Self-employment tax considerations for members of a limited liability company (“LLC”) have come to the forefront recently due to the tax court decision in Vincent J. Castigliola, et ux., et al. v. Commissioner (“Castigliola”)1. This has long been a gray area as the Internal Revenue Code (“IRC”) and the Treasury Regulations (“Regulations”) have not explicitly addressed whether members of an LLC are subject to self-employment (“SE”) tax on pass-through income generated by the entity. Therefore, it has been the role of the courts to help define and lay out the treatment of self-employment taxes for LLC members. Recently, the Tax Court, in Castigliola, provided guidance on this issue. The effect of this case may have far-reaching implications on how businesses are structured and how tax practitioners advise their clients.
LLCs and Self-Employment Tax
LLCs have attributes of both corporations and partnerships. Unless otherwise elected, an LLC typically files as a partnership for tax purposes and members enjoy the pass-through advantages of having no double taxation. Additionally, members of the LLC have the limited liability protection similar to that of a corporation.
The Internal Revenue Code provides clear protective guidance when it comes to a limited partner in a partnership. It states that distributive share of income or loss of a limited partner is to be excluded from self-employment income.2 Alternatively, a general partner is subject to self-employment tax on his or her distributive share of income and loss. However, the IRC does not mention whether a member of an LLC is subject or not subject to self-employment tax on his or her distributive share.
Proposed regulations have addressed the self-employment tax for both service partnerships3 and non-service partnerships. By default, an LLC member normally is considered a limited partner. Under the proposed regulations, in an LLC with a primary trade or business of performing services, a member who provides such services would not be considered a limited partner for SE tax purposes. The proposed regulations further exclude certain people from being classified as limited partners for SE tax purposes. For instance, if a member has personal liability for the debts of the partnership; has authority to contract on behalf of the partnership; and/or participates in the trade or business for more than five hundred hours during the tax year; such person would not qualify as a limited partner.4 Under the proposed regulations, if the member is not considered or treated as a limited partner, that member would be subject to SE tax on their distributive share of partnership income whether such income is actually distributed or not.5
These proposed regulations have not been issued in final form. Therefore, taxpayers are not bound to follow them. On the other hand, the Department of the Treasury has not withdrawn the proposed regulations and many practitioners believe they provide a window into the thinking of many at Treasury and the IRS.
The Castigliola Case
In Vincent J. Castigliola, et ux., et al. v. Commissioner, the tax court found that members of a professional limited liability company (“PLLC”) were subject to self-employment tax on their distributive shares of income.
Vincent J. Castigliola, et ux., et al. v. Commissioner concerns three lawyers who were members of a Mississippi law firm organized as a PLLC. These members received a guaranteed payment for their services, on which they correctly paid self-employment tax. However, the members excluded their distributive share of the PLLC’s income from self-employment tax. The court dealt with issues concerning whether these limited members would have to pay SE tax on the distributive shares of their partnership income and whether these members should be treated as limited partners or not.
Self-employment income, under IRC Section 1402(a), includes “…distributive share (whether or not distributed) of income or loss described in section 702(a)(8) from any trade or business carried on by a partnership of which he is a member…”.6
However, an exception from self-employment income is provided under IRC Sec. 1402: “…there shall be excluded the distributive share of any item of income or loss of a limited partner, as such, other than guaranteed payments described in section 707(c)…”.7 The key term here is limited partner. Indeed, this was the exception cited by the petitioners in Castigliola. The petitioners claimed that as limited partners / members, their distributive shares of income should be excluded from self-employment tax.
The Tax Court did not agree. Instead, the court noted that the exception for self-employment income purposes, as laid out in Sec. 1402(a)(13), was enacted before LLCs were commonly used. Furthermore, the court cited a previous case, Renkemeyer8, in which it was determined that there is no authoritative definition of a limited partner under section 1402. Since there is no authoritative definition of a limited partner, the courts must apply statutory construction to determine congressional intent.
The court reasoned that a limited partner is normally assumed to be a partner in a limited partnership (“LP”) in which a general partner would manage the business, have unlimited liability, and be subject to self-employment tax.
In an LLC, there is no general partner. Limited members in an LLC may participate in management of the business. Therein lies the crux of the issue: a limited member in an LLC is the not quite the same as a limited partner in an LP. Yet, the tax code was written with a limited partner in an LP in mind.
The Tax Court’s opinion in Castigliola is that, if an LLC member provides significant services, then the member is not to be treated as a limited partner under IRC guidelines. They may, in fact, be treated as a limited partner for state purposes, but that has no bearing on proper federal tax treatment. Therefore, it stands to reason that, if an LLC member is not treated as limited, then that member would be subject to self-employment tax. The SE tax would not only be levied on guaranteed payments but also on any distributive share of partnership / LLC income.
With the number of limited liability company structures being utilized to conduct business rapidly expanding each year, tax practitioners will need to look to judicial authority and court rulings for guidance on self-employment tax for LLC members until the Treasury Department issues final regulations on the matter.
1 Vincent J. Castigliola, et ux., et al. v. Commissioner, TC Memo 2017-62
2 IRC Sec. 1402(a)(13)
3 Prop. Reg. 1.1402(a)-2(h)(5)
4 Prop. Reg. 1.1402(a)-2(h)(2)
5 Prop. Reg. 1.1402(a)-2(d)
6 IRC Section 1401(a)
7 IRC Section 1402(a)(13)
8 Renkemeyer, Campbell, & Weaver, LLP v. Commissioner, (2011) 136 TC 137, 136 TC No 7
COVID-19 Tax Planning Update We are hearing this question more and more now that the CARES Act has passed—are there other tax planning items to examine to minimize the amount of paperwork? Section...
One of the questions we are getting from clients is “If my business has had some recent losses, but we also think we may be eligible for the research and development credit, how does the CARES allow...
COVID-19 is changing our daily lives in terms of medical safety and how we conduct business. At Calvetti Ferguson, many of our clients have reached out with questions about their businesses, since...