The landscape of self-employment tax for LLC members has been shaped by various Tax Court rulings, which provide valuable insights for tax planning. The self-employment tax for closely held businesses has become more important in light of several self-employment tax cases decided by the Tax Court in the last year.
Three notable cases that highlight the complexities of this issue are Fleischer v. Commissioner, T.C. Memo 2016-238 (December 29, 2016); Castigliola v. Commissioner, T.C. Memo 2017-62 (April 12, 2017); and Hardy v. Commissioner, T.C. Memo 2017-16 (January 17, 2017).
Self-employment income is defined under section 1402(a) as “gross income derived by an individual from any trade or business carried on by such individual, less the deductions…plus his distributive share (whether or not distributed) of income or loss…from any trade or business carried on by a partnership of which he is a member…” It does not include any net earnings over the contribution and benefit base ($127,200 in 2017), subtracting the wages paid to such individual during such taxable year (section 1402(b)(1)), or earnings less than $400 in a particular tax year (section 1402(b)(2)).
Section 1402(a)(13) states that “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) to that partner for services actually rendered to or on behalf of the partnership to the extent that those payments are established to be in the nature of remuneration for those services.”
The Tax Code and Treasury Regulations do not provide any guidance on how to treat a member of a limited liability company (LLC) for purposes of the self-employment tax rules.
Fleischer v. Commissioner: A Cautionary Tale for S-Corporations
In the case of Fleischer v. Commissioner, a financial consultant’s attempt to use an S-Corporation to shield income from self-employment tax was scrutinized. The Tax Court’s decision underscored the importance of the S-Corporation being the actual provider of services and having a contract recognizing its controlling position. This case serves as a critical reminder for entities to structure their agreements to clearly reflect the relationship between the service provider and the corporation.
Ryan Fleischer was a registered financial consultant and decided to start his own business. He entered into an agreement with LPL, a brokerage company, that stated that Fleisher was an independent contractor. Later, he incorporated Fleischer Wealth Plan (FWP) as its sole shareholder and elected S-Corporation status. Three weeks after incorporating FWP, he entered into an employment agreement with FWP under which the company paid him a salary to “perform duties in the capacity of Financial Advisor.” He then entered into a broker contract with MassMutual Financial Group (MassMutual). The contract was between Fleischer and MassMutual, with no mention of FWP, and Fleischer signed the contract in his personal capacity. The contract explicitly stated that there was no employer-employee relationship between Fleischer and MassMutual. Neither Fleischer nor the companies modified the contracts to include FWP. Fleischer did not report any self-employment tax on the returns.
In response to Fleischer’s Tax Court petition challenging the IRS determination, the Tax Court applied the following test:
For a corporation, not its service-provider employee, to be the controller of the income, two elements must be found: (1) the individual providing the services must be an employee of the corporation whom the corporation can direct and control in a meaningful sense; and (2) there must exist between the corporation and the person or entity using the services a contract or similar indicium recognizing the corporation’s controlling position.
The court held that Fleischer did not satisfy the second element because Fleischer, not his S corporation, had earned all of the income.
Castigliola v. Commissioner: The Definition of a “Limited Partner”
The Castigliola case involved three attorneys who converted their general partnership into a professional limited liability company (PLLC). The Tax Court’s analysis focused on the partners’ management roles and concluded that without a specified general partner, all members functioned as general partners, subjecting their income to self-employment tax. The PLLC did not have a written operating agreement or any other document showing the members’ management power was limited. The Tax Court found that the law practice continued to be operated in the same manner before and after the conversion from a general partnership to a PLLC. Therefore, although the members had limited liability, the Tax Court concluded the members were more akin to general partners who had control of the PLLC, and did not qualify for the Section 1402(a)(13) exclusion from self-employment income tax. This ruling emphasizes the need for a written operating agreement delineating management roles to potentially qualify for the limited partner exception under section 1402(a)(13).
Hardy v. Commissioner: Investment Activity and Self-Employment Tax
In contrast, the Hardy case presented a scenario where a plastic surgeon’s distributive shares from a surgery center were not subject to self-employment tax. The surgeon’s role was deemed to be that of an investor, without active participation in the center’s management. This decision highlights the distinction between active business income and passive investment income, with significant implications for self-employment tax liability.
In Castigliola v. Commissioner, T.C. Memo. 2017-62, the Tax Court found that active members of a member-managed LLC were liable for self-employment tax on their distributive shares of the firm’s income. This ruling was based on the premise that the members were actively engaged in the firm’s business and did not qualify for the limited partner exception to self-employment tax.
Conversely, in Hardy v. Commissioner, T.C. Memo. 2017-16, the Tax Court held that an LLC member’s income was not subject to self-employment tax because the member was not actively involved in the daily operations of the business, thus qualifying for the limited partner exception.
These decisions underscore the importance of how an LLC is managed and how members’ roles are defined and executed. For active members involved in day-to-day management, the likelihood of being subject to self-employment tax is high. On the other hand, members not actively managing the business may find themselves exempt from self-employment tax, akin to limited partners in a limited partnership.
The implications for tax planning are significant. Tax advisors and LLC members must carefully consider the structure of their LLC and the members’ involvement in management when assessing self-employment tax obligations. While some may opt for a limited partnership structure to clarify their tax stance, others may choose to take a calculated risk with an LLC, potentially setting a precedent for future cases.
As tax laws and interpretations continue to evolve, professionals must stay informed and adapt their strategies accordingly. The insights from these Tax Court cases provide a framework for understanding and navigating the intricacies of self-employment tax as it applies to LLC members.
For those seeking to delve deeper into the nuances of these rulings and their implications for business structuring and tax planning, engaging with a knowledgeable tax advisor or attorney is advisable. These professionals can provide tailored advice that takes into account the specific circumstances of each case and the latest legal developments.