Attorneys

• Dean M. Naccarato
• Hugh W. Nevin, Jr.

Related Practices

• International Tax Advisory Services

The limited liability company (LLC) has become very popular as the entity through which business owners choose to operate their businesses.  However, business owners often overlook the maximum 15.3 percent federal self-employment tax liability that may result from choosing to operate in the form of an LLC.  For many business owners, a significant self-employment tax savings may be achieved by operating in the form of either a limited partnership or an S corporation instead.  Further, the self-employment tax considerations inherent in the choice-of-entity issues facing business owners may differ depending on whether the business owner is a U.S. taxpayer (i.e., a U.S. citizen or resident alien) or a nonresident alien. 

Self-Employment Tax in the Limited Partnership and S Corporation Context

U.S. federal income tax law imposes self-employment tax on an individual’s net earnings from self-employment at a rate of 12.4 percent on the first $94,200 of such net earnings and 2.9 percent on the entire amount of such net earnings (for a maximum of 15.3 percent).  An individual’s share of income from a partnership is generally considered to be net earnings from self-employment (subject to self-employment tax); provided, however, that the distributive share of a “limited partner” in a partnership is not considered to be net earnings from self-employment.  Accordingly, a limited partner in a limited partnership generally is not subject to self-employment tax on such limited partner’s share of the income of the limited partnership. 

A shareholder in an S corporation is only subject to self-employment tax on such shareholder’s share of the S corporation’s income to the extent that it is attributable to services performed by the shareholder on behalf of the S corporation.  Any amount that is in excess of the amount attributable to services performed is considered a return on the shareholder’s investment and is not subject to self-employment tax.      

Self-Employment Tax in the LLC Context

The application of the self-employment tax to members of LLCs that are treated as partnerships for federal income tax purposes currently is unsettled since members of LLCs often have characteristics similar to both general partners and limited partners of limited partnerships.  Like limited partners in a limited partnership, members of an LLC have limited liability with respect to their investment in the LLC.  However, like a general partner in a limited partnership, members of an LLC often participate in the business of the LLC.  The characteristics of members of LLCs have created confusion among taxpayers as to whether a member of an LLC should be treated as a “limited partner” exempt from self-employment tax on his or her share of the LLC’s income.  In response to this confusion, the IRS has issued proposed regulations (the “Proposed Regulations”) stating its position on this issue.

The Proposed Regulations take the position that a member of an LLC will not be treated as a “limited partner” and will be subject to self-employment tax on such member’s entire share of the LLC’s income if the member: (i) has personal liability for the debt of or claims against the LLC; (ii) has authority to contract on behalf of the LLC; or (iii) participates in the LLC’s trade or business for more than 500 hours during the taxable year.  While the proposed regulations have not yet been finalized, they are the most definitive authority currently published with respect to the IRS’s view on this issue.  Under the Proposed Regulations, a member of an LLC who plans on materially participating in the conduct of the LLC’s business may run the risk of becoming subject to self-employment tax on such member’s share of the LLC’s income.  Accordingly, business owners should consider:  (i) a limited partnership or S corporation as a means through which to operate their business or (ii) forming a separate entity to manage the LLC, in order to avoid self-employment tax on all or a portion of their share of the business’s income. 

Self-Employment Tax Considerations for Nonresident Aliens

U.S. federal income tax law generally provides that nonresident aliens are exempt from self-employment tax on all of their earnings (including allocatable shares of LLC or limited partnership income); unless an existing Social Security totalization agreement between the United States and the country of the nonresident aliens residence makes the nonresident alien subject to U.S. Social Security tax.  Accordingly, a nonresident alien, unlike a U.S. taxpayer, may be able to operate a business through an LLC and still avoid paying self-employment tax on such nonresident alien’s share of the LLC’s income.   

Careful thought and consideration regarding future tax consequences should be given prior to forming any business entity, and choosing the best entity for you can significantly reduce tax liability.

For more information, please contact hnevin@cohenlaw.com or dnaccarato@cohenlaw.com