Small Business Owners and Partners Need to Remember the Tax Consequences of Self-Employment

(Last Updated On: January 24, 2017)

The nature of an individual’s tax liability will typically rely upon whether they are employed by an employer or self-employed.

An employer matches the social security contribution (or pays both portions), but the self-employed person is required to absorb the entire cost of the social security tax.

Persons subject to the self-employment tax include sole proprietors and the members of a partnership, which for tax purposes includes members of a limited liability company (LLC) taxed as a partnership.

For a partner, a distributive share of partnership income is generally treated as earnings from self-employment making the share subject to the self-employment tax. However, a limited partner can exclude his or her share of partnership income from self-employment income since it is not related to employment related activities (unless that income is received as guaranteed payments, such as salary and professional fees for services performed during the year—these do constitute self-employment income, since they represent compensation).

This distinction is less clear with a limited liability company, which is generally taxed as a partnership unless an election is made to have it taxed as a corporation. (A single member LLC is taxed as a sole proprietorship, unless it too elects to be taxed as a corporation.) Because members of an LLC are neither general nor limited partners, the application of self-employment taxes to members has been unclear. Proposed regulations were issued in 1997 and were quickly denounced by members of Congress as unduly subjecting individuals to self-employment tax. In the Taxpayer Relief Act of 1997, Congress included a provision prohibiting the issuance of final regulations and a Senate resolution stated that the Treasury Department should withdraw them. The IRS has to date taken no further action with respect to the proposed regulations; they were never finalized. We can only presume that the proposed regulations continue to reflect the views of the Internal Revenue Service and they will serve as the basis for this discussion.

The proposed regulations intend to apply the same standards to LLCs as apply to limited and general partnerships. They adopt an approach that focuses upon the relationship between the individual, the entity and the entity’s business. Generally, a member will be treated as a limited partner (and thus excluded from counting partnership income as self-employment income) unless the individual (1) has personal liability for the debts of or claims against the entity; (2) has statutory authority to contract on behalf of the entity; or (3) participates in the entity’s trade or business for more than 500 hours during the taxable year. (Note: if substantially all the activities involve the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science or consulting, an individual who provides services as part of that trade or business would never be considered a limited partner.)

Under the proposed regulations, there is also the possibility of bifurcation: an individual who is not a limited partner under the above criteria would be permitted to exclude from net earnings from self-employment a portion of his or her distributive share if he or she holds more than one class of interest in the entity. Thus, a member of an LLC might be able to hold an interest tantamount to a general partnership interest while also holding a limited interest that would not be subject to self-employment tax.

The self-employment income issue is another example of the folly of characterizing an S corporation as “a corporation taxed like a partnership.” While in both cases there is no tax at the entity level (items of income, gain or loss flow through to the owners of the entity), there are a myriad of instances where the tax treatment is far from identical. One instance: an S corporation shareholder’s share of the income of the entity is simply not subject to self-employment tax and no analysis as to liability or hours worked is necessary to reach this determination.

Of course, payments to an S corporation shareholder for services rendered will be subject to social security or self-employment tax. Where traditionally the issue of unreasonable compensation had the IRS asserting that an entity owner was receiving excess compensation (some of which should accordingly be taxed as dividends that are not deductible to the corporation), in the S corporation setting this issue arises more likely in an assertion that compensation is insufficient in light of the services performed and that an ostensible share of the distributive income should be reclassified as compensation.

One may ask how important this is when social security taxes for old age, survivors, and disability insurance (OASDI) applies only to wages paid within an OASDI wage base of $106,800. The answer lies in the fact that there is a Medicare tax component of 2.9% on self-employment income that applies to all earnings from self-employment. A self-employed person earning $100,000 over the OASDI wage base would incur an additional $2,900 of self-employment tax.

Note: As of the writing of this article, President Obama’s healthcare proposal would apply the 2.9% Medicare payroll tax to “interest, dividends, annuities, royalties and rent” and may also apply it to capital gains, though the latter has not yet been explicitly mentioned in the proposal. This tax would apply to singles earning more than $200,000 and joint filers over $250,000. It would come on top of the Senate healthcare bill’s 0.9% increase in the payroll tax, which would bring the combined employee-employer (or self-employed) share to 3.8%. Obviously, this would increase the significance of the classification of an individual’s share of an entity’s income.