A recent memorandum opinion of the U. S. Tax Court has significant implications for investors in various types of business entities with respect to the applicability of tax under the Self-Employment Contributions Act (SECA). The opinion cuts against prior authorities that generally impose SECA tax on income received by an active member of a limited liability company (LLC). The Tax Court looked to the actual management of the LLC, rather than the fact that the taxpayer was a member-manager and technically possessed management authority over the LLC.
Tax Under the SECA
Tax imposed under the SECA, commonly referred to as self-employment tax (SE tax), is a Social Security and Medicare tax for individuals who work for themselves. The SE tax is intended to mirror taxes imposed on employers and employees under the Federal Insurance Contributions Act (FICA). In 2017, the SE tax rate is 15.3 percent on the first $127,200 of an individual’s self-employment income, with a 2.9 percent rate on the amount of SE income between $127,200 and $200,000 (for single taxpayers) or $250,000 (for married taxpayers filing jointly), and a 3.8 percent rate on the excess above those thresholds. The SE tax thresholds are indexed annually to reflect real wage growth.
Influence on Choice of Entity and Investment Structuring
Why is SE tax relevant in the entity formation process or during investment structuring efforts? Generally, a business owner pays SE tax on business income earned directly (individually) or through a partnership. An LLC may be treated for federal tax purposes as either transparent (for example, a disregarded entity) or as a partnership. When a taxpayer owns an S corporation, his salary is subject to FICA tax, but his share of the S corporation’s income as an owner isn’t subject to SE tax.
Special considerations apply to limited partnerships (LPs) and LLCs. An LP is an entity that vests authority to run the business in one or more general partners and is also owned by one or more limited partners who don’t have authority to operate the business. This model parallels that of an LLC that’s manager-managed; for example, the LLC has one or more managers who have authority to transact business on behalf of the LLC and one or more members who more passively hold an interest in the LLC. Unlike LPs, the treatment of LLCs isn’t expressly provided for in the law.
The SE tax rules treat limited partners and members of manager-managed LLCs similar to the owners of S corporations. Earnings in the form of salary or wages are subject to SE tax, while the share of partnership or LLC income isn’t subject to SE tax. However, a limited partner or member who’s also a general partner or LLC manager, respectively, is subject to SE tax on partnership or LLC income received as a general partner or LLC manager. The business’s income received by such person in his capacity as a limited partner or LLC member, on the other hand, isn’t subject to SE tax.
Hardy v. Commissioner
In Hardy v. Comm’r, T.C. Memo. 2017-16 (Jan. 17, 2017), the taxpayer invested in an LLC that owned and operated a surgery center together with seven other practicing physicians. Each member was also a manager of the LLC, but the LLC was in practice professionally managed by its employees without the taxpayer’s day-to-day input. The LLC billed patients for the use of the facility.
The taxpayer maintained a separate medical practice and allowed his patients to choose where they wanted to have surgeries performed – at the LLC surgery center or elsewhere. When patients chose the LLC surgery center, they paid the LLC for use of the facility and the taxpayer for his services as a surgeon, separately.
The Tax Court held that the taxpayer didn’t actually manage the LLC, despite his status as a manager, and that he was in reality a passive investor in the LLC. Here, the taxpayer was likened to a limited partner who would be eligible for an exclusion from SE tax. As a result, the taxpayer’s distributable distributive share of income from the LLC wasn’t subject to tax under the SECA. Prior authorities have specifically addressed the form of entity involved for state law purposes, such as limited liability limited partnership, whereas Hardy doesn’t.
New Category of Exception
Based on this recent Tax Court decision, the income of an LLC member earned in the capacity of a pure investor seems to be a new category of exception from the SECA. This is consistent with the general concept in the 1997 proposed “stealth tax” regulations that would have looked at activity and not just whether an entity was an LP or an LLC. Given this recent decision, investors in a business who wish to minimize their exposure to SE tax might consider structuring such business as an LP—perhaps through an LLC owned by the LP. The statutory exception only applies to an LP, so the Hardy case is the first to specifically interpret the statute like the proposed regulations that the IRS never finalized for political reasons. Proper planning should be undertaken pre-formation to ensure that the investment isn’t unduly burdened by this 15.3 percent tax, which could effectively vitiate any meaningful return on said investment.