United States: Choice Of Business Entity: Do Self-Employment Taxes Disfavor Limited Liability Companies? (An Update)

In a previous newsletter,¹ I argued that a properly structured limited liability company ("LLC") should be able to mitigate self-employment taxes just as effectively as a limited partnership or S corporation, and recommended that business owners not organize (or classify) their business entities as S corporations solely on account of self-employment tax considerations.

Since the prior newsletter was published, there have been two developments that have caused some tax advisors to again recommend that business owners convert their limited partnerships and LLCs to S corporations. One development is the Renkemeyer case,² which some have interpreted as imposing self-employment tax on all limited partnership income of non-passive partners (including LLC members). The other development is the new 3.8% tax on net investment income, which some argue gives an S corporation an added tax advantage over limited partnerships and LLCs.

As discussed below, neither of these developments justifies abandoning the LLC as a favored business entity structure for many businesses.

BACKGROUND

Employment Taxes on Wages

Income an individual receives as employee wages is subject to employment taxes at a combined (employer and employee) tax rate of 15.3% on the first $113,700 of wages (indexed), and 2.9% on the excess. For 2013 and later years, the 2.9% rate on excess wages is increased by 0.9% (to 3.8%) for certain high income individuals (married individuals filing jointly with greater than $250,000 of modified adjusted gross income, and single individuals with greater than $200,000 of modified adjusted gross income). The additional 0.9% tax is imposed solely on the employee.

Self-Employment Tax ("SET")

SET is imposed on income derived by an individual from any trade or business carried on by the individual, including the individual's distributive share of income from a partnership trade or business. SET generally does not apply to passive investment income or to gains from capital assets. The tax is imposed at the same rates as the taxes on wages (with any taxable wages counted against the $113,700 base).

Significantly, SET is not imposed on the distributive share of income of "a limited partner, as such," other than guaranteed payments for services actually rendered. The history and intent of this "limited partner exception" is discussed in the prior newsletter.

RECENT DEVELOPMENTS

Renkemeyer Case

Renkemeyer involved an attempt by a three law partners to avoid SET on their law firm earnings. The law firm was organized as a general partnership that elected to be classified as a limited liability partnership. The election did not change the firm's legal status as a general partnership, did not diminish any partner's authority as a general partner, and did not comprehensively limit any partner's liability for partnership obligations. For 2004, the partnership allocated 88% of the firm's income to an S corporation that had a 10% interest in partnership profits. For 2005, the partnership allocated 97% of the partnership income to the three partners as holders of a special class of partner interests ("investing partner interests") which the partners claimed was exempt from SET.

The Tax Court rejected the special allocation of income to the S corporation for 2004, and concluded all of the partnership's income allocable to the law partners for each year was subject to SET. Referencing the legislative history of the SET limited partner exception, the court concluded that the partners' distributive shares of income were subject to SET because the income was not "earnings of an investment nature," but rather arose from services performed. The court's analysis suggested that only a wholly passive limited partner is protected from SET under the limited partner exception.

Tax on Net Investment Income ("NIIT")

Beginning in 2013, IRC Section 1411 imposes a tax of 3.8% on net investment income of certain high income taxpayers. Net investment income is defined to include not only traditional types of investment income (interest, dividends, annuities, royalties, rents, and net capital gains), but also income derived from (a) a passive activity (within the meaning of IRC Section 469) with respect to the taxpayer, or (b) a trade or business of trading in financial instruments or commodities. Net investment income does not include any income taken into account in determining SET.

IRC Section 469 generally defines a "passive activity" as a trade or business in which the taxpayer does not "materially participate" as defined in applicable regulations.

IMPLICATIONS

Renkemeyer

Renkemeyer involves such an egregious case of overreaching that it should have little precedential effect on cases involving properly structured and documented limited partnership or LLC arrangements. The simple fact that the partnership in Renkemeyer was a general partnership with no limits on any partner's management rights and no comprehensive limited liability protection for any of its partners should alone be sufficient to distinguish the case and limit its holding to its facts. Also, the fact that the law partners received little or no direct compensation for services rendered is another factor easily distinguishing that case from a properly structured arrangement. Finally, the fact that the Renkemeyer involved a personal services business would also distinguish the case from arrangements involving more capital intensive businesses. For all of these reasons and others, Renkemeyer should not be read as broadly restricting the limited partner exception to purely passive limited partners.

Tax on Net Investment Income

Some tax advisors are again touting S corporations as a preferred form of business entity because it can be operated free from both SET and NIIT. The advice is sound as far as it goes: if (a) the S corporation is engaged in the active conduct of a trade or business (other than trading in financial instruments or commodities), (b) the individual materially participates in the S corporation's business (typically as an employee), and (c) the individual is adequately compensated for services rendered to the business (typically through wage payments), the residual income allocated to the individual as a shareholder should escape both SET and NIIT. The residual income is not self-employment earnings because the income is derived from a business carried on by the S corporation and not by the individual. The residual income is not net investment income because the individual materially participates in the S corporation's business (i.e., the income is not derived from a passive activity).

Although the SET and NIIT advantages of an S corporation are real, what is often not addressed is whether the resulting tax savings (if any) will be significant relative to the many disadvantages of operating as an S corporation (e.g., limitations on types and number of shareholders, ban on multiple classes of ownership interests, basis limitations, restrictions on tax-free transfers of appreciated property to and from the business, and limitations on stepped-up basis sale transactions). In many cases, the potential tax savings either do not materialize or do not come close to justifying the disadvantages of operating as an S corporation.

Another overlooked or misunderstood issue is whether a limited partnership or LLC can achieve the same SET and NIIT benefits as an S corporation.

In the case of an LLC, while income derived as a member is not literally within the SET limited partner exception, the IRS has previously acknowledged that a member in an LLC classified as a partnership for federal income tax purposes can be a "limited partner" for SET purposes. Accordingly, as explained in the previous newsletter, if the individual does not have authority to bind the LLC in his capacity as a member, and if the individual materially participates in the LLC in the individual's separate capacity as a manager (or preferably as an employee of a manager entity) and is adequately compensated for those services, then the individual's allocable share of income as a member should be exempt from SET under the limited partner exception. Such income should also be exempt from NIIT (because the activity is not a passive activity with respect to the taxpayer).

CONCLUSION

Neither the Tax Court decision in Renkemeyer nor the new NIIT appreciably impacts the calculus on whether a closely-held business should be organized as a limited partnership, an LLC, or an S corporation. For most closely held businesses, an LLC continues to be the preferred choice of business entity.

An S corporation is often the least attractive choice of flow-through business entity. Even if an S corporation offered SET and NIIT advantages over limited partnerships and LLCs, the actual tax savings (if any) are often insignificant relative to the drawbacks of operating as an S corporation. Moreover, there is a strong argument that an S corporation enjoys no SET or NIIT advantages over an LLC.

So if your advisor is recommending that you organize your business as, or convert it to, an S corporation rather than operating as a limited partnership or LLC, it might make sense to get a second opinion.

Footnotes

1 Choice of Business Entity: Do Self-Employment Taxes Disfavor Limited Liability Companies?, Strasburger Business and Law Newsletter (April 2008).

2 Renkemeyer, Campbell & Weaver, LLP v. Commissioner, 136 T.C. 137 (2011).

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.