The federal tax code’s self-employment tax provisions were enacted long before the existence of limited liability companies (LLCs). As LLCs became increasingly popular, an important question arose: How do the self-employment tax rules apply to LLC members? Despite IRS attempts to make the issue go away, that question still exists for LLCs with several members, which we’ll call “multi-member LLCs.”
Limited vs. General Partners
Members of multi-member 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 self-employment tax rules) that apply to partners also apply to LLC members who are treated as partners. (For the rules that apply to LLCs with only one owner, see “Clear Rules for Single-Member LLCs” at right.)
To understand the self-employment tax issue for LLC members that are treated as partners, we must start with the longstanding special self-employment tax rule for limited partners. Under that special rule, a limited partner includes in his or her self-employment 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’re often called “partner salaries.”
The special self-employment tax rule for limited partners is beneficial to them because they typically don’t receive any guaranteed payments for services (partner salaries). Therefore, they typically don’t owe any self-employment tax on their shares of partnership income.
In contrast, a general partner must include his or her share of the partnership’s net income from business activities in self-employment income. Therefore, general partners usually owe self-employment tax on their shares of net partnership income.
The favorable special self-employment tax rule for limited partners was enacted long before LLCs existed. Can LLC members claim they’re limited partners for self-employment tax purposes because they’re not personally liable for the LLC’s debts? If the answer is yes, they could avoid self-employment tax by simply not taking any guaranteed payments. Instead, they could simply take random self-employment-tax-free distributions to collect their shares of the LLC’s cash flow. While that’s arguably a viable position, the IRS will likely disagree in the event of an audit.
History of IRS Guidance
The IRS issued two sets of proposed regulations in 1994 and 1997 on how the self-employment tax could apply to limited partners. Both generated controversy by proposing that these individuals would be required to pay self-employment tax on their shares of partnership income in addition to any guaranteed payments for services. The same treatment would have applied to LLC members who are treated as partners for federal income tax purposes.
The proposed rules were criticized for attempting 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 July 1, 1998.
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.
Sizable Tax Hit
For 2022, the self-employment tax rate is 15.3% on the first $147,000 of net self-employment income (gross income from self-employment minus expenses allowed for self-employment tax purposes), including net self-employment income passed through to you from an LLC.
That rate is comprised of:
- 12.4% for the Social Security tax component of the self-employment 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 self-employment income levels ($200,000 if you’re unmarried or $250,000 if you’re married and file a joint return). The 3.8% rate consists of the regular 2.9% Medicare tax plus the 0.9% additional Medicare tax on higher income people.
For example, Michelle’s share of the net income from an LLC that operates a business is $200,000. To determine her self-employment tax liability, Michelle must multiply her net income from the LLC ($200,000) by 92.35%. The result is $184,700. So, her self-employment tax bill will be $23,584 [($147,000 times 12.4%) + ($184,700 times 2.9%)].
Important: In calculating your net self-employment income, you don’t get to deduct contributions to a self-employed retirement plan, the deduction for a portion of your self-employment tax or the deduction for self-employed health insurance premiums.
Annual Adjustments for Inflation
Every year, the Social Security tax ceiling goes up based on inflation. In turn, your self-employment tax bill goes up. In August 2021, the Social Security Administration issued the following projected ceilings for 2023 through 2027:
- $156,000 for 2023,
- $162,900 for 2024,
- $168,600 for 2025,
- $173,300 for 2026, and
- $180,600 for 2027.
These numbers may be alarming enough. But the actual ceilings could be significantly higher due to higher-than-expected inflation.
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 self-employment tax on their shares of the LLC’s net business income. In other words, the IRS claims that the aforementioned limited partner exception doesn’t 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 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 in the fact 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.
In other words, the IRS takes anti-taxpayer positions on both the self-employment tax issue and the PAL issue — even though the underlying reasoning is contradictory.
Tax Court Weighs In
In a 2017 decision, the U.S. Tax Court noted that neither the tax code nor any regulatory authority defines the term “limited partner” for purposes of the limited partner self-employment tax exception. Nevertheless, the court opined that the LLC members (the taxpayers in the case) weren’t limited partners within the ordinary meaning of the term and were, therefore, ineligible for the limited partner exception. (Vincent Castigliola v. Commissioner, 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. All the members participated in management by collectively making decisions regarding such matters 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, because all members had the same rights and responsibilities, they held positions analogous to those of general partners. Therefore, 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 self-employment tax. The taxpayers had taken the position that they owed self-employment tax only on guaranteed payments received from the LLC.
Essentially, the Tax Court in Castigliola took it upon itself to define the term-limited partner for purposes of eligibility for the limited partner self-employment tax exception. After two failed IRS attempts to issue regulations on the subject and 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. And the IRS continues to take the position that LLC members should be treated as limited partners for PAL purposes. Therefore, while the Castigliola decision certainly isn’t 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 skepticism.
Clear Rules for Single-Member LLCs
To avoid any confusion when reading the main article, it’s important to draw a line between multi-member limited liability companies (LLCs) and single-member LLCs, meaning those with only one owner. The existence of a single-member LLC is generally disregarded for federal income tax purposes unless an election is made to treat it as a corporation. In other words, a so-called disregarded single-member LLC owned by an individual is invisible for most federal income tax purposes, including self-employment tax purposes.
Therefore, an individual who owns a disregarded single-member LLC that’s engaged in a business must calculate self-employment tax on Schedule SE, just like a sole proprietor does. That means the member will owe self-employment tax on any net self-employment income produced by the single-member LLC.
In light of the Castigliola decision, assuming that active LLC members are eligible for the limited partner self-employment tax exception is an aggressive position. But that position is still supported by 1) the statutory language on the self-employment tax treatment of limited partners, 2) the IRS’s position that LLC members should be treated as limited partners for PAL purposes, and 3) the fact that, to this day, no authoritative IRS guidance on the subject of LLC members’ eligibility for the limited partner exception has ever been issued. Contact one of our tax professionals to help understand how the self-employment tax rules apply to the members of your LLC.