On March 13, 2018 the IRS announced five new compliance campaigns (3/13/18 IRS Announcement - SECA Tax), one of which relates to the reporting of self-employment income by limited partners in partnerships and LLCs. In the past there has been much uncertainty and inconsistency about the reporting of self-employment income by LLC members. Sec. 1402(a)(13) states that, other than guaranteed payments, the distributive share of all other income to a "limited partner" is excluded from self-employment tax. This has led to many LLC members, whether active in the business or not, to exclude their earnings from self-employment taxes.
Recent court cases have defined the term "limited partner" for self-employment taxes more narrowly than simply the benefit of limited liability. In a 2011 case, Renkemeyer, Campbell, & Weaver LLP v. Commissioner the Tax Court determined that Congress intended the above provision in Sec. 1402 to define a limited partner as someone who is merely a passive investor and is not engaged in any partnership activity. This definition of limited partner is expected to be used by the IRS in future audit determinations, and would significantly increase the number of individuals subject to self-employment taxes. It is also important to note that any active members who would be subject to self-employment taxes would not be subject to the 3.8 percent net-investment tax. Additionally, 50 percent of self-employment tax is deductible in computing adjusted gross income.
Some of the factors that a member of an LLC will want to review are level of participation in the business, whether they have any personal liability for the business and whether they have any management authority to bind the business. If any of these factors apply perhaps it would be beneficial to analyze the benefits of changing to an S corporation. For further guidance on this issue contact us in one of our many locations.