Limited liability companies (LLCs) have become the entity of choice for many businesses. That's largely because LLCs combine the S corporation benefits of flow-through taxation and limited liability along with partnership-type flexibility for distributions and ownership interests.
But the news isn't all good. Operating as an LLC rather than an S corporation carries downsides. Specifically, LLC members (owners) are treated as partners and are, therefore, subject to self-employment (SE) tax.
In 2004, the total SE tax rate is 15.3 percent. Breakdown: The Social Security portion of the tax (12.4 percent) is applied against the first $87,900 of earnings. The Medicare portion (2.9 percent) applies to all SE income, without limit.
But fear not; a couple of wise moves can help LLC owners pare down their SE tax obligations.
Wiggle through partnership loophole
The SE tax applies to most trade or business income. But certain items are excluded from the tax, including real estate rentals, dividends, interest and limited partners' shares of partnership net income.
That last exclusion—limited partners' profits—might provide you an escape from SE tax if LLC members can be considered limited partners. No definitive IRS guidance exists on this topic, but the IRS did issue proposed regulations in 1997.
The regulations, in effect, say you can be treated as a limited partner for SE tax purposes by meeting all of these conditions:
1. You must avoid personal liability for the LLC's debts.
2. You have no authority to contract on behalf of the LLC.
3. You participate in the LLC's operations 500 hours or less during the year.
Note: If your LLC offers services in health, law, engineering, architecture, accounting, actuarial science or consulting, none of the service providers will be considered limited partners for SE tax purposes.
2 ways to qualify as limited partner
With those basic rules in mind, here are two strategies for qualifying as a limited partner and, thus, avoid SE tax:
1. Divide and conquer. You could segregate your company's business activities into separate LLCs. If you provide less than 500 hours of service to each separate LLC and a nonmanager member, you'll likely meet the limited partner tests, and your income will not be subject to SE tax.
2. S may stand for savvy. You could form an S corporation to hold your LLC interest. Then the S corporation could lease your services (as an employee of the S corporation) to the LLC.
Any salary paid to you by the S corporation would be subject to Social Security and Medicare taxes. But neither your share of LLC profits paid to the S corporation nor your share of the S corporation's profits would be subject to SE tax.