Net income from self-employment is defined in Sec. 1402(a) as net income from any trade or business plus the distributive share (whether or not actually distributed) of income or loss (to the extent a loss is not limited by the basis, passive activity, at-risk, or other rules) from any trade or business carried on by a partnership (including a limited liability company (LLC) classified as a partnership for federal income tax purposes). Rev. Rul. 65-272 provides that items of income and allowable deductions attributable to any trade or business carried on by a partnership that are required to be taken into account separately under Secs. 702(a)(1) through (8), plus any distributive share of partnership income or loss, are considered as realized from a trade or business and used in computing an individual partner’s net earnings from self-employment to the extent not otherwise excluded under Sec. 1402(a). This general rule implies that members of an LLC classified as a partnership are subject to self-employment (SE) tax on their share of the LLC’s income from a trade or business. However, Sec. 1402(a)(13) provides an exception for limited partners.
Note: Since the existence of a single-member LLC (SMLLC) is disregarded for most federal tax purposes (unless the SMLLC elects to be classified as a corporation), an individual who owns a disregarded SMLLC that is engaged in a business clearly is subject to SE tax on the SMLLC’s net income.
Related SE tax issues facing LLCs
Guaranteed payments, whether received for services or for the use of capital, are included in an individual’s net earnings subject to SE tax unless they are received from an LLC that is not engaged in a trade or business (Regs. Sec. 1.1402(a)-1(b)). With a few limited exclusions, “trade or business” has the same broad meaning for this purpose as it has in Sec. 162 (Sec. 1402(c); Regs. Sec. 1.1402(c)-1). The exclusions are those set forth in Secs. 1402(c)(1) through (6) and Regs. Secs. 1.1402(c)-2 through -7 (e.g., services performed as an employee covered by Social Security or the Railroad Retirement program, certain services performed as a public official, and certain services performed by ordained ministers and other religious personnel).
Planning tip: A limited partner is subject to SE tax on guaranteed payments only to the extent they are received for services (Sec. 1402(a)(13)).
A member’s treatment of a payment for SE tax must be consistent with the treatment on the LLC’s Form 1065, U.S. Return of Partnership Income. In Howell, T.C. Memo. 2012-303, the court concluded that payments treated as guaranteed payments on the return filed by the LLC were guaranteed payments subject to SE tax on the member’s return, despite the member’s argument that she provided only minimal services to the LLC.
An LLC may be considered to have a trade or business when classifying a guaranteed payment as SE income, even though the income and related deductions from certain activities are generally excluded from SE income. This would be the case, for example, when the LLC is engaged in a rental real estate activity that rises to the level of a trade or business. Although a member’s distributive share of the LLC’s income from the rental real estate is not subject to SE tax (provided the member is not a real estate dealer) under Sec. 1402(a)(1) and Regs. Sec. 1.1402(a)-4, a guaranteed payment received from such an LLC would be subject SE tax.
When the LLC’s income is predictable, a member in this situation wishing to avoid SE income might rather receive a preferential allocation of LLC income than a guaranteed payment of the same amount. Even though the economic effect to all concerned would be generally the same, the income from the preferential allocation would be part of the member’s distributive share of rental income and would be excluded from SE income, whereas the guaranteed payment would constitute SE income.
Caution: Under Sec. 707(a)(2), if a member performs services for an LLC and receives a related income allocation and distribution, the arrangement may be treated as a payment to a third party for services. Under proposed regulations, when this disguised-payment-for-services rule applies, it applies for all purposes of the Code, including SE taxes.
Planning tip: Although a guaranteed payment and a preferential income allocation followed by a distribution can be economically similar, guaranteed payments received by members are not qualified business income (QBI) for the Sec. 199A deduction. On the other hand, a preferential income allocation can be QBI, provided the arrangement is not recharacterized as a disguised payment for services. Note, however, that a preferential income allocation is not guaranteed, so the member is exposed to the risk that the LLC will have little or no income to allocate.
A guaranteed payment is SE income only if the recipient is an individual or a disregarded entity (such as an SMLLC or a grantor trust), the income of which is taxed to an individual. Other types of recipients, such as C corporations, S corporations, or partnerships, are not subject to SE tax. If a guaranteed payment is received by an LLC, the income will pass through to the members and may be subject to SE tax under generally applicable rules, but not because the income received by the LLC was a guaranteed payment (Sec. 1402(a)).
Certain retirement payments to LLC members are not subject to SE tax, provided they meet specific requirements. The payments must be made under a written retirement plan that provides for bona fide retirement payments on a periodic basis to members generally, or to a class or classes of members, and the payments must continue at least until the member’s death. To constitute bona fide retirement payments, the payments must be paid on account of retirement and measured by and based upon such factors as years of service and compensation received. Eligibility to receive such retirement payments generally must be based on age or physical condition or a combination of age or physical condition and years of service (Regs. Sec. 1.1402(a)-17(b)(1)).
Members as employees
Members of an LLC that is classified as a partnership for federal income tax purposes cannot be employees of the LLC for employment tax purposes (Rev. Rul. 69-184). Some taxpayers have attempted to avoid this rule by hiring a certified professional employer organization (CPEO) to treat partners/ LLC members as employees. A CPEO is an employee leasing company that meets certain criteria (see Regs. Sec. 301.7705-1(b)(1)). A CPEO can be treated as the sole employer of any worksite employee who is included in a service contract between the CPEO and a customer (Sec. 3511).
Proposed regulations under Sec. 3511 led some practitioners to believe that, in some cases, a partner could be treated as an employee of a CPEO rather than as self-employed. But the IRS clarified in Chief Counsel Advice (CCA) 201916004 that payments made by a CPEO to a partner in a partnership under a contract between the partnership and the CPEO must always be treated as a payment to a self-employed individual.
Planning tip: LLCs sometimes grant a profits interest to employees as incentive compensation. The LLC and the individual might prefer that the individual retain employee status, especially if the profits interest is relatively small. CCA 201916004 indicates that the IRS considers Rev. Rul. 69-184 to apply without exception. Although the IRS has asked for comments in the past about situations where it might be appropriate to treat partners as employees, there is currently no basis for treating individuals who are partners as employees for employment tax purposes.
As a general rule, rental income from real estate (including personal property leased with the real estate) is exempt from SE tax, unless the taxpayer is a dealer in real estate (Regs. Sec. 1.1402(a)-4(a)). This rule applies regardless of how the activity is characterized under the passive-activity-loss rules. However, income derived from renting living space (private residences or multiple-housing units such as condos) is not considered income from real estate rental if services are also rendered to the occupant (Regs. Sec. 1.1402(a)- 4(c)). Furnishing heat and light; cleaning public entrances, exits, stairways, and lobbies; or collecting trash are not considered to be services rendered to the occupant. But services rendered primarily for the occupant’s convenience (such as maid service) do subject income from the rental activity to SE tax.
Whether services provided in connection with renting out a living space are for the occupant’s convenience depends on the facts. CCA 202151005 provides two examples related to short-term rentals offered on an online marketplace (such as Airbnb or VRBO). In the first situation, the taxpayer rented fully furnished vacation property and provided daily maid service, access to dedicated Wi-Fi, recreational equipment for the occupants’ use, and prepaid vouchers for ride-share services from the property to the nearest business district. Here, the IRS attorneys concluded that the services were provided for the occupants’ convenience because they were not clearly required to maintain the space in a condition for occupancy and were so substantial that the compensation for them constituted a material portion of the rent. So, the net rental income from those properties was SE income.
In the second situation, the taxpayers rented a fully furnished room and bathroom in their home. Renters could access the home’s common areas only to enter and exit their room and bathroom. They had no access to other common areas such as the kitchen and laundry room. The taxpayer cleaned the space between each occupant’s stay. Here, the net rental income was not SE income because the services were not primarily for the occupants’ convenience. Instead, the services (cleaning and maintaining the property) kept it suitable for occupancy.
Income from renting personal property is SE income if the taxpayer is in the trade or business of renting such property. Generally, based on the Supreme Court’s decision in Groetzinger, 480 U.S. 23 (1987), a trade or business is an activity that the taxpayer engages in regularly and continuously with the primary purpose of generating income or profit.
Shaun M. Hunley, J.D., LL.M., is an executive editor with Thomson Reuters Checkpoint. For more information about this column, contact firstname.lastname@example.org.
This case study has been adapted from Checkpoint Tax Planning and Advisory Guide’s Limited Liability Companies topic. Published by Thomson Reuters, Carrollton, Texas, 2022 800-431-9025); tax.thomsonreuters.com).