In certain situations, taxpayers may successfully thread the needle to not pay either net investment income tax or self-employment tax on some income from a pass-through entity that the taxpayer actively participates in.
This article was published in the August 25, 2016 issue of Middle Market Growth, a weekly newsletter published by Association of Corporate Growth (ACG).
Because of the increases in the Medicare tax, many taxpayers are interested in structuring to minimize self-employment tax. However, due to the introduction of the Medicare tax on net investment income, the Medicare tax also applies to passive income, such as interest, dividends, capital gains and income from passive activities. Traditionally, self-employment tax has not applied to distributions from limited partnerships (LPs) with respect to limited partnership interests because, in the past, limited partners were passive investors who did not provide services to the LP. Now, of course, to the extent that the income is from a passive activity or otherwise qualifies as net investment income, the Medicare tax on net investment income would apply to income from the LP.
Generally, partners in a limited liability partnership (LLP) who provide services to the LLP are subject to self-employment tax on all earnings from the LLP. As LLPs are traditionally used for service businesses, such as law firms and accounting firms, this outcome makes sense as self-employment taxes are supposed to apply to services income. This outcome is frequently carried over to limited liability companies (LLCs) where the members perform services for the LLC. However, in any business where capital is a significant factor in producing income, if an LLC member both produces services and provides capital, self-employment taxes should not apply to the income allocated to the capital. The Medicare tax on net investment income may apply, but it may not if the member actively participates. However, as the rules for self-employment taxes have not been updated to deal with the increased popularity of LLCs or limited partners who provide services to LPs, there are no controlling rules regarding self-employment and LLCs and LPs that reflect the new realities of how these entities operate.
The original rules regarding self-employment and LPs were designed to limit Social Security coverage to active employment and were written at a time when limited partners were passive investors in LPs. Thus, section 1402(a)(13)1 was originally enacted in 1976 to prevent passive investors from gaining coverage under the Social Security tax system.2 Proposed regulations regarding what a limited partner is were issued in 1994, and new proposed regulations were issued in 1997. However, Congress then issued a moratorium, saying that no regulations could be finalized on the issue for a year. Despite the expiration of the moratorium, no regulations on the point have been finalized.
The proposed regulations provide that an individual partner in a tax partnership (which would include an LLC taxed as a partnership) who has authority to bind the partnership is not a limited partner. Further, the preamble to the proposed regulations, in a discussion of the proposed regulations and their intent, states that “these rules [permitting bifurcation in certain limited circumstances] exclude from an individual’s net earnings from self-employment amounts that are demonstrably returns on capital invested in the partnership.”3 As the proposed regulations are not currently in effect, people generally have only relied on them if favorable. Increasingly, however, the IRS is taking the position that LLC members are not limited partners for purposes of section 1402(a)(13).4
Although illogical, there now appears to be more support for limiting self-employment taxes when an LP is used because the original favorable rules, which limit the application of self-employment taxes to a limited partner’s interest in an LP, literally apply to LPs. Additionally, as noted above, there have been indications that the IRS is willing to be more aggressive with LLCs regarding self-employment issues. Ultimately, there should not be a difference between using an LLC and an LP, and taxpayers should not count on getting a more favorable outcome simply based on using an LP. However, right now based on IRS activity and the literal language of the statute, people are generally more comfortable with using LPs to minimize self-employment taxes. It is important to remember, though, that the original concept of a limited partner was of a passive investor. Thus, when a limited partner is actively participating in the business of the LP, it is much more vulnerable to the argument that its income from the LP should be subject to self-employment taxes. Whichever entity is used, it makes sense to clearly delineate amounts paid for services as guaranteed payments. Any such guaranteed payments should be set at a reasonable amount for such services. Additionally, structuring to utilize a separate entity (which must be a separate entity for tax purposes, thus a disregarded entity cannot be used for this purpose) to provide services may make the delineation of payments cleaner.
Another approach to minimizing self-employment taxes is to use an S-corporation, as the law is clear that only amounts paid as salary to shareholders are subject to self-employment taxes. The salary has to be reasonable, but otherwise the law is clear on that point. S-corporations, however, have significant limitations on the number of shareholders and the type of shareholders permitted, as well as not allowing more than one class of stock. Thus, compensating employees with equity is more difficult in an S-corporation than in an LLC or LP. Another significant issue with utilizing an S-corporation is that, unlike a partnership, assets cannot be distributed without a tax cost. So, although an S-corporation may solve self-employment tax issues, it frequently creates other issues, particularly on sale. Further, eventually, the differences between S-corporations and partnerships with respect at least to self-employment should be removed. It seems likely that tax legislation will remove this S-corporation advantage in the future. In the interim, S-corporations can be used advantageously in certain situations. However, it must be recognized that there are costs to offset some of the advantages, and the advantages and disadvantages should be carefully evaluated.
Generally, individuals, trusts and estates with income above certain thresholds are subject to the 3.8 percent Medicare tax on net investment income, which includes interest, dividends, capital gains and passive income. The net investment income tax does not apply to amounts subject to self-employment tax.5 However, net investment income does not include income from an active trade or business conducted through a pass-through entity, including gains from the disposition of such activity, with certain exceptions for trading in financial instruments or commodities. Therefore, generally, income from a trade or business that the taxpayer actively participates in is not subject to net investment income. Thus, in certain situations, taxpayers may successfully thread the needle to not pay either net investment income tax or self-employment tax on some income from a pass-through entity that the taxpayer actively participates in. However, due to the increasingly all-encompassing nature of the IRS’s stance regarding what self-employment taxes apply to, the needle is getting harder to thread.