SE Tax, LLC Interest & Hindsight?

11/15/2012

When you work for someone else, the employer pays ½ of the FICA/Medicare tax and you pay the other ½.  Conversely, when you are self-employed, which also includes a partner in a partnership, you pay 100% of the self-employment tax (“SE Tax”) (i.e., currently 15.3% for which there is a deduction from adjusted gross income for ½ of the actual SE Tax).  A limited partner in a partnership generally is not subject to SE Tax unless, for example, the limited partner receives re-numeration for services rendered (e.g., a guarantee payment).  Further, an LLC with more than one member is generally taxed as a partnership for federal income tax purposes. 

In Howell v. Comm’r, TC Memo. 2012-303 (November 1, 2012), a husband and wife formed a California limited liability company (hereinafter “LLC”).  The wife had better credit so they intended to use her credit and credit card to secure loans for the LLC. The wife held 60% of the membership units and her husband the remaining 40%.

On October 1, 1999, the LLC entered into an agreement with the husband whereby he would provide management services to the LLC. The wife signed the management agreement on behalf of the LLC.   The wife executed documents on behalf of the LLC and discussed marketing strategies with her husband.

On its 2000 and 2001 tax returns, the LLC reported gross receipts of $300,000 and $380,000 respectively; ordinary income of $12,000 & $18,000 respectively; guarantee payments of $165,000 & $259,000 respectively; and substantial partnership distributions to the husband and wife.  Upon audit, the IRS determined that the guarantee payments were subject to SE Tax.  As a result of that fact, the taxpayers attempted to disavow the form of the payments as guarantee payments that would not be subject to SE Tax.  As a general matter, a taxpayer is bound to their form while both the IRS and the courts can look to the substance of a transaction.  In order for a court to allow a taxpayer to disavow the form of the transaction, the taxpayer must then introduce strong proof to establish the taxpayer's claimed substance of the transaction; a preponderance of credible evidence is not sufficient. (See Estate of Durkin v. Comm’r , 99 T.C. 561, 572-574 (1992); Ill. Power Co. v. Comm’r,  87 T.C. 1417 (1986)).

The taxpayers failed to meet their burden of proof (“strong proof” is the threshold in order to disavow the form) that the wife received the payments in exchange for services and they failed to establish how much of the payment was for services.    

Howell highlights at least two items: 1. “Books & records” means more than simply bank statements and receipts/invoices.  To the extent there are agreements supporting the provision of services or sale of goods between related parties, the best defense is to have a third party expert study that substantiates the charges. 2. It is virtually impossible to call an audible after the play has ended.   Finally, the new 3.8% Medicare tax contained in the Patient Protection and Affordable Care Act (a/k/a “Obamacare”) could impact LLCs taxed as partnerships.   If the wife in Howell were to successfully have argued that her distributive share of the LLC's income is not subject to self-employment tax on the grounds that she is akin to a limited partner and not active in the business, this income is likely subject to the 3.8% Medicare tax. However, if the member treats a portion of the distributive share of the LLC's income as income from self-employment on the grounds that he or she is an active member, the 3.8% Medicare tax would not apply.

IRS Circular 230 Disclosure: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. 

This material is for informational purposes only. It is not intended to be and should not be construed as legal advice.