Does An LLC Member Pay Self-Employment Tax?

There is an issue concerning LLCs that has existed for approximately as long as I have been in the profession. I am thinking about it because I recently finished a research memo which included this issue.

This time we are talking about limited liability companies (LLCs) and self-employment income. One pays self-employment tax on self-employment income, and the dollars can add up rather quickly.

The offending party is the following enchanting prose from Code section 1402(a)(13) addressing self-employment income:

           

… 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 … "

We do not need degrees in taxation to zero in on the term “limited partner” as being the key to this car. If you are a limited partner you get to exclude “the distributive share” of something. Since the IRS wants you to pay tax on something, the less of that something is probably a good thing.

So what is a limited partner in this conversation?

We don’t know.

The above wording came from an IRS proposed Regulation in 1977. The IRS stirred such a hornet’s nest that Congress put a hold on the Regulation. The hold has long since expired, but the IRS has not wanted to walk back onto that hill. It has been 37 years.

To be fair, the playing field changed on the IRS.

Have you ever heard of the Estate of Ellsasser? Don’t worry if you haven’t, as I suspect that many tax CPAs have not. Let’s time travel back to 1976. In addition to Bob Newhart and the Carol Burnett Show, people were buying tax shelters. The shelters worked pretty well back then, long before the passive activity rules entered the game. One of those shelters used to provide one with self-employment income, on which one would pay self-employment – also known as social security – tax.

Doesn’t sound like much of a shelter, doesn’t it?

The purpose was to get social security credits for someone who had not worked, had not earned enough credits, or had not earned enough to maximize their social security benefits.

The IRS did not like this at all, because at the time it was concerned with people taking advantage of social security. That was before our government decided to bankrupt us all, which act has now switched to the IRS demanding money from anyone foolish enough to make eye contact.

You see, in those days, there were entities known as “limited partnerships” in which a general partner made all the decisions and in return the limited partners got regular checks. A limited partner had little or no sway over the management of the place. It was an investment, like buying IBM or Xerox stock. There was no way the IRS was going to let a limited partner buy social security credits on the back of a limited partnership investment. No sir. Go get a job.

Fast forward about twenty years. There is a new sheriff in town, and that sheriff is the limited liability company (LLC). The states had created these new toys, and their claim to fame is that one could both work there and limit one’s liability at the same time. Unheard of! A limited partnership could not do that. In fact, if a limited partner started working at the place he/she would lose the protection from partnership liabilities. No limited partner was going to do that voluntarily.

And there you have a tax Regulation written in the 1970s referencing a “limited” partner. Twenty years later something new appears “limiting” one’s exposure to entity liabilities, but not being at all what the IRS had in mind two decades before.

And so the question became: does an LLC member have to pay self-employment tax?

And the issue has recently compounded, because there is also a new ObamaCare tax (the additional Medicare tax of 0.9%) which applies to …. wait on it… self-employment income. Yep, it applies to something the IRS cannot even define.

And then you have tax professionals trying to work with this nonsense. We do not have the option of putting the issue on the shelf until the baby is old enough to go to college. We have to prepare tax returns annually.

So I was looking at something titled “CCA 201436049.” It is nowhere as interesting as the final season of Sons of Anarchy, but it does touch upon our magic two words from the 1970s.

BTW, a “CCA” is a “Chief Counsel Advice” and represents an internal IRS document. It cannot be cited or used as precedence, but it gives you a VERY GOOD idea of what the IRS is thinking.

In our CCA, there is company that manages mutual funds. The management company used to be an S corporation and is now an LLC. The members of the management company pretty much do all the investment activity for the mutual funds, and the management company gets paid big bucks. The management company in turn pays its members via a W-2 and then “distributes” the remaining profit to them. The members pay social security on the W-2 (same as you or I) but not on the distributive share.

OBSERVATION: For the tax purist, a partnership is not allowed to pay its partner a W-2. The reason is that a partner in a partnership is considered to be self-employed, and self-employed people do not receive W-2s. LLCs have thrown a wrench into practice, however, and it is not uncommon to see an LLC member receive a W-2.

To get a CCA, the taxpayer has to be in examination. An IRS person in the field requests direction on how to handle an issue. The issue here is whether that distributive share should be subject to self-employment tax or not. A CCA is therefore like giving instructions to IRS examiners in the field.

The IRS goes through the same tax history we talked about above, and it is very skeptical that just “limiting” someone’s liability was the intent of the 1970s Regulation. It goes on to take a look at two recent cases.

In Renkemeyer, the Tax Court determined that lawyers within a law practice did not fit the “limited partner” exception, especially since they were actively working, something a 1970s “limited partner” could not do. They had to pay self-employment taxes on their distributive income.

In Reither the taxpayer issued W-2s and argued that that was sufficient to keep the rest of the distributive income from being subject to self-employment tax. The District Court made short work of the argument, primarily because there is no statutory support for it.

So … surprise, surprise… the CCA determined that the management company’s distributive share was subject to self-employment tax.

By itself, this is not surprising. What I did notice is that the IRS is paying more attention to this issue, and it is winning its cases. How much longer can it be before Congress finds this “new” source of tax revenue?

Granted, I think the odds of any meaningful tax legislation between Congress and this White House to be close to zero. There will be at least a couple of years.  That said, I suspect that tax planners have only so many years left to ramp this car onto the interstate before Congress takes our keys away.

Ohio Reforms Its Local Income Taxation

I remember having to quickly ramp-up on local taxes after moving to Cincinnati. I grew up in Florida, which has no state or local individual income taxes. We moved here from Georgia, which has a state but no local income taxes. I did not realize at the time that I was moving to a region which has approximately 80% or more of all the local income taxes in the nation – Ohio, Indiana, Pennsylvania and Kentucky.

The Kentucky local individual taxes are – for the most part – occupational taxes. If you do not work in one of those counties or cities, you generally do not have to worry about it. I live in Kentucky, for example, but I pay no Kentucky local income taxes. I do not work in Kentucky.

Indiana has county taxes, but they are filed with the state individual income tax return. Think of it as a “piggy-back” tax.

Ohio had to be different. For one thing, Ohio cities tax their residents, meaning that – if you live within the city – you have yet one more tax return to file. It doesn’t matter whether you work there (in contrast to Kentucky), and in many cases you have to file a return whether you owe tax or not. You might not owe tax, for example, if the city allows (at least some) credit for the local taxes paid to the city where you work (for example, if you live in a suburb but work downtown).

Add to this that each city has local autonomy to determine its taxable base, within the limits of Ohio law. One city could tax supplemental retirement benefits (SERPs), while another would not. One city could allow you to carry over a net operating loss (NOL) to future years, while another city would not.  Even if the city allowed an NOL, your city might allow a carryover of five years, while another would allow only three.

Even for a tax pro, it is a pain.

On December 19, 2014 the Governor signed a bill that promises to bring some standardization to the wild west of Ohio local income taxation. It is called the Ohio Municipal Income Tax Reform Act, and it will be effective for tax years beginning on and after January 1, 2016. The delay was intentional, as tax forms may need to be redesigned and instructions updated. A tax bill signed in December does not leave much time for that. 

Let’s go over the high points:

(1) The calculation of local taxable income will begin with federal adjusted gross income. The adjustments to federal AGI have been significantly standardized and include, for example, interest, dividends and capital gains.

NOTE: There are two cities in Ohio that start with Ohio adjusted gross income (from the Ohio state income tax return). Those two do not have to change to the new law. One of them is in Cincinnati and rhymes with Indian Hill. The effect for residents of Indian Hill is to tax their interest, dividends and capital gains. 

(2) Partnerships and LLCs will be taxed at the entity level only. Partners and members will subtract this income (as an adjustment under (1) above) when calculating their city tax.

That leaves Subchapter S shareholders to discuss.

(3) Subchapter S corporations will also be taxed at the entity level.

In addition, S shareholders may also continue to be taxed at the individual level if they live within 119 selected municipalities.

OBSERVATION: Obviously not as good as the rule for partnerships and LLCs. Why the difference? Who knows.          

(4) Losses from a passthrough entity (that is, a partnership, LLC, Subchapter S or (unlikely) a trust) may offset self-employment, rental, royalty and farming income. The reverse is also true.

(5) Net losses from (4) however cannot offset wages and salaries.

(6) Employee business expenses (that is, “Form 2106” expenses) will be deductible to the extent deducted for federal purposes.

(7) Ohio cities will have to limit their consideration of “domicile” to 25 common law-type tests. The cities are not permitted to add to these 25 tests.

NOTE: This is the “snowbird” test. I have had cities tell me they do not recognize snowbirds. A house there means you are taxed there, whether you spend much time at the house or not.

(8) An employee or sole proprietor is allowed to go into and out of a city for up to 20 days without triggering withholding for that city’s income tax.

NOTE: The previous threshold was 12 days. Notice that we are discussing withholding taxes only. A city may still contact a business for business income taxes if it spots business vans and work trucks stopping within the city.

(9) Pensions are not taxable.

NOTE: SERPs are considered to be wages, not pensions. SERPS are deferred compensation plans, usually funded exclusively by the employer. The tax reporting for a SERP is done on Form W-2 - the same reporting as one's wages or salary - so the cities take the position that SERPs are wages and not pension income.

(10)        Returns will be due (for a calendar year taxpayer) on April 15.

(11)        The returns will be automatically extended if a federal extension is requested.

(12)        Estimated individual income taxes will be required only if the estimated tax due is $200 or more.

(13)        Any tax due (before withholdings or estimates) of $10 or less will be reduced to zero.

NOTE: You still have to file the tax return, though.

(14)        Any interest due will charged at the federal rate plus 5% (Ohio’s rate is federal plus 3%).

(15)        Net operating losses are standardized.

a.     Beginning January 1, 2017 all cities will allow a uniform 5-year carryover (with a phase-in).

b.     Earlier NOLs will be permitted as allowed by pre-change city law.

c.      City NOLs will be calculated using federal limitations such as passive activity, basis or at-risk limitations.

NOTE: This is a subtle but very significant change – in favor of the cities.

(16)        Certain administrative changes, such as requiring the cities to send out an assessment notice -clearly marked “ASSESSMENT” – before they can change your numbers on the city return.

The Ohio Society of CPAs was an outspoken advocate of these changes. I am  sympathetic to arguments the cities raised, but I am nonetheless thankful for some standardization. I prepare or review local returns. I have to bill for this, as this is my profession. I have routinely seen business clients with multiple local returns where the cumulative tax is a fraction of the professional fee to prepare the returns. I submit that a tax is unfair when the preparation fee routinely exceeds any tax so raised. Call it Hamilton's razor if you wish. 

By the way, I would apply the same razor to federal and state taxes. A corollary to the razor would require Congress to reduce its revenue estimates from any proposed tax by the compliance costs (that is, the professional fees) of complying with said proposed tax. I suspect we wouldn't see as much nonsense as we presently have in the tax Code.
 

If I Had A Pony, I Would Ride It On My (Tug) Boat

If you have a business, and especially if that business has real estate, odds are very good that your tax advisor will talk to you about the “repair regulations” this filing season.

The IRS and taxpayers have spent decades arguing and going to court over whether an expenditure is a repair (and immediately deductible) or a capital improvement (which cannot be deducted immediately but rather must be depreciated over time). Eventually the IRS decided to pull back, review the existing court cases and develop some rhyme or reason for tax practice in this area. They were at it for years and years.

And now we have the “repair regulations.”

I debated whether to write on this topic, as one can leave the pavement and get lost in the weeds very quickly. It is like a romper room for tax nerds. Still, we have to at least discuss the high points.

Let’s set this up. Say that you have a tug boat. The boat is expected to last you approximately 40 years, if you maintain and keep it up. Every 4 or so years, you anchor the tug and give it a good overhaul, replace what needs replacing and rebuild the engine. This is going to cost you well over $100 grand.

Question: is this a repair (hence deductible) or a capital improvement (not immediately deductible but depreciable over time)?

It is not immediately clear. This costs a lot of money, so one’s first response is that it has to be capitalized and depreciated. However, regular use of a tug presumes heavy maintenance of this kind over its life. That sounds more like a repair expense.

The IRS has introduced the concept of a unit of property. We have to base the repair versus capitalization decision on the unit of property. Is the engine the unit of property (UOP) or is it the overall boat?

The main test for UOP is “functional interdependence.” The placing in service of one thing depends on the placing in service of something else.

Well, a tug boat engine without a tug boat to put it in is not of much use to anybody, so we would say that the overall boat is the unit of property.

Progress. Do we now know whether to capitalize or deduct the engine?

Nope.

Onward.

We next climb through a fence we will call the “BAR,” which stands for

·        Betterment

·        Adaptation

·        Restoration

If you get stuck on any rung of the “BAR,” you have to capitalize the cost. Sorry.

Let’s have a quick peek at which each term means:

·        Betterment

o   You made the thing larger, stronger, more efficient.

We did not turn the thing into a “monster” tug. Let’s move on.

·        Adaptation

o   You tweaked the thing for a different use or purpose.

Nope. It’s still a tug. Can’t fly it or drive it on a highway.

·        Restoration

o   Returning the thing to a usable condition after you have run it into the ground, either because you neglected it (and it fell apart) or it just got too old.      

Doesn’t sound like it. We are not neglecting the tug in any way, and it still has many years of use left.

This is looking pretty good for our tug.

Let’s go through a few more rules, just in case.

If your CPA prepares audited financial statements for you, the IRS will not challenge your deducting something up to $5,000 as a repair as long as you did the same thing on your financial statements.  

That tug thing costs way more than $5,000. Let’s continue. 

NOTE: BTW, if you do not have an audit, the IRS drops that dollar limit down to $500.

If we are talking about “materials and supplies,” the IRS will not challenge your deducting something as long as it costs $200 or less. Fuel for that tug would be considered “materials and supplies.” 

That tug work blew past $200 like it was standing still. Let’s proceed.

If you capitalize the thing on your books and records, the IRS will not argue that you should have deducted it instead.

            Downright charitable of them. Let’s move on.

If a repair is expected to be done more than once over the life of the UOP, then the IRS will not challenge your deducting it as a repair.

Whoa. We have something here. That boat is expected to last somewhere around four decades. The heavy maintenance has to be done every so many service hours, generally meaning every three or four years. Looks like we can deduct the repairs to our tug.

Let’s dock the tugboat and briefly discuss a building. Perhaps we can see our tug from our building.

The IRS is taking the position that a building is both one unit of property and more than one unit of property.

I do not make this up, folks.

The IRS wants certain systems of a building – like its HVAC or its elevators – to also be considered a separate UOP. Let’s take an example. Let’s say that you are replacing a bunch of windows on that building. You would then evaluate whether it is a repair or an improvement by reference to the building as a whole. This is a good thing, as it would take a lot to “improve” the building as a whole. This makes it more likely that the answer will be a deductible repair.

However, say that you replace an elevator. The IRS says that you have to look at elevators separately from the overall building. We’ll, it does not take much to improve an elevator if you are just comparing it to an elevator. This is a bad thing, as it makes it more likely that the result will be a capital improvement.

BTW there is a separate test if your building costs less than a $1 million when you bought it. The IRS will “spot” you a certain amount before it will challenge whether something is a repair or not. It’s for the smaller landlords, but it is something.

And there you have the highlights of the repair regulations.

Depending on your fact patterns, there may be elections and forms that you have to attach to your tax return. Your tax advisor may even request that you change your underlying bookkeeping – like expensing stuff under $5000/$500 on your general ledger, for example. Some of these will require extra work, and hence additional fees, by and from your advisor.

And there is one more thing.

Let’s go back to the tugboat.

Let’s say that you did the major overhaul four years ago and capitalized the cost. You are now deducting those repairs over time as depreciation. The new rules now allow you to deduct the cost immediately as a repair. Had we only known!

Is it too late for us? Four years back is one more year than the statute of limitations permits, so we cannot go back and amend your return.

The IRS – to their credit – realized the unfairness of this situation, and it will let you go back and apply these new rules to that old tax year. The IRS calls it a “partial disposition,” and you can deduct what’s left of that capitalized tugboat repair on your 2014 tax return. It is called a “Change in Accounting Method” and is yet another multi-page form with your return, but at least you can get the deduction. But only on 2014. Let it slip a year and you can forget about it.

If any of the above rings a bell, please discuss the “repair regulations” with your tax advisor. Seriously, after 2014 you may be stuck. Tax does not have to be fair.

Lyle Lovett - If I Had A Boat