced by the SMLLC. No question about it.
The muddled SE tax issue for members of multi-member LLCs
Now it gets interesting. We start with the fact that members of LLCs that are classified as partnerships for federal income tax purposes are treated as partners for federal income tax purposes. So, as a general rule, the same federal income tax rules, including the SE tax rules, that apply to individual partners also apply to individual LLC members who are treated as partners.
Moving right along, to understand the SE tax issue for LLC members, we must start with the longstanding special SE tax rule for limited partners. Under that special rule, a limited partner includes in SE income only guaranteed payments from the partnership for services rendered to the partnership. Guaranteed payments are payments that are determined without regard to the partnership’s income. They are often called “partner salaries.” This special SE tax rule for limited partners is beneficial to them because they typically do not receive any guaranteed payments for services (partner salaries), and therefore they typically do not owe any SE tax on their shares of partnership income. Source: Internal Revenue Code Section 1402(a)(13).
In contrast, a general partner must include his or her share of the partnership’s net income from business activities in SE income. Therefore, general partners usually owe SE tax on their shares of net partnership income. Source: Internal Revenue Code Section 1402(a).
The favorable special SE tax rule for limited partners was enacted long before LLCs existed. So how do LLC members deal with the SE tax issue? Can they claim they are limited partners for SE tax purposes because they are not personally liable for the LLC’s debts? If the answer is yes, they can avoid the SE tax by simply not taking any guaranteed payments. Instead, they can simply take random SE-tax-free distributions to collect their shares of the LLC’s cash flow. But is that a viable position? Arguably yes, although the IRS will certainly disagree in the event of an audit.
A history lesson on SE taxes for limited partners
Back in 1994 and 1997, the IRS issued two sets of proposed regulations on the subject of SE tax for limited partners. Both generated controversy by proposing that these individuals would be required to pay SE tax on their shares of partnership income in addition to any guaranteed payments for services. Ditto for LLC members who are treated as partners for federal income tax purposes. Commentators like me criticized the proposed rules as attempts to impose new taxes on affected individuals without the benefit of supporting legislation. Congress agreed and prohibited the release of any temporary or final regulations on the subject before 7/1/98. Of course, that date has long since passed, and nobody believes that the proposed regulations (which are still on the books) have any validity at this point. No further regulations have been issued on the subject.
What is the self-employment tax rate?
How hard can the SE tax hit? Hard! For 2022, the SE tax rate is 15.3% on the first $ 147,000 of net SE income (gross income from self-employment minus expenses allowed for SE tax purposes), including net SE income passed through to you from an LLC.
That 15.3% rate is comprised of:
* 12.4% for the Social Security tax component of the SE tax plus
* 2.9% for the Medicare tax component.
* Above the $ 147,000 threshold, the Social Security tax component goes away, but the 2.9% Medicare tax continues before rising to 3.8% at higher SE income levels ($ 200,000 if you’re unmarried or $ 250,000 of you’re a married joint-filer). The 3.8% rate consists of the “regular” 2.9% Medicare tax plus the 0.9% Additional Medicare tax on higher earners.
Example: Say your share of the net income from a multi-member LLC that operates a business is $ 200,000. Multiply that figure by .9235. The result is $ 184,700, and that’s the net SE income amount that’s subject to the SE tax. For 2022, your SE tax bill will be a whopping $ 23,584. [($ 147,000 x 12.4%) + ($ 184,700 x .029%)].
Sadly, in calculating your net SE income, you don’t get to deduct contributions to a self-employed retirement plan, the deduction for a portion of your SE tax, or the deduction for self-employed health insurance premiums.
It will only get worse
Every year, the Social Security tax ceiling goes up based on an inflation adjustment. In turn, your SE tax bill goes up. Last August, the Social Security Administration issued its latest projected ceilings for future years.
* $ 156,000 for 2023.
* $ 162,900 for 2024.
* $ 168,600 for 2025.
* $ 173,300 for 2026.
* $ 180,600 for 2027.
These numbers are alarming enough, but it’s a pretty safe bet that the actual ceilings will be significantly higher due to surging inflation.
Beware of contradictory IRS positions
The IRS takes the position that individual members of a multi-member LLC that’s classified as a partnership for tax purposes owe SE tax on their shares of the LLC’s net business income. In other words, the IRS claims that the aforementioned limited partner exception does not apply to LLC members, even though they generally have no personal liability for the entity’s debts, just like limited partners.
Meanwhile, the IRS continues to take the completely contradictory position that members of multi-member LLCs that are treated as partnerships for tax purposes must be treated as limited partners for purposes of applying the passive activity loss (PAL) rules. The IRS position is grounded on the fact that that LLC members have limited liability for the entity’s debts, like limited partners. This is an unfavorable limitation for LLC members, because stricter PAL rules apply to limited partners.
So, the IRS takes one anti-taxpayer position on the SE tax issue, and a completely contradictory anti-taxpayer position on the PAL issue. Heads I win. Tails you lose.
What Tax Court has said on SE taxes
In a 2017 decision, the Tax Court noted that neither the Code nor any regulatory authority defines the term limited partner for purposes of the limited partner SE tax exception. Nevertheless, the Tax Court opined that the LLC members (the taxpayers) in this case were not limited partners within the ordinary meaning of the term and were therefore ineligible for the limited partner exception. Source: Vincent Castigliola, TC Memo 2017-62.
The taxpayers were attorneys who operated as members of a professional LLC that was classified as a partnership for tax purposes. There was no written LLC operating agreement or any other evidence showing that the members’ management powers were limited. In fact, all the members participated in management by collectively making decisions regarding such things as their distributive shares of LLC income; borrowing money; and hiring, firing, and compensating employees. All the members supervised associate attorneys and signed checks for the LLC.
According to the Tax Court’s logic, because all members had the same rights and responsibilities, they must all have had positions analogous to those of general partners. Therefore, according to the Tax Court, the taxpayers were ineligible for the limited partner exception, and all the income passed through to them by the LLC (in addition to guaranteed payments received by them) was subject to SE tax. The taxpayers had taken the position that they owed SE tax only on guaranteed payments received from the LLC.
Observation: In the Castigliola decision, the Tax Court basically took it upon itself to define the term limited partner for purposes of eligibility for the limited partner SE tax exception. After all these years, after two failed IRS attempts to issue regulations on the subject, and after IRS reluctance to issue any other authoritative guidance on the subject, it seems questionable that the Tax Court had the power to do so unilaterally. As stated earlier and as acknowledged by the Tax Court, neither the Internal Revenue Code nor any regulations have done that. And the IRS to this day continues to take the position that LLC members should be treated as limited partners for PAL purposes. Therefore, while the Castigliola decision is certainly not good news for those who wish to take the position that LLC members are eligible for the limited partner exception, the decision should perhaps be viewed with a jaundiced eye.
The bottom line, such as it is
Not all questions can be conclusively answered. The SE tax question for LLC members is one of them.
In light of the Castigliola decision, understand that taking the position that you as an active LLC member are eligible for the limited partner SE tax exception is aggressive. If you get audited and the IRS identifies the issue, you could be assessed back taxes, interest, and penalties. That said, the position is still supported by the statutory language on the SE tax treatment of limited partners, by the IRS’s position that LLC members should be treated as limited partners for PAL purposes, and by the fact that no authoritative IRS guidance on the subject of LLC members’ eligibility for the limited partner exception has ever been issued to this day. We report. You decide.