FICA Tax Planning Using LLCs
Posted on 10/17/2016 at 12:00 AM by David Repp
LLCs may have some tax disadvantages to S corporations when it comes to FICA tax planning. Dividends paid to an S corporation shareholder (absent reasonable compensation issues, discussed above) are normally never subject to FICA taxes, whereas earnings and profits of an LLC's trade or business allocable to LLC members who are involved in the LLC's business will be subject FICA taxes. IRC § 1402. However, earnings and profits from the LLC allocable to LLC members who are not involved in the LLC's business may be excluded from FICA taxation. IRC § 1402(a)(13). To accomplish FICA taxation avoidance for a member, a member must not:
- have personal liability for the debts of, or claims against, the LLC by reason of being a member;
- have authority to contract on behalf of the LLC under the statute or law pursuant to which the LLC is organized; or
- participate in the LLC's trade or business for more than 500 hours during the taxable year. Prop. Treas. Reg. § 1.1402(a)-2(h).
Some courts have recently focused on just two factors: (1) the owner of the interest must not be actively participating in the partnership’s business, and (2) the income received by that person must be in the nature of investment income. Renkemeyer, Campbell & Weaver, LLP, 136 T.C. No. 7 (Feb 9, 2011).
CAUTION: If substantially all the activities of an LLC involve the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, or consulting, the proposed regulations provide that any individual who provides services as part of that trade or business is not exempt from FICA taxation. Prop. Treas. Reg. § 1.1402(a)-2(h).
The proposed regulations indicate an LLC member can own dual interests in an LLC that have tax characteristics of a general partnership interest and a limited partnership interest. Prop. Reg. §1.1402(a)-2(h). The theory is that income from the LLC interest that looks like a limited partnership interest is not subject to self-employment tax. Prop. Reg. §1.1402(a)-2(h)(3). Thus, some practitioners have advocated that an LLC member who is actively involved in the LLC may be able to bifurcate his or her share of the LLC income between two different types of membership interests: one membership interest that has characteristics of a limited partnership interest and another that has the characteristics of a general partnership interest. This seems to be specifically allowed under the Proposed Regulations. Prop. Reg. §1.1402(a)(2)(h)(3). However, there is no authority (a part from the proposed regulations) to substantiate these practitioners' position.
Other practitioners take the position that a member who is actively involved in the business of the LLC cannot artificially bifurcate their income as subject to FICA tax and not subject to FICA tax. This position is based on several recent court cases that treat LLC members as “general” partners for passive activity rule purposes. See, e.g., Thompson v. U.S., 87 Fed. Cl. 728, acq. in result only, AOD 2010-02, 2010-14 I.R.B.; Garnett v. Comr., 132 T.C. No. 19 (2009); Gregg v. U.S., 186 F. Supp. 2d 1123 (D. Or. 2000); see also Temp. Reg. 1.469-5T(e)(3)(ii) (stating that any limited partner owning a general partnership interest will be classified as materially participating-no bifurcation allowed). These practitioners claim that it is inconsistent to treat a member as actively engaged in a trade or business but yet not be subject to FICA tax.
A Chief Counsel Advice (“CCA”) memorandum issued September 30, 2016, echoes cases that hold a partner’s interest cannot be bifurcated. CCA 20160014. In the CCA, a partner holding the majority interests in a limited liability company owning and operating certain franchises was required to include all his allocated partnership income as self-employment subject to FICA tax. The partner was the chief executive with power to contract, hire and fire employees and generally made all business decisions concerning the business. The partner attempted to bifurcate his income between guaranteed payments which are always subject to FICA tax, and income from his limited partnership interest which he claimed reflected investment income. The CCA responded by saying that because he held and exercised significant management authority, all his income from the franchisee business is subject to self-employment income. Obviously, the IRS is pushing for a bright-line rule to apply in these matters rather than the subjective analysis in determining which part of income is from services and which part is from investment of capital.
The material in this blog is not intended, nor should it be construed or relied upon, as legal advice. Please consult with an attorney if specific legal information is needed.
- David Repp
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